Lecture Note 8 - Market Efficiency

Investments (BUS2007)
Spring 2023
Lecture Note 8.
Market efficiency
(Reference Book Chapter 8)
Da-Hea Kim
Intro (1)
 Market efficiency
 Market prices fully reflect all available information quickly.
 Securities are correctly priced, reflecting all relevant information.
 Do you believe that markets are efficient?
 Market efficiency is a highly controversial topic.

 Evidence is mixed.
 Efficient Market Hypothesis (EMH)
Da-Hea Kim Lecture note 8. Market efficiency 2

Intro (2)
 The investment strategy depends on the belief in market efficiency.
 Suppose that you are a proponent of the EMH. Which of the two investment
strategies―the active investment strategy & the passive investment
strategy― should you follow?
⇒ The investment strategy
• Active investment strategy: Picking mispriced securities to outsmart the market.

• Passive investment strategy: Buying and holding a well-diversified portfolio without
attempting to search out mispriced securities.
• If the market is efficient, any attempt to beat the market would be futile.

Overview
 Stock price movements under the EMH.
 Random walk
 Event study
 Evidence that contradicts and supports the market efficiency

 Various stock market anomalies
 Performance of professional money managers

Stock price movements under the EMH: Random walks (1)
 Stock price movements
∇ Samsung Electronics’ stock prices over the past 10 days
(April 11, 2023 to April 23, 2023)
 Could you identify any predictable pattern
66,200 66,100
in stock prices?
66,000
66,000 65,900
• Could you predict tomorrow’s stock price
65,800 65,700 based on the past stock prices?
65,600
65,600 65,500
 Does randomness in price changes indicate
65,400
that the market is inefficient?
65,300 65,300
65,200
65,200 65,100 ⇒
65,000
23-4-10 23-4-12 23-4-14 23-4-16 23-4-18 23-4-20 23-4-22 23-4-24 23-4-26

Stock price movements under the EMH: Random walks (2)
 When the stock market is efficient, stock prices should follow a random walk.
 Random walk: Process equally likely to step up or down by the same amount.
 If prices reflect all available information, it must be that stock prices change only in
response to new information.
 New information, by definition, must be unpredictable.
 Stock price predictability: evidence of market inefficiency

Stock price movements under the EMH: Event study (1)
 Stock price movements (returns) around corporate events
 When corporate events (e.g., earnings, M&A, stock splits, issues of new debt or equity, etc.)
occur, new information is revealed to the public.
 In an efficient market, security prices fully reflect all available information quickly.
The size of reaction to
The reaction to news should
news should be proper
occur only at the moment
based on the contents
of news announcement.
of news.
 Test on how security prices moves around various corporate events

• Event study: a statistical method to assess the impact of an event on the value of a firm

 Think about
 Suppose that a company announced reduction in the revenue forecast. There is no other
news relevant to the company value.
 The stock price movements: 100 → 101

 The realized rate of return over the announcement day: _____________
 Does the positive return on the stock imply that the reduction in the revenue forecast is
good news to the company?

 Event study
 To measure the pure reaction to news, we should control for the normal rate of returns.
• AR, Abnormal rate of returns (residual): 𝑨𝑹𝒊𝒕 = 𝑹𝒊𝒕 − 𝑬(𝑹𝒊𝒕 )

 𝐴𝑅 : the abnormal rate of returns
 𝑅 : the actual (observed) rate of returns
 𝐸(𝑅 ) : the normal (ordinary) rate of returns; rates of returns commensurate with the risk of
the security
• CAR, Cumulative abnormal rate of returns

• 𝑪𝑨𝑹𝒊𝝉 = ∑𝝉𝒕 𝟏 𝑹𝒊𝒕 − 𝑬(𝑹𝒊𝒕 )

 Example) A company announced a new agreement to market its respective products in China on July 18.
Assume the company has an expected return equal to the market return. Graph the cumulative abnormal
return (CAR) for the stock.
Market Company Abnormal

