6.5.A - The Efficient Markets Hypothesis

1. The Efficient Markets Hypothesis

  1. The Efficient Markets Hypothesis (EMH) asserts that (1) stocks are always in equilibrium and (2) it is impossible for an investor to “beat the market” and consistently earn a higher rate of return than is justified by the stock’s risk. In other words, a stock’s market price is always equal to its intrinsic value. To put it a little more precisely, suppose a stock’s market price is equal to the stock’s intrinsic value but new information arrives that changes the stock’s intrinsic value. The EMH asserts that the market price will adjust to the new intrinsic value so quickly that there isn’t time for an investor to receive the new information, evaluate the information, take a position in the stock before the market price changes, and then profit from the subsequent change in price.
  2. Here are three points to consider. First, almost every stock is under considerable scrutiny. With 100,000 or so full-time, highly trained, professional analysts and traders each following about 30 of the roughly 3,000 actively traded stocks (analysts tend to specialize in a specific industry), there are an average of about 1,000 analysts following each stock. Second, financial institutions, pension funds, money management firms, and hedge funds have billions of dollars available for portfolio managers to use in taking advantage of mispriced stocks. Third, SEC disclosure requirements and electronic information networks cause new information about a stock to become available to all analysts virtually simultaneously and almost immediately. With so many analysts trying to take advantage of temporary mispricing due to new information, with so much money chasing the profits due to temporary mispricing, and with such widespread dispersal of information, a stock’s market price should adjust quickly from its pre-news intrinsic value to its post-news intrinsic value, leaving only a very short amount of time that the stock is “mispriced” as it moves from one equilibrium price to another. That, in a nutshell, is the logic behind the efficient markets hypothesis.
  3. The weak form of the EMH asserts that all information contained in past price movements is fully reflected in current market prices. If this were true, then information about recent trends in stock prices would be of no use in selecting stocks—the fact that a stock has risen for the past three days, for example, would give us no useful clues as to what it will do today or tomorrow. In contrast, technical analysts, also called “chartists,” believe that past trends or patterns in stock prices can be used to predict future stock prices.
  4. Weak-form advocates argue that if this pattern truly existed then other investors would soon discover it, and if so, why would anyone be willing to sell a stock after it had fallen for three consecutive days? In other words, why sell if you know that the price is going to increase by 10% the next day? For example, suppose a stock had fallen three consecutive days to $40. If the stock were really likely to rise by 10% to $44 tomorrow, then its price today, right now, would actually rise to somewhere close to $44, thereby eliminating the trading opportunity. Consequently, weak-form efficiency implies that any information that comes from past stock prices is too rapidly incorporated into the current stock price for a profit opportunity to exist.
  5. The semistrong form of the EMH states that current market prices reflect all publicly available information. Therefore, if semistrong-form efficiency exists, it would do no good to pore over annual reports or other published data because market prices would have adjusted to any good or bad news contained in such reports back when the news came out. With semistrong-form efficiency, investors should expect to earn returns commensurate with risk, but they should not expect to do any better or worse other than by chance.
  6. Another implication of semistrong-form efficiency is that whenever information is released to the public, stock prices will respond only if the information is different from what had been expected. For example, if a company announces a 30% increase in earnings and if that increase is about what analysts had been expecting, then the announcement should have little or no effect on the company’s stock price. On the other hand, the stock price would probably fall if analysts had expected earnings to increase by more than 30%, but it probably would rise if they had expected a smaller increase.
  7. The strong form of the EMH states that current market prices reflect all pertinent information, whether publicly available or privately held. If this form holds, even insiders would find it impossible to earn consistently abnormal returns in the stock market.


