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 Chapter 10
Market Efficiency

OUTLINE

The Efficient Market Hypothesis (EMH)

Types of Efficiency
Degrees of Informational Efficiency
The Semi-Efficient Market Hypothesis
Security Prices and Random Walks
Anomalies
The Low-PE Effect
Low-Priced Stocks
The Small Firm and Neglected Firm Effects
Market Overreaction
The January Effect
The Weekend Effect
The Persistence of Technical Analysis
Final Thoughts

SUMMARY

The efficient market hypothesis (EMH) concerns informational efficiency and the fair pricing
function, not operational efficiency. The essence of the EMH is that so many people watch the
marketplace that few, if any, individuals can consistently make windfall profits by picking stocks
better than the next person.
There are three forms of the EMH. The weak form says that past prices, or charts, are of no value in
predicting future stock price performance. The semistrong form says that security prices already fully
reflect all relevant publicly available information. The strong form of the EMH includes private, inside
information as well. Considerable empirical research supports the semistrong form; however, we know
that, contrary to the strong form, insiders can make illegal profits.
The random walk theory does not state that security prices move randomly. Rather, it maintains
that the news arrives randomly and that, in accordance with the EMH, security prices rapidly adjust to
this random arrival of news.
Anomalies are occurrences in the market that are inexplicable by finance theory. Stocks with low
PEs tend to show unusually higher returns; January is a good month for the stock market; and small
firms tend to do especially well in January. Technical analysis is diametrically opposed to the efficient
market hypothesis, yet it has many advocates, including well-educated finance professors and
practitioners.

ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS

1. Even in an efficient market, someone needs to ascertain the relative risk of the competing
investments and explore how these investments are correlated. Also, it is the action of security
analysts that help keep the market efficient.

33
34 Chapter 10: Market Efficiency

2. This a dangerous question. If you say you believe it absolutely, the interviewer might ask, “Then
why should we hire you?” If you say it is academic nonsense, you are dismissing a great deal of
financial research out of hand. The best answer is probably to say that you believe the markets are
quite efficient, that you agree with the semi-efficient market hypothesis, and that you believe there
will always be a place in the market for superior investment research.

3. The semi-efficient market hypothesis states that some stocks (pink sheet stocks, for instance) are
priced less efficiently than others simply because there are not as many analysts following them.
The semi-strong form of the EMH deals with the information set available to the analyst rather
than the available security universe.

4. The random walk theory states that news arrives randomly. The EMH states that security prices
react to the news. Note the EMH does not say that security prices move randomly.

5. Student response.

6. Charts are based on past data; the weak form of market efficiency states that past data are of no
value in predicting future prices.

7. Operational efficiency deals with the extent to which orders at the exchange are processed
correctly and in timely fashion. Informational efficiency deals with the speed and accuracy with
which security prices adjust to new information.

8. It is difficult to justify a blanket condemnation of charting techniques when it is clear that there is
a great deal about technical analysis that remains unknown, and when so many people find utility
in the graphical presentation of past data. The fact that research has found no consistently useful
way to employ charts does not mean it cannot be done.

9. A regression equation measures the best fitting line through a scattering of points. Some of the
data points will lie above the line and some below. Some individual securities are likely to show a
positive intercept, just as some will show a negative intercept. A small proportion of positive
intercepts do not invalidate the efficient market hypothesis. Also, the intercept results from the
examination of past data. The important next step would be to see if this information could be
used to earn above average returns in the future.

10. A test of market efficiency should ultimately distinguish between statistical significance and
economic significance. Many such tests find evidence of statistically significant relationships that
would have permitted someone to earn an abnormally large profit. However, these profits almost
always disappear when the test incorporates trading fees and taxes.

11. There is considerable room for disagreement regarding the meaning of the price/earnings ratio.
Finance is much more concerned with future events than it is with past events. A trailing PE,
based on past data, does not necessarily tell you anything about the future. If a company has some
“normal” level of earnings and earnings growth, the current PE (especially when presented as a
“relative” PE) may serve as a marker indicating whether the current price is higher or lower than it
has traditionally been.

12. Many people consider such a low price to be associated with an unusually risky stock.
 Chapter 10: Market Efficiency 35

13. There is increasing evidence (such as the Fama and French studies) that small firms provide
superior investment returns over the long term. Many portfolio managers have come to
incorporate a preference for small capitalization firms into an investment style.

