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NOBEL PRIZE FOR ECONOMICS (2013)

Excess market
Market Efficiency volatility –Behavioral
finance
• Eugene Fama (1970) • Robert Shiller
(1981)

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MARKET
EFFICIENCY
2 Manara Toukabri
PhD Finance
OVERVIEW
 In the 1950s, an early application of computers in economics
was for analysis for economic time series.

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 Business cycle theorists felt that tracing the evolution of
several economic variables over time would clarify and predict
the progress of the economy through boom and bust periods.
 A natural candidate for analysis was the behavior of stock
market prices over time.
 Maurice Kendall examined this proposition in 1953.

 He found to his great surprise that he could identify no

predictable patterns in stock prices .
 Prices seemed to evolve randomly.

 They were as likely to to go up as they were to go down on

any particular day, regardless of past performance.
 The date provided no way to predict price mouvements 3
OVERVIEW
 At first blush, Kendall’s reuslts were disturbing to some

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financial economists.
 They seemed to imply that stock market is dominated by
irratic market psychology, or « animal spirits » that is
follows no logical rules.
 In short, the results appeared to confirm the irrationality
of the market.
 On further reflection, however, economists came to
reverse their interpretation of Kendall’s study.
 It soon became apparent that random price mouvements
indicated a well-functionning or efficient market, not an
irrational one.
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 New information, by definition, must be unpredictable;
if it could be predicted, then the prediction would be part
of today’s information.

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EFFICIENT MARKET VERSUS PERFECT CAPITAL MARKETS

The quality of market valuation methods depends heavily on the

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concept of market efficiency. Efficient markets can be
described as either perfect capital markets and efficient capital
markets.
A perfect market means an economy in continuous equilibrium
— that is, a market which instantly and correctly responds to new
information, providing signals for real economic decisions. The
following are necessary conditions for perfect capital markets:
1) Markets are frictionless (a financial market without transaction
costs).
2) Production and securities markets are perfectly competitive.
3) Markets are informationally efficient.
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4) All individuals are rational expected-utility maximizers
VERSIONS OF THE EFFICIENT MARKET
HYPOTHESIS 

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 It is commun to distinguish three versions of the efficient
market : the weak, semistrong and strong forms of the
hypothesis.
 These versions differ by their notions of what is meant
by the term all available information.

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In an efficient capital market prices fully and instantaneously reflect all
available information; thus, when assets are traded, prices are accurate
signals for capital allocation. In this case, an efficient capital market only
follows Rule 3 of a perfect capital market.
Fama (1970) defines three “types” of efficiency, each of which is based on
a different notion of exactly what type of information is understood to be
relevant. They are:
1) Weak form efficiency: No investor can earn excess returns by
developing trading rules based on historical price or return information.
2) Semi-strong form efficiency: No investor can earn excess returns from
trading rules based on publicly available information.
3) Strong form efficiency: No investor can earn excess returns using any
information, whether or not publicly available.
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 VERSIONS OF THE EFFICIENT MARKET HYPOTHESIS

1) The weak Form:

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asserts that stock prices already reflect all information that
can be derived by examined market trading data, such as the
history of past prices, trading volume, or short interest.
This version of the hypothesis implies that trend analysis is
fruitless . Past stock price data are publicly available and
virtually costless to obtain. The week form hypothesis holds
that if such data ever conveyed reliable signals about future
performance, all investors would have learned already to
exploit the signals. Utlimately, the signals lose their value as
they become widely known because a buy signal, for
instance, would result in an immediate price increase.
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VERSIONS OF THE EFFICIENT MARKET HYPOTHESIS

2) The semistrong form:

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states that all publicly available information regarding the
prospects of a firm must be reflected already in the stock
price. Such information includes, in addition to past
prices, fundamental data on the firm’s product line,
quality of management, balance sheet composition,
patents held, earning forecasts, and accounting
practices. Again, if any investor has access to such
information from publicly available sources, one would
expect it to be reflected in stocks prices.

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VERSIONS OF THE EFFICIENT MARKET HYPOTHESIS

3) Strong-form:

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version of the efficient market hypothesis states that stock
prices reflect all information relevant to the firm, even
including information available only to compagny insiders.
This version of the hypothesis is quite extreme. Few would
argue with the notion that corporate officers have access to
pertinent information long enough before release to enable
them to profit from trading on that information. Indeed,
much of the activites of the provincial securities
commissions is directed toward preventing insiders from
profiting by exploiting their privileged situation.

