Market Efficiency
Chapter 4
Forms of Market Efficiency,
(i.e., what information is used?)
• A Weak-form Efficient Market is one in which past prices and volume
figures are of no use in beating the market.
• If so, then technical analysis is of little use.
• A Semistrong-form Efficient Market is one in which publicly available
information is of no use in beating the market.
• If so, then fundamental analysis is of little use.
• A Strong-form Efficient Market is one in which information of any kind,
public or private, is of no use in beating the market.
• If so, then “inside information” is of little use.
7-2
How New Information Gets into Stock Prices, I
• In its semi-strong form, the EMH states simply that stock prices fully reflect publicly available
information.
• Stock prices change when traders buy and sell shares based on their view of the future prospects
for the stock.
• But, the future prospects for the stock are influenced by unexpected news announcements.
• Prices could adjust to unexpected news in three basic ways:
• Efficient Market Reaction: The price instantaneously adjusts to the new
information.
• Delayed Reaction: The price partially adjusts to the new information.
• Overreaction and Correction: The price over-adjusts to the new information,
but eventually falls to the appropriate price.
7-3
Evidence against Efficient Market Hypothesis / Market
Anomalies
• Unfavorable Evidence
1. Large reaction to earnings announcement
2. Small-firm effect: small firms have abnormally high returns
3. January effect: high returns in January
4. Value versus Growth
5. Momentum and reversal
Market Anomalies - 1
Lagged reaction to the earnings
announcement
• Event study
• Earning announcements, stock splits,
dividend changes, etc.
• Standardized Unexpected Returns (SUR)
Market Anomalies - 2
• The Small-Firm Effect is an anomaly. Many empirical studies have shown that
small firms have earned abnormally high returns over long periods of time,
even when the greater risk for these firms has been considered.
• The small-firm effect seems to have diminished in recent years but is still a challenge to the
theory of efficient markets
• Various theories have been developed to explain the small-firm effect, suggesting that it may
be due to rebalancing of portfolios by institutional investors, tax issues, low liquidity of small-
firm stocks, large information costs in evaluating small firms, or an inappropriate
measurement of risk for small-firm stocks
Market Anomalies - 4
• Value versus Growth Investing
• Growth stocks (or glamour stocks) are stocks with prices that are high relative to earnings, cash
flows, and book value, at least in part because the market anticipates high future growth.
• Value investing is the tendency to overweight value stocks (relative to growth stocks) in one’s
portfolio.
Market Anomalies - 5
Momentum and reversal
• Momentum exists when returns are
positively correlated with past returns,
while reversal exists when returns are
negatively correlated with past returns.
• For short-term (one-month) intervals,
there is reliable reversal. For medium-
term intervals (about 3–12 months) there
is well documented momentum. And for
long-term intervals (about 3–5 years)
reversal is typical.
Theoretical requirements for Market efficiency
1. Support 1: All investors are always rational.
2. Support 2: Investors’ errors are uncorrelated.
3. Support 3: There are no limits to arbitrage.
Limits to Arbitrage
• Firm-specific risk
▪ Reluctant to take large positions in a single security due
to the possibility of an unsystematic event
• Noise trader risk, or Sentiment-based risk
▪ Keynes: “Markets can remain irrational longer than you
can remain insolvent.”
• Implementation costs
▪ Transaction costs may outweigh potential arbitrage profit