Date CAR Day 4.00
return return return
3.50
July 12 -0.2 -0.4
3.00
July 13 0.1 0.3
2.50
July 16 0.6 0.8
CAR (%)
2.00
July 17 -0.4 -0.2 1.50
July 18 -1.9 1.3 1.00
0.50
July 19 -0.8 -0.6
0.00
July 20 -0.9 -1.0 -4 -3 -2 -1 0 1 2 3 4
-0.50
July 23 0.6 0.4
Days relative to event day
July 24 0.1 0.0

 How should the CAR respond to the good news in an efficient market?
CAR (%)
Days relative to event day

-8 -6 -4 -2 0 2 4 6 8
△ Good news announcement

 An inefficient market may underreact/overreact to news.
• If the market underreacts to good news • If the market overreacts to good news
CAR (%) CAR (%)
0 0
Days relative Days relative

-8 -6 -4 -2 0 2 4 6 8 to event day -8 -6 -4 -2 0 2 4 6 8 to event day

Forms of market efficiency (1)
 Market efficiency is relative to type of information
 Weak-form EMH
• Stock prices already reflect all information contained in the history of past trading.
• Past prices, trading volume, or short interest.
 Semistrong-form EMH
• Stock prices already reflect all publicly available information.
• History of past trading + fundamental data on the firm’s product line, quality of management,
balance sheet composition, patents held, earning forecasts, and accounting practices.
 Strong-form EMH
• Stock prices reflect all relevant information, public or private.
• All publicly available information + inside information

 Information sets for market efficiency
Strong-form information set:  Q1) The market is weak-form efficient.

All information of any kind, public or private Then, is the market semistrong-form
efficient?
Semistrong-form information set:
All publicly available information
Weak-form information set:  Q2) The market is semistrong-form

Past price and volume efficient. Then, is the market weak-form
efficient?
 Direction of valid implication

: Strong-form EMH ⇒ Semistrong-form EMH ⇒ Weak-form EMH

 Quiz 1) Suppose that, after conducting an analysis of past stock prices, you come
up with the following observations. Which would appear to contradict the weak
from of the efficient market hypothesis ?
a) The average rate of return is significantly greater than zero.
b) The correlation between the return during a given week and the return during the
following week is zero.
c) One could have made superior returns by buying stocks after a 10% rise in price.
d) One could have made higher-than-average capital gains by holding stocks with low
dividend yields.

 Quiz 2) Which of the following observations would provide evidence against the
semistrong form of the efficient market theory?
a) Mutual fund managers do not on average make superior returns.
b) You cannot make superior profits by buying (or selling) stocks after the announcement of
an abnormal rise in dividends.
c) Low P/E stocks tend to have positive abnormal returns.
d) In any year approximately 50% of pension funds outperform the market.

 Quiz 3) Suppose that the CAR responds to the good news announcement as
follows. Does this support the market efficiency?
CAR (%)
Days relative
-8 -6 -4 -2 0 2 4 6 8 to event day

Evidence against the market efficiency (1)
 Market anomalies
 Patterns of returns that seem to contradict the efficient market hypothesis.
 Well-known anomalies
• Momentum effect
• Reversal effect
• Small-firm effect
• Book-to-market effect
• Post-Earnings-Announcement-Drift

 Momentum effect
 Jegadeesh and Titman (1993)
 Good or bad recent performance of particular stocks continues over intermediate horizon.
 Portfolios of the best performing stocks in the recent past (ex., 12 months) (i.e., ”winners”)
appear to outperform the worst performing stocks (i.e., ”losers”).
 Strategy to make money: Buy ____________, Sell ____________, & Hold for intermediate horizon.
 Implication for market efficiency: _______________ __________-form efficiency.

 Reversal effect
 De Bondt and Thaler (1985)
 Good or bad recent performance of particular stocks is reversed over long horizon.
 Losers rebound and winners fade back.
 Strategy to make money: Buy ____________, Sell ____________, & Hold for long horizon.
└ Contrarian investment strategy
 Implication for market efficiency: _______________ __________-form efficiency.

