Efficient Market Hypothesis

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Efficient Market Hypothesis

 What is market efficiency?

 How does the asset management industry fit into

market efficiency?
 Testing of market efficiency

Weak form efficiency
Semi-strong form efficiency
Strong form efficiency

 What is the explanation for market (in)efficiencies?

Random Walk
 If you knew that a stock was going to rise 10% in a

year, you would try and buy it immediately.
 But if everyone has access to the same information then no one would sell! The stock price would rise immediately.  A forecast about favourable future performance leads to favourable current performance.
 Since new information is unpredictable, prices should follow a random walk—price changes are random and unpredictable.

Efficient Market Hypothesis
 Efficient market hypothesis says that the stock

prices reflects all available information.
 Three types

Weak: Current price reflects information from historical trading data such as past prices, trading volume and short interest. Semi-strong: Current price reflects all publicly information regarding prospects of a firm
Strong: Stock prices reflect all information relevant to the firm, even including information available to company insiders.

 If the market is strong form efficient, then it is also

weak form and semi-strong form efficient.
 If the market is semi-strong form efficient then it is also weak form efficient.
 Note that the relationship does not work the other way: If the market is weak form efficient, you cannot make a statement about semi-strong form efficiency.

Competition is a source of Efficiency
 The asset management industry is responsible for

managing a substantial part of all funds in the stock market. Outperforming competitors can result in larger fund inflows and consequently larger salaries.
This incentive results in a large amount of effort being placed on investment research.
Hence the plethora of bank research reports, investment newsletters, advisors, etc...
With so many people looking for “new” information, chances of actually uncovering it are slim.

Technical analysis
 Technical Analysis uses past prices and volume

information to predict future prices.
 Depends on slow response to fundamental supply-anddemand factors.
 Examples of terminology:

Relative strength/weakness: Examine the ratio of stock price to a market indicator like the S&P 500. If the ratio increases/decreases over time, the stock is said to experience relative strength. This trend is expected to continue and lead to profit opportunities.
Resistance levels or support levels: A price level above which it is unlikely the stock price will rise or below which the stock it is unlikely to fall

 If technical analysis worked, which form of efficiency

would it violate?

Relative Strength-Example

•The black line is the S&P 500 index. The solid blocks are the intraday-range of the FBN stock
•In May the stock showed relative weakness. It then went on to underperform the S&P.

Resistance Levels-Example

•The stock tends to stay above the support level (till it convincingly goes over it).

Fundamental Analysis
 Fundamental Analysis uses accounting information

like earnings and dividend prospects, economic information like expectations of future interest rates.
 Goal is to find strongly performing firms which are underestimated by the market (in the opinion of the analyst).  Alternatively, one could find poorly performing which are not as bad as estimated by the market.
 If fundamental analysis were to work, what form of efficiency would it violate?

Fundamental Analysis-Microsoft

Portfolio Management
 Active management

Use analysis to look for “cheap” stocks. Cost of such analysis is high.
Suitable if you have a large portfolio and can afford such costs.

 Passive management

No attempt to look for cheap stocks or outsmart market.
Buy index funds and ETF’s.

An Exchange Traded Fund is usually a