2. Is the Stock Market Efficient? The Empirical Evidence

  1. Empirical studies are joint tests of the EMH and an asset pricing model, such as the CAPM. They are joint tests in the sense that they examine whether a particular strategy can beat the market, where “beating the market” means earning a return higher than that predicted by the particular asset pricing model. Before addressing tests of the particular forms of the EMH, let’s take a look at market bubbles.
  2. The history of finance is marked by numerous instances in which (1) prices climb rapidly to heights that would have been considered extremely unlikely before the run-up; (2) the volume of trading is much higher than past volume; (3) many new investors (or speculators?) eagerly enter the market; and (4) prices suddenly fall precipitously, leaving many of the new investors with huge losses. These instances are called market bubbles.
  3. The stock market bubbles that burst in 2000 and 2008 suggest that, at the height of these booms, the stocks of many companies—especially in the technology sector in 2000 and the financial sector in 2008—vastly exceeded their intrinsic values, which should not happen if markets are always efficient. To understand why this doesn’t happen, let’s examine the strategies for profiting from a falling market: (1) Sell stocks (or the market index itself) short; (2) purchase a put option or write a call option; or (3) take a short position in a futures contract on the market index. Following is an explanation for how these strategies work (or fail).
  4. Loosely speaking, selling a stock short means that you borrow a share from a broker and sell it. You get the cash (subject to collateral requirements required by the broker) but you owe a share of stock. For example, suppose you sell a share of Google short at a current price of $500. If the price falls to $400, you can buy a share of the stock at the now-lower $400 market price and return the share to the broker, pocketing the $100 difference between the higher price ($500) when you went short and the lower price ($400) when you closed the position. Of course, if the price goes up, say to $550, you lose $50 because you must replace the share you borrowed (at $500) with one that is now more costly ($550). Even if your broker doesn’t require you to close out your position when the price goes up, your broker certainly will require that you put in more collateral. 
  5. Recall that a put option gives you the option to sell a share at a fixed strike price. For example, suppose you buy a put on Google for $60 with a strike price of $500. If the stock price falls below the strike price, say to $400, you can buy a share at the low price ($400) and sell it at the higher strike price ($500), making a net $40 profit from the decline in the stock price: $40 = −$60 −$400 + $500. However, if the put expires before the stock price falls below the strike price, you lose the $60 you spent buying the put. You can also use call options to bet on a decline. For example, if you write a call option, you receive cash in return for an obligation to sell a share at the strike price. Suppose you write a call option on Google with a strike price of $500 and receive $70. If Google’s price stays below the $500 strike price, you keep the $70 cash you received from writing the call. But if Google goes up to $600 and the call you wrote is exercised, you must buy a share at the new high price ($600) and sell it at the lower strike price ($500), for a net loss of $30: $70 −$600 + $500 = −$30.
  6. With a short position in a futures contract on the market index (or a particular stock), you are obligated to sell a share at a fixed price. If the market price falls below the specified price in the futures contract, you make money because you can buy a share in the market and sell it at the higher price specified in the futures contract. But if the market price increases, you lose money because you must buy a share at the now higher price and sell it at the price fixed in the futures contract.
  7. Most studies suggest that the stock market is highly efficient in the weak form, with two exceptions. The first exception is for long-term reversals, with studies showing that portfolios of stocks with poor past long-term performance (over the past five years, for example) tend to do slightly better in the long-term future than the CAPM predicts, and vice versa. The second is momentum, with studies showing that stocks with strong performance in the short-term past (over the past six to nine months, for example) tend to do slightly better in the short-term future than the CAPM predicts, and likewise for weak performance.21 Strategies based on taking advantage of long-term reversals or short-term momentum produce returns that are in excess of those predicted by the CAPM. However, the excess returns are small, especially when transaction costs are considered.
  8. Most studies show that markets are reasonably efficient in the semistrong form: It is difficult to use publicly available information to create a trading strategy that consistently has returns greater than those predicted by the CAPM. In fact, the professionals who manage mutual fund portfolios, on average, do not outperform the overall stock market as measured by an index like the S&P 500 and tend to have returns lower than predicted by the CAPM, possibly because many mutual funds have high fees.
  9. However, there are two well-known exceptions to semistrong-form efficiency. The first is for small companies, which have had historical returns greater than predicted by the CAPM. The second is related to book-to-market ratios (B/M), defined as the book value of equity divided by the market value of equity (this is the inverse of the market-to-book ratio defined in Chapter 3). Companies with high B/M ratios have had higher returns than predicted by the CAPM.
  10. The evidence suggests that the strong form EMH does not hold, because those who possessed inside information could and have (illegally) make abnormal profits. On the other hand, many insiders have gone to jail, so perhaps there is indeed a trade-off between risk and return.




Last modified: Tuesday, August 14, 2018, 8:45 AM