Efficient Market

Efficient Capital Market

An efficient capital market is one in which security prices adjust
rapidly to the arrival of new information and, therefore, the current
prices of securities reflect all information about the security. This is
referred to as an informational efficient market.
Efficient market is one where the market price is an unbiased
estimate of the true value of the investment.
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key concepts
Market efficiency does not require that the market price be equal
to true value at every point in time. All it requires is that errors in
the market price be unbiased, i.e., that prices can be greater than or
less than true value, as long as these deviations are random.
Randomness implies that there is an equal chance that stocks are
under or over valued at any point in time.
If the deviations of market price from true value are random, it
follows that no group of investors should be able to every time
find under or over valued stocks using any investment strategy.
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Random Walk:
The efficient market hypothesis is related with the idea of a
random walk, which says that all successive price changes
represent random departures from previous prices.
The logic of the random walk idea is that if the flow of
information is unimpeded and information is immediately reflected
in stock prices, then tomorrows price change will reflect only
tomorrows news and will be independent of the price changes
today.

Random Walk(Cont.):
As news is unpredictable, the resulting price changes must be
unpredictable and random. As a result, prices fully reflect all
known information.
It implies that uninformed investors buying a diversified portfolio
at prices given by the market will obtain a rate of return as that
achieved by the experts.

Assumptions:
A large number of profit maximizing participants analyze and value
securities, each independently of the others.
New information regarding securities comes to the market in a
random fashion, and the timing of one announcement is generally
independent of others.

Assumptions(Cont.):
Profit-maximizing investors adjust security prices rapidly to
reflect the effect of new information. Although the price
adjustment may be imperfect, it is unbiased.
This means that sometimes the market will over adjust and other
times it will under adjust, but you cannot predict which will occur
at any given time.
Security prices adjust rapidly because of the many profitmaximizing investors competing against one another.
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Price Adjustments:
The combined effect of (1) information coming in a random,
independent, unpredictable fashion and (2) Many competing investors
adjusting stock prices rapidly to reflect this new information means
that one would expect price changes to be independent and random.
Adjustment process requires a large number of investors following
the movements of the security, analyzing the impact of new
information on its value, and buying or selling the security until its
price adjusts to reflect the new information.

Price Adjustments(cont.)
This implies that informationally efficient markets require some
minimum amount of trading and that more trading by many
competing investors should cause a faster price adjustment, making
the market more efficient.
Finally, because security prices adjust to all new information, these
security prices should reflect all information that is publicly available
at any point in time.

Efficient Market Hypothesis:

Most of the early work related to efficient capital markets was
based on the random walk hypothesis, which contended that
changes in stock prices occurred randomly.
Fama(1968) presented the efficient market theory where stocks
always trade at their fair value, making it impossible for investors
to either purchase undervalued stocks or sell stocks for inflated
prices.
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Efficient Market Hypothesis(Cont.):

It would be impossible to outperform the overall market through
expert stock selection or market timing, and that the only way an
investor can possibly obtain higher returns is by chance or by
purchasing riskier investments.
Fama divided the overall efficient market hypothesis (EMH) into
three sub-hypotheses depending on the information set involved:
(1) weak-form EMH (2) semi-strong-form EMH (3) strong-form
EMH.
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Weak-form EMH:
The weak-form hypothesis asserts that stock prices already reflect
all information that can be derived by examining market trading data
such as the history of past prices, trading volume etc.
It implies that charts and technical analyses (that implies that by
observing and studying the historical information about the behavior
of a given stock, one can predict the future price movements of the
security )are not beneficial.
Past stock price data are publicly available and if such data ever
conveyed reliable signals about future performance, all investors
already would have learned to exploit the signals
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Weak-form EMH(Cont.):
It assumes that current market prices already reflect all past
returns and any other historical market data should have no
relationship with future rates of return.
Therefore, this hypothesis challenges that you should gain little
from using any trading rule that decides whether to buy or sell a
security based on past rates of return or any other past market data.
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Semi-Strong-form EMH
Under semi-strong form efficiency, the current price reflects the
information contained not only in past prices but all public
information (including financial statements and news reports) and no
Approach on using and manipulating this information would be
useful in finding under valued stocks