 Momentum and Reversal effects
 Cumulative profits of momentum strategies across holding periods
CAR (%)
Months relative to
4 8 12 16 20 24 28 32 36 portfolio formation

 The small-firm effect
 Stocks of small firms outperform stocks of big firms.
 Strategy to make money:

25
Buy ______________ & Sell _____________.
20 19.2 17.1
Annual return(%)
16.8 15.9 15.4 15.4
14.6 13.7
15 13.0
 Implication for market efficiency: 11.2
10
_______________ __________-form efficiency.
5
0
1 2 3 4 5 6 7 8 9 10
Size decile: 1 = small, 10 = large

 The book-to-market (B/M) effect
 Stocks with high B/M outperform stocks with low B/M.
20 17.5
 Strategy to make money: 16.4
15.6
Annual return (%)

15 13.2 13.3 13.4
11.9 12.2
Buy ______________ & Sell _____________. 11.0 12.1
10
 Implication for market efficiency: 5
_______________ __________-form efficiency. 0

1 2 3 4 5 6 7 8 9 10
Book-to-market decile: 1 = low, 10 = high

 Post-Earnings-Announcement price Drift (PEAD)
 Firms with positive earnings news tend to outperform firms with negative earnings news
even after firms’ earnings announcements.
 Strategy to make money:

Buy ____________________________
& Sell _____________________________.
 Implication for market efficiency:

_______________ __________-form efficiency.

Interpreting market anomalies (1)
 Risk premiums or Inefficiencies?
 Risk premiums
• Fama and French (1993)
• Stocks with higher factor loadings on size or market-to-book factors have higher average returns;
evidence of a risk premium associated with the factor.
 Inefficiencies
• Lakonishok, Shleifer, and Vishny (1995)
• Anomalies are evidence of systematic errors in the forecasts of stock analysts.
• Analysts extrapolate past performance too far into the future and therefore overprice firms with
recent good performance and underprice firms with recent poor performance.
• Ultimately when market participants recognize their errors, price reverse.

Interpreting market anomalies (2)
 Anomalies or Data mining (data snooping)?
 If one reruns the database of past returns over and over and examines stocks returns along
enough dimensions, simple chance will cause some criteria to appear to predict returns.
 Some anomalies have not shown much staying power after being reported in the academic
literature.
• After the small-firm effect was published in the early 1980s, it promptly disappeared for
much of the rest of the decade.
 How to address the problem of data mining?

• Find a dataset that has not already been researched
• See whether the relationship in question shows up in the new data.

Evidence in favor of the market efficiency (1)
 Think about
 At a cocktail party, your friend tells you that he beat the market for the past
year. Suppose you believe him. Is this a violation of the efficient market
hypothesis?

 Performance of professional money managers
 Even professional money managers have trouble beating the market.
 The distribution of risk-adjusted returns for U.S. mutual funds is bell-shaped, with a
negative mean.
▲ Mutual fund abnormal returns computed using four-factor model, 1993-2007

 Performance of professional money managers
 Test on persistence of mutual fund performance
<Cahart (1997) & Bollen and Busse (2004)>
• Whether better performer in one period continue

to outperform in later periods.
• The flatness of the dashed line: most of the

original performance differential disappears.
• For majority of managers, over- or underperform

ance in any period is largely a matter of chance.
▲ Performance over time of mutual fund groups
by initial-year performance

 The role of professional money managers
 If markets are efficient, little role exists for professional money managers.
 You should shop for low management fees, and you should not work with full-
service brokers.
 The role of professional money managers in an efficient market is to tailor the

portfolio to investors’ risk aversion and tax bracket, rather than to beat the
market.

Conclusion: So, are markets efficient?
 Do you believe that markets are efficient?
 Are stock prices predictable?
 Can you (or anyone else) consistently “beat the market” using a certain
information?

Homework (1)
 A famous economist just announced in The Wall Street Journal his findings that the
recession is over and the economy is again entering an expansion. Assume market
efficiency. Can you profit from investing in the stock market after you read this
announcement? Explain.

