Chapter (11).

Dr. Muath Asmar
Investment & Portfolio
Management
AN-NAJAH
NATIONAL UNIVERSITY
Faculty of Graduate Studies

INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter Eleven
The Efficient Market
Hypothesis

• Maurice Kendall (1953) found no predictable
pattern in stock price changes
• Prices were as likely to go up as to go down on any
particular day, regardless of past performance
• How do we explain random stock price changes?
Overview
©2021 McGraw-Hill Education 11-3

• Efficient market hypothesis (EMH)
• Prices of securities fully reflect available
information
• Investors buying securities in an efficient market
should expect to obtain an equilibrium rate of
return
Efficient Markets

• Stock prices should follow a random walk
• Stock price changes are random and
unpredictable
• Necessary consequence of intelligent investors
competing to discover relevant information on
which to buy or sell stocks before the rest of the
market becomes aware of that information
Random Walks

Cumulative Abnormal Returns
Before Takeover Attempts

Stock Price Reaction to
CNBC Reports

• Information:
• The most precious financial commodity
• Strong competition assures prices reflect
information
• Higher investment returns motivates information-
gathering
• Diminutive marginal returns on research activity
suggest only managers of the largest portfolios
will find it useful pursuing
Competition as the Source of
Efficiency

1. Weak-form asserts that stock prices already
reflect all information contained in the history of
past prices
2. Semistrong-form asserts that stock prices
already reflect all publicly available information
3. Strong-form asserts that stock prices reflect all
relevant information, including insider
information
• All versions assert that prices should reflect
available information
Versions of the EMH

• Technical analysis - Research to identify
mispriced securities that focuses on recurrent
and predictable stock price patterns and on
proxies for buy or sell pressure in the market
• Key to success is a sluggish response of stock
prices to fundamental supply-and-demand factors
• EMH implies technical analysis should be fruitless
Technical Analysis

• Fundamental analysis
• Assessment of firm value that focuses on such
determinants as earnings and dividends
prospects, expectations for future interest rates,
and risk evaluation
• Seeks to find firms that are mispriced
• Attempt to find firms that are better than everyone
else’s estimate or troubled firms that may be great
bargains
• EMH predicts that most fundamental analysis
is doomed to failure
Fundamental Analysis

• Active Management
• An expensive strategy
• Suitable for very large portfolios
• Passive Management
• No attempt to outsmart the market
• Accept EMH
• Index Funds and ETFs
• Low cost strategy
Active versus Passive Portfolio
Management

• Even if the market is efficient, a role exists for
portfolio management:
• Diversification
• Tax considerations
• Risk profile of investor
• E.g., investors of different ages
Portfolio Management in an Efficient
Market

• Inefficient markets result in systematic
resource misallocation
• Overvalued securities can raise capital too cheaply
• Corporations with undervalued securities may
pass up profitable opportunities because the cost
of raising capital is too high
• Efficient market ≠ perfect foresight market
Resource Allocation

• An event study is a methodological approach
designed to measure the impact of an event
of interest on stock returns
• The abnormal return due to the event is the
difference between the stock’s actual return
and a proxy for the stock’s return in the
absence of the event
Event Studies

• Returns are adjusted to determine if they are
abnormal
• Market model approach:
a. Expected Return:
b. Abnormal Return:
How Tests Are Structured
t Mt tr r e   
( )t t Mte r r   

• Magnitude issue
• Only managers of large portfolios can earn enough
trading profits to make the exploitation of minor
mispricing worth the effort
• Selection bias issue
• Only unsuccessful (or partially successful) investment
schemes are made public; good schemes remain
private
• Lucky event issue
• For every big winner, there may be many big losers, but we
never hear of these managers
Are Markets Efficient?

• Returns over short horizons
• Tendency of poorly performing stocks and well-
performing stocks in one period to continue that
abnormal performance in following periods is the
momentum effect
• Returns over long horizons
• Reversal effect is the tendency of poorly
performing stocks and well-performing stocks in
one period to experience reversals in following
periods
Weak-Form Tests

• Fama and French
• Return on the aggregate stock market tends to be
higher when the dividend yield is high
• Campbell and Shiller
• Earnings yield can predict market returns
• Keim and Stambaugh
• Bond spreads can help predict broad market
returns
Predictors of Broad Market Returns

Semistrong Tests:
Small-Firm Effect

Semistrong Tests:
Book to Market Effects

• Price Drift
– Ball and Brown find a
sluggish response of
stock prices to firms’
earnings
announcements
– Market appears to adjust
to the earnings
information only
gradually, resulting in a
sustained period of
abnormal returns
Semistrong Tests:
Post-Earnings-Announcement Price Drift

• Efficient market anomalies are patterns of
returns that seem to contradict the EMH
• P/E effect – Basu discovered that portfolios of
low-P/E ratio stocks have provided higher returns
than high P/E portfolios
• Neglected-firm effect – investments in stock of
less well-known firm shave generated abnormal
returns
• Liquidity effect – Illiquid stocks have a strong
tendency to exhibit abnormally high returns
Semistrong Tests: Other Anomalies

• The ability of insiders to trade profitability in
their own stock has been documented in
studies by Jaffe, Seyhun, Givoly, and Palmon
• SEC requires all insiders to register their
trading activity
• Trades become public information
Strong-Form Tests:
Inside Information

• Feature that small firms, low market-to-book
firms, and recent “losers” seem to have in
common is a stock price that has fallen
considerably in recent months/years
• Fama and French argue that these effects can be
explained by risk premiums
• Lakonishok, Shleifer, and Vishny argue that these
effects are evidence of inefficient markets
Interpreting the Anomalies

Predictors of GDP Growth

• Anomalies or data mining?
• Book-to-market, size, and momentum may be real
anomalies
• Anomalies over time
• Should self-destruct in well-functioning markets
• Chordia, Subrahmanyam, and Tong find evidence
that liquidity and low trading costs facilitate
efficient price discovery
Interpreting the Evidence
(1 of 2)

• Bubbles and market efficiency
• Bubbles occur when a rapid run-up in prices
creates a widespread expectation that they will
continue to rise
• E.g., tulip mania in 17th-century Holland
• Rush to “get in on the action”
• Inevitably, the run-up stalls and the bubble ends in
a crash
Interpreting the Evidence
(2 of 2)

• Some analysts may add value, but:
• Tend to be overwhelmingly positive in the
assessment of the prospects of firms
• Difficult to separate effects of new information
from changes in investor demand
• Recommendations may lead to investing
strategies that are too expensive to exploit
Stock Market Analysts

• Casual evidence does not support the claim
that professionally managed portfolios can
consistently beat the market
• Conventional performance benchmark today
is a four-factor model
• Three Fama-French factors
• Momentum factor
Mutual Fund Performance
(1 of 2)

Estimates of Individual
Mutual Fund Alphas

• Consistency
• Carhart — finds minor persistence in relative
performance across managers, but much of that
persistence seems due to expenses and
transaction costs
• Bollen and Busse — support for performance
persistence over short horizons
• Berk and Green — skilled managers will attract
new funds until the costs of managing those extra
funds drive alphas down to zero
Mutual Fund Performance
(2 of 2)

Risk-adjusted Performance in Ranking
Quarter and Following Quarter

• Enough anomalies exist in the empirical
evidence to justify the search for underpriced
securities that clearly takes place
• However, the market is competitive enough that
only differentially superior information or insight
will earn money
• Margin of superiority that any professional
manager can add is so slight that the statistician
will not easily be able to detect it
So, Are Markets Efficient?

Chapter (11).

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Chapter (11).

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