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IMPLICATIONS OF THE EMH FOR INVESTMENT POLICY
1) TECHNICAL ANALYSIS
 Technical analysis is essentially the search for recurring and predictable

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patterns in stock prices.
 Technical analysis assumes a sluggish response of stock prices to
fundamental supply and demand factors.
 This assumption is diametrically opposed to the notion of an efficient
market.
 Technical analysts sometimes are called chartists because they study
records or charts of past stock prices, hoping to find patterns they can
exploit to make a profits.
 The chartist compares stock performance over a recent period to
performance of the market or other stocks in the same industry.
 The efficient market hypothesis predicts that technical analysis is without
merit.

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IMPLICATIONS OF THE EMH FOR INVESTMENT POLICY
1) TECHNICAL ANALYSIS

 The past histoy of prices and trading volume is publicaly

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available at minimal cost.
 Therefore, any information that was ever available from
analyzing past prices has already been reflected in stock
prices.
 As investors compete to exploit thier commun
knowledge of stok’s price price histoy, they necessaily
drive stock prices to levels where expected rates of
returns are commensurate with risk.
 At those levels, stocks are neither bad nor good buys,
they are just fairly priced, meaning one should not
expect abnormal returns. 13
IMPLICATIONS OF THE EMH FOR INVESTMENT POLICY
2) FUNDAMENTAL ANALYSIS

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 Fundamental analysis uses earnings and dividend
prospects oh the firm, expectations of future interest
rates, and risk evaluation of the firm to determine proper
stock prices.
 Ultimately, it represent an attempt to determine the
present discounted value of all the payments a
shareholder will receive from each share of stock.
 If that value exceeds the stock price, the fundamental
analyst will recommend purchasing the stock.
 Fundamental analysts usually start with a study of past
earning and an examination of company balance sheets.
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IMPLICATIONS OF THE EMH FOR INVESTMENT POLICY
2) FUNDAMENTAL ANALYSIS

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 One again, the efficient market hypothesis predicts that most
fundamental analysis adds little value.
 If analysts rely on publicly available earnings and industry
information, one analyst’s evaluation of the firm prospects is
not likely to be significantly more accurate than another’s.
 There are many well-informed, well-financed firms
conducting such market research, and in the face of such
competition, it will be difficult to uncover data not also
available to other analysts.

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IMPLICATIONS OF THE EMH FOR INVESTMENT
POLICY
2) FUNDAMENTAL ANALYSIS

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 Only analysts with a uniue insight will be rewarded.
 Fundamental analysis is difficult ,it’s not enough to do a
ggod analysis of a firm; you can make money only if
your analysis is better than that of your competitor,
because the market price is expected already to reflect all
commonly available information.

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IMPLICATIONS OF THE EMH FOR INVESTMENT POLICY
3) ACTIVE VERSUS PASSIVE PORTFOLIO MANAGEMENT

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 By now it is apparent that causal efforts to pick stocks
are not likely ta pay off.
 Competition among investors ensures that any easily
implemented stock evaluation technique will be used
widely enough so that any insights derived will be
reflected in stock prices.
 Only serious, time consuming, and expensive
techniques are likely to generate the differential insight
necessary to generate trading profits.

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IMPLICATIONS OF THE EMH FOR INVESTMENT POLICY
3) ACTIVE VERSUS PASSIVE PORTFOLIO MANAGEMENT

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 Proponents of the efficient market hypothesis belive that active
management is largely wasted effort and unlikely to justify the expenses
incurred.
 Therefore, they advocate a passive investment strategy, that makes no
attempt to outsmart the market.
 A passive strategy aims only at establishing a well-diversified portfolio
of securities without attempting to find under-or overvalued stocks.
 Passive management usually is characterized by a buy-and-hold strategy,
because the efficient market theory indicates that stock prices are at fair
level, given all available information, it makes no sens to buy and sell
securities frequently, which generates large brokerage fees without
increasing expected performance.
 One commun strategy for passive management is to create an index
fund
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 Such a fund aims to mirror the performance of a board-based index of
stocks
WHAT IS AN INDEX-FUND?
 An index fund is a portfolio of securities chosen to

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replicate the performance of a specific benchmark
portfolio, such as a stock market index or a bond market.
 Indexing is a passive strategy in which portfolio
rebalaning occurs only when the benhmark composition
changes.
 Exp Vanguard S&P 500 ETF

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Thank you for your attention

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