Reading: Efficient Markets Hypothesis

Random Walks and Efficient Markets

Random Walk: the theory that stock price movements are unpredictable, so  there is no way to know where prices are headed.

- Studies of stock price movements indicate that they do not move in neat patterns

- This random pattern is a natural outcome of markets that are highly efficient and respond quickly to changes in material information

Random Walk

Efficient Markets

•Efficient Market Hypothesis (EMH): information is reflected in prices – not only the type and source of information, but also the quality and speed with which it is reflected in prices. The more information that is incorporated into prices, the more efficient the market becomes.

•Levels of EMH
-Weak Form EMH
-Semi-strong Form EMH
-Strong Form EMH

Weak Form of EMH

•Weak Form of EMH
- Past data on stock prices are of no use in predicting future stock price changes
- Everything is random
- Should simply use a “buy and hold” strategy

Semi-strong Form of EMH

•Semi-strong Form EMH
- Abnormally large profits cannot be consistently earned using public information.
- Any price anomalies are quickly found out and the stock market adjusts

Strong Form of EMH

•Strong Form EMH
- There is no information, public of private, that allows investors to consistently earn abnormally high returns.

- Seems to be evidence that the market is not strong form efficient

-Reason for inside trading laws

Market Anomalies

•Calendar Effects
- Stock returns may be closely tied to the time of year or time of week.
- Questionable if really provides opportunity
- Examples: January Effect, weekend effect

•Small-Firm Effect
- Size of a firm impacts stock returns
- Small firms may offer higher returns than larger firms, even after adjusting for risk

•Earnings Announcements
- Stock price adjustments may continue after earnings adjustments have been announced
- Unusually good quarterly earnings reports may signal buying opportunity

•P/E Effect (Value Effect)
- Uses P/E ratio to value stocks
- Low P/E stocks may outperform high P/E stocks, even after adjusting for risk