14. There are 9 correct responses, 6 incorrect responses, and 8 runs. Using the RUNS file from the
software disk, the likelihood of these results happening by chance is 45.54%. (Note that the
number of runs may not be as useful here as the proportion of guesses that are correct.)

15-17 Student responses.

18. Up to $100,000. The Insider Trading and Securities Fraud Enforcement Act of 1988 increased
this amount to $1 million.

19. (CFA Guideline Answer: Reprinted with permission).

A. The notion that stock prices already reflect all available information is referred to as the efficient
market hypothesis (EMH). It is common to distinguish among three versions of the EMH: the
weak, semi-strong, and strong forms. These versions differ by their treatment of what is meant by
“all available information.”

The weak-form hypothesis asserts that stock prices already reflect all information that can be
derived from studying past market trading data. Therefore, “technical analysis” and trend
analysis, etc., are fruitless pursuits. Past stock prices are publicly available and virtually costless
to obtain. If such data ever conveyed reliable signals about future stock performance, all investors
would have learned already to exploit such signals.

The semi-strong form hypothesis states that all publicly available information about the prospects
of a firm must be reflected already in the stock’s price. Such information includes, in addition to
past prices, all fundamental data on the firm, its products, its management, its finances, its
earnings, etc., etc. that can be found in public information sources.

The strong-form hypothesis states that stock prices reflect all information relevant to the firm,
even including information available only to company “insiders.” This version is an extreme one.
Obviously, some “insiders” do have access to pertinent information long enough for them to profit
from trading on that information before the public obtains it. Indeed, such trading – not only by
the “insiders” themselves, but also by relatives and/or associates – is illegal under rules of the
SEC.

For the weak form or the semi-strong forms of the hypothesis to be valid does not require the
strong-form version to hold. If the strong-form version were valid, however, both the semi-strong
and the weak-form version of efficiency would also be valid.

B. Even in an efficient market, a portfolio manager would have the important role of constructing and
implementing an integrated set of steps to create and maintain appropriate combinations of
investment assets. Listed below are the necessary steps in the portfolio management process:

1) Counseling the client to help the client to determine appropriate objectives and identify and
evaluate constraints. The portfolio manager together with the client should specify and
quantify risk tolerance, required rate of return, time horizon, taxes considerations, the form of
income needs, liquidity, legal and regulatory constraints, and any unique circumstances that
will impact or modify normal management procedures/goals.
36 Chapter 10: Market Efficiency

2) Monitoring and evaluating capital market expectations. Relevant considerations, such as

economic, social, and political conditions/expectations are factored into the decision making
process in terms of the expected risk/reward relationship for the various asset categories.
Different expectations may lead the portfolio manager to adjust a client’s systematic risk level
even if markets are efficient.
3) The above steps are decisions derived from/implemented through portfolio policy and strategy
setting. Investment policies are set and implemented through the choice of optimal
combinations of financial and real assets in the marketplace – i.e., asset allocation. Under
the assumption of a perfectly efficient market, stocks would be priced fairly, eliminating any
added value by specific security selection. It might be argued that an investment policy,
which stresses diversification, is even more important in an efficient market context because
the elimination of specific risk becomes extremely important.
4) Market conditions, relative asset category percentages, and the investor’s circumstances are
monitored.
5) Portfolio adjustments are made as a result of significant changes in any or all relevant
variables.

20. (CFA Guideline Answer: Reprinted with permission).

A. Efficient market hypothesis (EMH) states that a market is efficient if security prices immediately
and fully reflect all available relevant information. Efficient means informationally efficient, not
operationally efficient. Operational efficiency deals with the cost of transferring funds. If the
market fully reflects information, the knowledge of that information would not allow anyone to
profit from it because stock prices already incorporate the information.

1. Weak form asserts that stock prices already reflect all information that can be derived by
examining market trading data such as the history of past prices and trading volume.

Empirical evidence supports the weak form.

A strong body of evidence supports weak-form efficiency in the major U.S. securities markets.
For example, test results suggest that technical trading rules do not produce superior returns after
adjusting for transactions costs and taxes.

2. Semistrong form says that a firm’s stock price already reflects all publicly available
information about a firm’s prospects. Examples of publicly available information are annual
reports of companies and investment advisory data.

Empirical evidence mostly supports the semistrong form.