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Semi-Strong-form EMH(Cont.)
Public information also includes all nonmarket information, such
as earnings and dividend announcements, price-to-earnings (P/E)
ratios, price-book value (P/BV) ratios, stock splits, news about the
economy, and political news.
This hypothesis implies that investors who base their decisions on
any important new information after it is public should not derive
above-average profits from their transactions because the security
price already reflects all such new public information.
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Strong-form EMH:
Under strong form efficiency, the current price reflects all
information, public as well as private, and no investors will be able
to consistently find under valued stocks.
So if the strong form persists, then no one can beat the market in
any way, not even by insider trading (Brealey et al.
The strong-form EMH extends the assumption of efficient
markets, in which prices adjust rapidly to the release of new public
information, to assume perfect markets, in which all information is
cost-free and available to everyone at the same time.
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Basis of EMH
i. A large number of rational profit maximizing investors exists
who
actively participate in the market, hence value securities rationally.
ii. If some investors are not rational, their irrational trades are
canceling each other out or arbitrageurs eliminate their influence
without affecting prices.
iii. Information is costless and widely available to market
participants at approximately same time. Investors react quickly
and fully to the new information, causing stock prices to adjust
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Example:
The expected, or normal return on shares of Apple is 18% per
year, or 0.045% per day. What can you generally say about
market efficiency if:
i) If you observe that after an earnings report came out, the actual
return for Apple is 3% on that particular day.
Even though the daily return is much higher than the expected or
normal daily return, and hence we have an abnormal return, there is
no reason to question market efficiency. First of all, there is new
information entering the market (an earnings announcement) so we
would expect to see a stock price reaction, making the new price
reflect all the information. Second, there is no consistency here, in
other words, it doesn't say anything about this happening
each and every time.
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ii) Same as i) but the report says that earnings are down by 38%
from last year.
It might be perceived as bad news if earnings are down, but we
have to be careful here. A decrease in earnings is only bad news to
the extent that it was unexpected. If investors were expecting to see
a drop in earnings, there is no bad news associated with a drop in
earnings, because that expectation should have been incorporated in
the stock prices already.
iii) Same as i) but earnings are down by 38%, while analysts
were expecting a drop of 10%
This is an example of bad news since the actual drop in earnings
was much more than people had anticipated. Therefore, this comes
as a surprise and the stock price will react to the news. It seems like
a strange reaction to see the stock price go up by 3% in this case.
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iv) Same as i) but earnings are up by 29%.

It looks like good news if earnings are up, but similar as above,
this is only true to the extent that the increase in earnings
is more than investors anticipated. The 3% therefore is very well
possible, but you cannot say in general that an increase in
earnings is good news. It depends on the expected change in the
earnings.

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v) Same as i) but earnings are up by 29%, while investors

were expecting 63%.
This

is an example of bad news, because the earnings have

increased by less than investors were expecting. Observing a

3% increase in the stock price seems strange here.
vi) You observe that the yearly return for Apple after the
announcement of their earnings is 26%.While we are making an
abnormal return of 26%-18%=8%, we do not now if we are able
to do this on a consistent basis. Therefore, this does not violate
market efficiency.
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vii) You observe that after each positive earnings report,

Apple experiences an abnormal return of 12% per year.
Here we are making a consistent, or on average abnormal
return, based on publicly available information (earnings
announcements), which violates semi-strong form efficiency. If
we could use even better information, our performance would
improve, so this is also a violation of strong form efficiency.
viii) You observe that after each earnings report, Apple has a
semi-annual return of 22% during the first six months after
the announcement.
Similar as above.
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ix) You observe that using the earnings information does not
help you in realizing any abnormal performance, but every time
you use the tips you get from your neighbor, who works at
Apple, you do realize abnormal returns.
This violated strong form efficiency only, because we know that
we cannot beat the market (or realize an abnormal return) when we
only use all the publicly available information. This means that
using even worse information, like past stock price patterns, will
definitely not work.
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Conclusion:
As the efficient market hypothesis defines efficient market is that
where all the investors are well informed about all the relevant
information about the stocks and they take action accordingly.
Due to their timely actions prices of stocks quickly adjust to the
new information, and reflect all the available information.
So no investor can beat the market by generating abnormal
returns.
In the weak form of efficient market technical analysis is useless,
while in semi strong form, both the technical and fundamental
analysis is of no use. And in strong form of efficient market even
the insider trader cannot get abnormal return.

