Chapter 8
The Efficient Market Hypothesis
8.1 Random Walks and
Efficient Market Hypothesis
8-2
Why are price changes random?



Random Price Changes
In very competitive markets, prices should react to
only NEW information
Flow of NEW information is random
Therefore, price changes are random
Idea that stock prices follow a “Random Walk”
8-3
Random Walk and the EMH
8-4
•
Stock prices that change in response to new (unpredictable)
information must move unpredictably.
 Random Walk
•
If stock price movements were predictable, that would be
evidence of stock market inefficiency because the ability to
predict prices would indicate that all available information was
not already reflected in stock prices.
•
Efficient Market Hypothesis (EMH)
: The hypothesis that prices of securities fully reflect
available information about securities.

Cumulative Abnormal Returns before Takeover Attempts:
Target Companies
In this case there appears to be information leakage before the
announcement date (day 0), but markets adjust quickly.
8-5
Stock Price Reaction to CNBC Midday Reports
8-6
Forms of the EMH

Weak-form hypothesis

- The relevant information is past information such as historical
prices and trading volume.
- If the markets are weak form efficient, use of such information
provides no benefit “at the margin.”
- This version of the hypothesis implies that trend analysis is
fruitless.
8-7
Forms of the EMH

Semistrong-form hypothesis

- The relevant information is all publicly available information such
as past prices and fundamental data on firm’s prospects.
- If the markets are semi-strong form efficient, then studying past
price and volume data & studying earnings and growth forecasts
provides no net benefit in predicting price changes at the margin.
8-8
Forms of the EMH


Strong-form hypothesis

- The relevant information is all information both public and private
or inside information.
- If the markets are strong form efficient, use of any information
(public or private) provides no benefit at the margin.
- SEC Rule 10b-5 limits trading by corporate insiders (officers,
directors and major shareholders). Inside trading must be reported.
8-9
Relationships between forms of the EMH
•
Notice that _______________________________
__________________ (but _____________)
•
Strong form efficiency would imply that
__________________________________________.
semi-strong efficiency implies weak
form efficiency holds
NOT vice versa
both semi-strong and weak form efficiency hold
8-10
8.2 Implications of the EMH
(for Security Analysis)
8-11
Types of Stock Analysis
& Relationship to the EMH
Technical Analysis:
-
Technical Analysis is using prices and volume information to predict
future price changes. This assumes prices follow predictable trends.

-
If the markets are weak form efficient or semi-strong form
efficient or strong form efficient, will technical analysis be able to
consistently predict price changes? NO
8-12
Basic Types of Technical Analysis
Identifying common price patterns
One of these patterns is real and one of these is
computer simulated with random price changes.
Can you tell which is which?
8-13
Basic Types of Technical Analysis
Support and resistance levels
Support level:
- A price level below which it is supposedly unlikely for a stock or stock index t
o fall.
Resistance level:
- A price level above which it is supposedly unlikely for a stock or stock index to
rise.
A resistance level may arise at say $31.25 if a stock repeatedly rises to
$31.25 and then declines, indicating that investors are reluctant to pay
more than this price for the stock.
A stock price above $31.25 would then indicate a 'breakout' which would
be a bullish signal.
8-14
Types of Stock Analysis
& Relationship to the EMH
Fundamental Analysis:

- If the markets are weak form efficient or semi-strong form efficient or strong form efficient, will fundamental anal

ysis be able to consistently predict price changes?
Using economic and accounting information to
predict stock price changes
If the markets are only weak form efficient?
Fundamental Analysis CAN predict price changes.
If the markets are semi-strong or strong form efficient?
Fundamental Analysis CANNOT predict price changes.
8-15
Fundamental Analysis
Fundamental analysis assumes that stock prices should be equal to

Fundamental analysis is thus
the discounted value of the expected future cash
flows the stock is expected to provide to investors.
“art” of identifying over- and undervalued securities
based on an analysis of the firm's financial
statements and future prospects.
8-16
Fundamental Analysis
Fundamental analysis varies in technique but generally focuses on
forecasting the firm's future dividends or earnings,
discounting those future cash flows by the required rate
of return (usually obtained from the CAPM),
and comparing the resulting estimated price with the
current stock price.
8-17
Fundamental Analysis
If the estimated price is greater than the current price, an inv
estor should buy the stock since it is undervalued and since it
s price should increase to the "true" or "fundamental" value

uncovered by the analyst.
If the estimated price is less than the current price, the stock
should be sold because the stock is currently overvalued by t
he market.
In either case if the analyst is correct, the investor should rec
eive an “abnormal return”.
8-18
Fundamental AnalysisForecasts already exist and for fundamental analysis to add value, your forecast must be better than the consensus for
ecast.
Not enough to find a good company, you must find a company that is better than others believe, i.e., mispriced.
8-19
Active Management



Passive Management


Implications of Efficiency for Active or P
assive Management
Assumes inefficiency,
use technical and/or
fundamental analysis to
pick securities
Security analysis
Timing strategies
Investment Newsletters
Buy and Hold portfolios
Index Funds
Consistent with semi-

strong efficiency
8-20
Even if the market is efficient, a role exists for portfolio man
agement



Market Efficiency and Portfolio Management
Identify risk & choose appropriate risk level
Tax considerations
Other considerations such as liquidity needs or diversify
away from the client’s industry.
8-21
8.3 Are Markets Efficient?
8-22
In practice, this means that when trying to figure out if some
portfolio manager is earning abnormal returns, we must co
mpare their performance to a randomly chosen portfolio.
I.E. they must outperform the random portfolio, or in practi
ce, they must beat some benchmark rate of return.
Empirical Tests of Informational Efficiency
8-23
Event studies
Assessing performance of professional managers
Testing a trading rule
Empirical Tests of Inform. Efficiency
Examine how quickly information is integrated into prices
around an informational event.
EMH suggests rapid assimilation of information into prices.
Can professional managers, using their resources and

tools, “beat” the market after considering risk?
EMH suggests professionals will not outperform the market.
Testing whether a rule that uses available information
can earn abnormal returns after considering the risk
and cost of using the rule.
EMH suggests that such rules will not work.
8-24
Cumulative Abnormal Returns before Takeover Attempts:
Target Companies
In this case there appears to be information leakage before the
announcement date (day 0), but markets adjust quickly.
8-25