Evidence strongly supports the notion of semistrong efficiency, but occasional studies (e.g.,
those identifying market anomalies including the small-firm effect and the January effect) and
events (e.g., stock market crash of October 19, 1987) are inconsistent with this form of market
efficiency. Black suggests that most so-called “anomalies” result from data mining.

3. Strong form of the EMH holds that current market prices reflect all information, whether
publicly available or privately held, that is relevant to the firm.

Empirical evidence does not support the strong form.

 Chapter 10: Market Efficiency 37

Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct,
prices would fully reflect all information, although a corporate insider might exclusively hold such
information. Therefore, insiders could not earn excess returns. Research evidence shows that
corporate officers have access to pertinent information long enough before public release to enable
them to profit from trading on this information.

B. Technical analysis in the form of charting involves the search for recurrent and predictable
patterns in stock prices to enhance returns. The EMH implies that this type of technical analysis is
without value. If past prices contain no useful information for predicting future prices, there is no
point in following any technical trading rule for timing the purchases and sales of securities.
According to weak-form efficiency, no investor can earn excess returns by developing trading
rules based on historical price and return information. A simple policy of buying and holding will
be at least as good as any technical procedure. Tests generally show that technical trading rules do
not produce superior returns after making adjustments for transactions costs and taxes.

Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future
interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts
that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no
investor can earn excess returns from trading rules based on any publicly available information.
Only analysts with unique insight receive superior returns. Fundamental analysis is not better than
technical analysis in enabling investors to capture above-average returns. However, the presence
of many analysts contributes to market efficiency.

In summary, the EMH holds that the market appears to adjust so quickly to information about
individual stocks and the economy as a whole that no technique of selecting a portfolio--using
either technical or fundamental analysis--can consistently outperform a strategy of simply buying
and holding a diversified group of securities, such as those making up the popular market
averages.

C. Portfolio managers have several roles or responsibilities even in perfectly efficient markets. The
most important responsibility is to:

1. Identify the risk/return objectives for the portfolio given the investor’s constraints. In an
efficient market, portfolio managers are responsible for tailoring the portfolio to meet the
investor’s needs rather than to beat the market, which requires identifying the client’s return
requirements and risk tolerance. Rational portfolio management also requires examining the
investor’s constraints, such as liquidity, time horizon, laws and regulations, taxes, and such unique
preferences and circumstances as age and employment.

Other roles and responsibilities include:

2. Developing a well-diversified portfolio with the selected risk level. Although an efficient
market prices securities fairly, each security still has firm-specific risk that portfolio managers can
eliminate through diversification. Therefore, rational security selection requires selecting a well-
diversified portfolio that provides the level of systematic risk that matches the investor’s risk
tolerance.

3. Reducing transaction costs with a buy-and-hold strategy. Proponents of the EMH advocate
a passive investment strategy that does not try to find under- or overvalued stocks. A buy-and-
hold strategy is consistent with passive management. Because the efficient market theory suggests
that securities are fairly priced, frequently buying and selling securities, which generate large
38 Chapter 10: Market Efficiency

brokerage fees without increasing expected performance, makes little sense. One common
strategy for passive management is to create an index fund that is designed to replicate the
performance of a broad-based index of stocks.

4. Developing capital market expectations. As part of the asset-allocation decision, portfolio

managers need to consider their expectations for the relative returns of the various capital markets
to choose an appropriate asset allocation.

5. Implement the chosen investment strategy and review it regularly for any needed
adjustments. Under the EMH, portfolio managers have the responsibility of implementing and
updating the previously determined investment strategy for each client.

D. Whether active asset allocation among countries could consistently outperform a world market
index depends on the degree of international market efficiency and the skill of the portfolio
manager. Investment professionals often view the basic issue of international market efficiency in
terms of cross-border financial market integration or segmentation. An integrated world financial
market would achieve international efficiency in the sense that arbitrage across markets would
take advantage of any new information throughout the world. In an efficiently integrated
international market, prices of all assets would be in line with their relative investment values.

Some claim that international markets are not integrated, but segmented. Each national market
might be efficient, but factors might prevent international capital flows from taking advantage of
relative mispricing among countries. These factors include psychological barriers, legal
restrictions, transaction costs, discriminatory taxation, political risks, and exchange risks.

Markets do not appear fully integrated or fully segmented. Markets may or may not become more
correlated as they become more integrated since other factors help to determine correlation.
Therefore, the degree of international market efficiency is an empirical question that has not yet
been answered.
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