The Efficient

Market
Hypothesis

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 EVIDENCE ?

An example from Adaptive Market by Andrew Lo

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 MY BELIEVE
8 See Graham rules 1137.xls
Those with computers/smartphone, try one stock
to see if we can have one fulfilling the rules.
 THE GRAHAM TECHNIQUE
FROM CH14

 Rules for stock selection:

 Purchase common stocks at less than their
working-capital value (or net current-asset value).
 Give no weight to plant or other fixed assets.
 Deduct all liabilities in full from assets.

Note: according to Graham, using this approach for

fund management, over thirty-odd-year period, have
earned an average of some 20% per year

If market is efficient, it is impossible to find cheap stocks consistently.

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OUTCOMES
CHECK IF YOU CAN DO/UNDERSTAND THE FOLLOWING AFTER
CLASS

• The Efficient Market Hypothesis and its tests

• Opposite views
• The performance of professionals

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 8.1 RANDOM WALKS AND EFFICIENT
MARKET HYPOTHESIS
• Random Walk
• Notion that stock price changes are random

• You might want to read A Random Walk Down Wall

Street written by Burton Gordon Malkiel
• significant flaws in both technical analysis and
fundamental analysis?

• Efficient Market Hypothesis (EMH)

• Prices of securities fully reflect available information

• Think about VW, price drops reflect its consequence

of cheating in pollutant emission
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• May also try The Superinvestors of Graham-and-
Doddsville" by Warren Buffett, see Buffett1984.pdf
FIGURE 8.1 CUMULATIVE ABNORMAL RETURNS
BEFORE TAKEOVER ATTEMPTS: TARGET
COMPANIES

You may want to look at the

share price of Power Asset
about the merger of
CKI HOLDINGS (01038.HK) and
POWER ASSETS (00006.HK),
around Sept. 8, 2015

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 ABNORMAL RETURN AFTER ANNOUNCEMENT
News from Aastocks website:

<Blue Chip Results>Hang Seng Bank FY Net Profit Up 82%; Total Div. $5.4
2016/02/22 12:24

*HANG SENG BANK FY Net Profit Up 82% to $27.494B; 4th Interim Div. $2.4
2016/02/22 12:08

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FIGURE 8.2 STOCK PRICE REACTION TO
CNBC REPORTS

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8.1 RANDOM WALKS AND EFFICIENT
MARKET HYPOTHESIS

• Competition as Source of Efficiency

• Investor competition should imply stock prices
reflect available information
• Investors exploit available profit opportunities
• Competitive advantage can verge on insider
trading

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 8.1 RANDOM WALKS AND EFFICIENT
MARKET HYPOTHESIS
• Versions of EMH

• Weak-form EMH
• Stock prices already reflect all information
contained in history of trading
• Semistrong-form EMH

• Stock prices already reflect all public information

• Strong-form EMH

• Stock prices already reflect all relevant

information, including inside information
• http://en.wikipedia.org/wiki/David_Li 16

Dow Jones insider trading incident

 8.2 IMPLICATIONS OF THE EMH
 Technical Analysis
 Research on recurrent/predictable price patterns and
on proxies for buy/sell pressure in market
 May try Technical Analysis Explained by Martin
Pring
 Resistance Level

 Unlikely for stock/index to rise above

 Support Level

 Unlikely for stock/index to fall below

What is the implication?

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 IMPLICATIONS OF THE EMH
 Fundamental Analysis
 Research on determinants of stock value, i.e.
earnings, dividend prospects, future interest
rate expectations and firm risk
Assumes stock price equal to discounted

value of expected future cash flow

What is the implication?

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 IMPLICATIONS OF THE EMH
 Active versus Passive Portfolio Management
 Passive investment strategy
 Buying well-diversified portfolio without attempting

to find mispriced securities

 Index fund
 Mutual fund which holds shares in proportion to
market index representation
 Active management assumes market inefficiency
 Is it correct?