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Evidence Against Market Efficiency

It is found in many stock exchanges of the world that these markets
are not following the rules of EMH.
The functioning of these stock markets deviate from the rules of
EMH. These deviations are called anomalies.
Anomalies could occur once and disappear, or could occur
repeatedly.
From the study of anomalies we can conclude that investor can beat
the market, and can generate abnormal returns by fundamental,
technical analysis, by analyzing the past performance of stocks and by
insider trading.

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Calendar anomalies
Weekend Effect:
The stock prices are likely to fall on Monday. Means the closing
price of Monday is less than the closing price of previous Friday.
Turn-of-the-Month Effect:
The prices of stocks are likely to increase in the last trading day of
the following month, and the first three days of next month.
January Effect:
The phenomenon of small-company stocks to generate more return
than other asset classes and market in the first two to three weeks of
January is called January effect.

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Fundamental anomalies
Value anomaly:
Value anomaly occurs due to false prediction of investors. They
overly estimate the future earnings and returns of growth
companies and underestimate the future returns and earnings of
value companies.
Low Price to Book Ratio:
The stocks with low price to book ratio generate more return than
the stocks having high book to market ratio.
High Dividend Yield
Stocks with high dividend yield outperform the market and
generate more return. If the yield is high, then the stock generates
more return.

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Fundamental anomalies(Cont.)
Low Price to Earnings (P/E)
The stocks with low price to earnings ratio are likely generate
more returns and outperform the market, while the stocks with
high price to earnings ratios tend to underperform than the index.
Overreaction anomaly:
Loser stocks overreact to market than winner stock because
overreaction effect is much large for loser than winner stocks
(De bondt & thaler, 1985).

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Low price to sale

Stocks with low price to sales ratio tends to outperform than
market averages. Companies may face the earning difficulties
eventually the prices decline. A decline in sales is more serious
than decline in earning.
If sales holds up management can recover the earning difficulties,
causes a rise in stock price and if sales decline than the stock price
will be affected
Ex-dividend date anomaly:
Sabet et al found evidence that there is negative and nonsignificant return on ex-dividend date and there is positive and
significant return on day before the dividend day payment.

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Technical Anomalies
Many researchers like Bodie et al. (2007) have found that when
the market holds weak form efficiency, then prices already
reflected the past information and technical analysis is of no use.
So the investor cannot beat the market by earning abnormal
returns on the basis of technical analysis and past information.
But here are some anomalies that deviate from this view.
Moving Averages
An important technique of technical analysis in which buying and
selling signals of stocks are generated by long period averages and
short period averages.
In this strategy buying stocks when short period averages rises
over long period averages and selling the stocks when short period
averages falls below the long period averages.
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Trading Range Break

This technique of technical analysis is based upon resistance and
support level.
A buy signal is created when the prices reaches at resistance level,
which is local maximum. As investor wants to sell at peak, this
selling pressure causes the resistance level to breakout than
previous level. This breaks out causes a buy signal.
A selling signal is created when prices reaches the support level
which is minimum price level. Thus technical analysis recommends
buying when the prices raises above last peak and selling when
prices falls below last trough. But this strategy is difficult to
implement.

Momentum effect
In momentum effect investors can outperform by buying past
winners and selling past losers.
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Conclusion:
There are three main types a) calendar anomalies b) fundamental
anomalies c) technical anomalies.
Calendar anomalies exist due to deviation in normal behaviors
of stocks with respect to time periods.
These include turn-of-year, turn-of week effect, weekend effect,
Monday effect and January effect.
There are different possible causes of theses anomalies like new
information is not adjusted quickly, different tax treatments,
cashflow adjustments and behavioral constraints of investors.

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Fundamental anomalies which includes that prices of stocks are not fully
reflecting their intrinsic values.
These include value versus growth anomaly dividend yield anomaly, overreaction
anomaly, price to earnings ratio anomaly and low price to sales anomaly. Value
strategies outperform than growth stock because of overreaction of market and
growth stocks are more affected by market down movement.
Dividend yield anomaly is that high dividend yield stocks outperform the market.
Stocks having low price to earnings ratio outperform.
Technical anomalies are based upon the past prices and trends of stocks
. It includes momentum effect in which investors can outperform by buying past
winners and selling past losers.
Technical analysis also includes trading strategies like moving averages and
trading breaks which includes resistance and support level. Based upon support
and resistance level investors can buy and sell stocks.

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