Homework (2)
 Determine whether the following phenomena would be either consistent with or
a violation of the efficient market hypothesis.
(a) Nearly half of all professionally managed mutual funds are able to outperform the
S&P 500 in a typical year.
(b) Money managers who outperform the market (on a risk-adjusted basis) in one year
are likely to outperform in the following year.
(c) Stock prices tend to be predictably more volatile in January than in other months.
(d) Stock prices of companies that announce increased earnings in January tend to
outperform the market in February.
(e) Stocks that perform well in one week perform poorly in the following week.

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Investments (BUS2007)

 Do you believe that markets are efficient?

 Market efficiency is a highly controversial topic.

Da-Hea Kim Lecture note 8. Market efficiency 2

⇒ The investment strategy

• Active investment strategy: Picking mispriced securities to outsmart the market.

Da-Hea Kim Lecture note 8. Market efficiency 3

 Evidence that contradicts and supports the market efficiency

 Performance of professional money managers

Da-Hea Kim Lecture note 8. Market efficiency 4

Da-Hea Kim Lecture note 8. Market efficiency 5

 New information, by definition, must be unpredictable.

 Stock price predictability: evidence of market inefficiency

Da-Hea Kim Lecture note 8. Market efficiency 6

 Test on how security prices moves around various corporate events

Da-Hea Kim Lecture note 8. Market efficiency 7

 The stock price movements: 100 → 101

Da-Hea Kim Lecture note 8. Market efficiency 8

• AR, Abnormal rate of returns (residual): 𝑨𝑹𝒊𝒕 = 𝑹𝒊𝒕 − 𝑬(𝑹𝒊𝒕 )

• CAR, Cumulative abnormal rate of returns

Da-Hea Kim Lecture note 8. Market efficiency 9

Market Company Abnormal

July 18 -1.9 1.3 1.00

Da-Hea Kim Lecture note 8. Market efficiency 10

Days relative to event day

△ Good news announcement

Da-Hea Kim Lecture note 8. Market efficiency 11

CAR (%) CAR (%)

Days relative Days relative

Da-Hea Kim Lecture note 8. Market efficiency 12

Da-Hea Kim Lecture note 8. Market efficiency 13

Strong-form information set:  Q1) The market is weak-form efficient.

Weak-form information set:  Q2) The market is semistrong-form

 Direction of valid implication

Da-Hea Kim Lecture note 8. Market efficiency 14

a) The average rate of return is significantly greater than zero.

Da-Hea Kim Lecture note 8. Market efficiency 15

a) Mutual fund managers do not on average make superior returns.

c) Low P/E stocks tend to have positive abnormal returns.

d) In any year approximately 50% of pension funds outperform the market.

Da-Hea Kim Lecture note 8. Market efficiency 16

Da-Hea Kim Lecture note 8. Market efficiency 17

 Patterns of returns that seem to contradict the efficient market hypothesis.

Da-Hea Kim Lecture note 8. Market efficiency 18

 Jegadeesh and Titman (1993)

 Implication for market efficiency: _______________ __________-form efficiency.

Da-Hea Kim Lecture note 8. Market efficiency 19

 De Bondt and Thaler (1985)

 Losers rebound and winners fade back.

 Implication for market efficiency: _______________ __________-form efficiency.

Da-Hea Kim Lecture note 8. Market efficiency 20

 Cumulative profits of momentum strategies across holding periods

Da-Hea Kim Lecture note 8. Market efficiency 21

 Stocks of small firms outperform stocks of big firms.

 Strategy to make money:

Da-Hea Kim Lecture note 8. Market efficiency 22

 Stocks with high B/M outperform stocks with low B/M.

Annual return (%)

 Implication for market efficiency: 5

_______________ __________-form efficiency. 0

Da-Hea Kim Lecture note 8. Market efficiency 23

 Strategy to make money:

 Implication for market efficiency:

 Implication for market efficiency: _____ -form efficiency.

 Implication for market efficiency: _____ -form efficiency.

_____ -form efficiency. 0