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 8.3 ARE MARKETS EFFICIENT?
 Issues
 Magnitude issue
 Efficiency is relative

 Selection bias issue

 Investors who find successful investment schemes

are less inclined to share findings

 Observable outcomes preselected in favor of failed
attempts
 Lucky event issue
 Lucky investments receive disproportionate
attention
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8.3 ARE MARKETS EFFICIENT?
 Weak-Form Tests: Patterns in Stock Returns
 Returns over short horizons (3 to 12 months holding
period)
 Momentum effect: Tendency of poorly- or well-

performing stocks to continue abnormal

performance in following periods Evidence of price
momentum.
 Returns over long horizons
 Reversal effect: Tendency of poorly- or well-
performing stocks to experience reversals in
following periods
Note: you may try employing the above findings
in your investment 21

You can refer to the articles mentioned in the text.

 8.3 ARE MARKETS EFFICIENT?
 Semistrong Tests: Market Anomalies
 Anomalies
 Patterns of returns contradicting EMH

 P/E effect
 Portfolios of low P/E stocks exhibit higher average

risk-adjusted returns than high P/E stocks

 How risky is it if you are investing in low P/E

stocks?

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 8.3 ARE MARKETS EFFICIENT?
 Semistrong Tests: Market Anomalies
 Small-firm effect
 Stocks of small firms can earn abnormal returns,

primarily in January
 Neglected-firm effect
 Stock of little-known firms can generate abnormal
returns
 Book-to-market effect
 Shares of high book-to-market firms can generate

abnormal returns
 Is it risky
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FIGURE 8.3 AVERAGE ANNUAL RETURN: TEN
SIZE-BASED PORTFOLIOS, 1926-2010
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Small-firm effect, NYSE stocks
19.8
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17.0 16.6
15.9
15.2 15.1
Annual return (%)

14.6
15 13.5
12.9
11.0
10

0
1 2 3 4 5 6 7 8 9 10
Size decile: 1 = small, 10 = large
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 FIGURE 8.4 AVERAGE ANNUAL RETURN AS
FUNCTION OF BOOK-TO-MARKET RATIO,
1926-2010
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18 17.3
16.1
16 15.5

14 13.4 13.4
Annual return (%)

13.1
11.8 11.7
12 11.7
11.0

10

0
1 2 3 4 5 6 7 8 9 10
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Book-to-market decile: 1 = low, 10 = high
 8.3 ARE MARKETS EFFICIENT?
 Semistrong Tests: Market Anomalies
 Post-earnings announcement price drift
 Sluggish response of stock price to firm’s earnings

announcement
 Abnormal return on announcement day,
momentum continues

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FIGURE 8.5 CUMULATIVE ABNORMAL RETURNS
AFTER EARNINGS ANNOUNCEMENTS

Magnitude of
surprise, 10 highest

You may want to

see if the stock price
of Hang Seng Bank
will follow

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 8.4 MUTUAL FUND AND ANALYST
PERFORMANCE
 Stock Market Analysis
 Analysts are overly positive about firm prospects
 Womack: Positive changes in recommendation

associated with 5% increase, negative with 11%

decrease, price impacts seem permanent
 Jegadeesh, Kim, Kristie, and Lee:
Recommendations are associated with price
change, but the level of consensus is inconsistent
predictor of future performance
 Barber, Lehavy, McNichols, and Trueman: Firms
with most-favorable recommendations outperform
firms with least-favorable recommendations 28
 8.4 MUTUAL FUND AND ANALYST
PERFORMANCE
 Mutual Fund Managers
 Wermers: Funds show positive gross alphas; negative
net alphas after controlling for fees, risk
 Berk and Green: Skilled managers with abnormal
performance will attract new funds until additional
cost, complexity drives alphas to zero
 Chen, Ferson, and Peters: On average, bond mutual
funds outperform passive bond indexes in gross
returns, underperform once fees subtracted
 See the text in this chapter listing a few investment
superstars (Warren Buffett, Peter Lynch, John
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Templeton, Mario Gabelli, etc.)
FIGURE 8.7 MUTUAL FUND ALPHAS
COMPUTED USING FOUR-FACTOR MODEL,
1993-2007 (BEST AND WORST 2.5% TAKEN OUT)

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Alpha: slightly negative mean
 EXERCISES

Q1-9

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