Thursday, February 26, 2009


Testing of the strong from of the EMH
The strong form could be tested by looking at the returns earned by people with private information, such as corporate insiders and specialists. If these people do earn superior returns, this would represent an anomaly for the strong form
Corporate insiders, such as directors and specialists, have been shown to earn superior returns, demonstrating that private information is not immediately reflected in stock prices. This was particularly the case with purchase transactions. Directors have assess to information within the corporate while specialists have privileged access to the order book on the NYSE.

Tests on value line rankings of stocks have indicated that rankings by value line advisory service predict future returns, but any excess return rapidly disappears after the rankings are published. In addition a, it is not possible to gain excess returns after transaction costs.

Tests based on analysts’ recommendations have had mixed conclusions. Generally, stocks on which recommendations are made will experience any abnormal price movement very rapidly on the same day of the recommendation.
Tests based on the returns earned by money managers indicate that a small majority achieved better risk-adjusted return than the market before transaction costs. However, the majority are not able to beat a buy and hold policy after transaction costs.
Generally, apart from directors and specialists who earn consistently superior returns, the tests tend to support the strong form of the EMH.

Testing of the EMH in overseas markets.

Tests of the EMH in European countries such as the UK have consistently portrayed a picture similar to that in the US, even for countries with very narrow markets. This suggests that it is appropriate to view European markets as having the same amount of informational efficiency as the US.
Implications of the EMH .
Technical analysis.

The implication of the EMH for technical analysis does not work if the EMH holds. It is not possible to make abnormal profits based on analysis of past market information.
Fundamental analysis,

For a fundamental analyst, it implies that if all you can do is analyze past economic events and information, it is very difficult to earn superior risk adjusted results. A buy and hold policy will perform just as well.
Nevertheless, the fact that research tests have shown that it is possible for some investors to make superior profits shows that analysis can reap benefits. This cannot be done merely by processing available information, but by using such information to estimated long-run variables that will derive returns in the future. The analyst would need to be superior to others for this to give superior profits over time.
In addition, it may be possible to take advantage of some of the anomalies noted above. For example, an analyst may concentrate on neglected stocks, hoping to acquire additional information by dint of extra effort.
Investors with superior information.

An investors with access to superior analysts should follow their recommendations. The best place to take advantage of superior analysis is in second-stocks, which are sufficiently liquid but not exhaustively researched.
An analyst will only offer superior returns if he can consistently outperform a randomly selected portfolio with equal risk levels through time.
Investors without superior information.

When an investor does not have access to superior analysts, he should establish his risk preferences and invest in / maintain a diversified portfolio (on a worldwide basis) which has this level of risk. This can be done through the separation theorem, by investing an appropriate amount in the market and the rest in risk-free assets. The portfolio should be rebalanced as appropriate.
Key objectives beyond this will be to minimize transaction costs by tax planning, reducing turnover of stocks, and buying liquid stocks (to reduce liquidity costs).
Use of index funds.

If capital markets are efficient and there are no superior analysts, then an investors objective should be to match the market, while minimizing any costs of research and trading. This will be the overall highest return for the investor.
Index (or market) funds are designed to track the market by buying a portfolio of shares that follow a market index closely, while reducing costs to the minimum. Such funds may follow a broad- based domestic equity index or a more specific index, such as an overseas market or small cap stocks.
This is the case for both US and European investment, since it was noted above that European markets also have a high level of efficiency.

Friday, February 13, 2009


Testing of the semi-strong form of the EMH .
Methods of testing.
The semi-strong form can be tested in two ways.
  1. Trying to predict future price movements by using currently available public information. For example, do stocks with high dividend yields earn superior returns to stocks with low dividend yields? These tests can be based on time series analysis of returns for individual stocks or cross-sectional data for different stocks.
  2. Seeing how quickly stock prices react to new information, to establish if there is a profit window. These tests are known as event studies.
When looking at how stock prices react to information, it is important to adjust the returns to information, it is important to adjust the returns to allow for market movements in the period concerned. Otherwise, any stock price movements may be solely due to general market movements.
The research therefore should focus on the abnormal price movement beyond that due to general market movement. For example, if the stock price would have been expected to rise by 10% due to general market movements and it actually rose by 12% there would be an abnormal gain of 2%. This would be referred to as an anomaly, since it is not expected under efficient markets.
In the long run, abnormal returns would be expected to come to zero, given an efficient market.
Time series tests.
Test based on ratio.
Time series test have indicated that it is possible to predict returns and make superior profits by looking at various ratios such as price to book, dividend yields, yield spreads of lower grade bonds over high grade bonds, etc.

Broadly speaking, studies have indicated that companies with low price to book rations and high dividend yields have outperformed over long periods of time. In addition, a high default spread (the amount by which the yield on low grade and AAA corporate bonds is different) has also been followed by high performance. On the face of it this would suggest that markets are not efficient, since these ratios can be used to earn higher returns even after allowing for transaction costs.

The reason for this may be that high dividend yields and high default spreads indicate a poor economic environment for stocks and bonds. As a result, investors require higher rates of return to compensate for the risk of investing in such securities.
Tests based on earnings reports.
Tests have looked at factors such as quarterly earnings report, aiming to establish whether it is possible to predict future stock price returns based on published earnings reports.

It has been found that it is possible to make abnormal returns when there are positive abnormal surprises in earnings, i.e. Earnings are significantly higher than expected. The positive information contained in the earnings surprise is not immediately reflected in the stock price.

In measuring whether or not an earnings surprise is significant, the early tests looked at percentage differences between actual earnings and expected earnings. More recent tests have looked at the difference between actual earnings and predicated earnings as a percentage of the estimate, based on a regression line predicting earnings using time series analysis.
These studies suggest that it is possible to make abnormal returns through trading based on earnings surprises. This evidence goes against the EMH.
Calendar studies
Other tests have looked at whether it is possible to make superior profits by following rules such as buying stocks in December and selling them in January.
This is to make advantage of tax-based trading in the market around the year-end when investors sell stocks in December and repurchase them in January. This is referred to as the January effect (or anomaly), stating that stock prices fall in December and then rise in January. It has been established that this is possible, but any gain may be eliminated by transaction costs. The effect worked for stocks that had suffered large declines in the previous year, but not for those which had large gains, supporting the tax motivation for this trading.
A weekend effect that has been tested is that returns on Mondays are negative, whereas returns on the other four working days are positive.
Cross-sectional tests.
Cross-sectional tests are based on the assumption that in an effect market all stocks should earn a risk adjusted return given their betas. I.e. the returns should all lie on the security market line. If it is possible to predict returns for stocks based on public information other than that based on the security market line, then it indicates on anomaly from the EMH.
One problem with these tests is that they assume that the asset pricing model being used as the basis for the test, e.g. the capital asset pricing model, is a good predictor of returns if the market is efficient. There is therefore a joint hypothesis in the test, that the asset pricing model does predict returns while the other factor being tested does not. If the asset pricing model is not effective, then the results will be distorted.
Tests of P/E ratios have indicated that stocks with low P/Es tend to outperform those with high P/Es. possibly because the market tends to overestimate the growth prospects of high P/E stocks.
Tests on PEG ratios (P/E to growth rate ratios) have given inconclusive evidence. Some people believe that companies with a P/E ratios compared to the expected growth rate in earnings will offer superior returns in the future.
Tests based on the size of the companies have indicated that small firms earn consistently higher risk adjusted returns than large firms. There may, however be measurement problems here because trading in small firms is infrequent. If the small firm actually has a higher beta than that measured for CAPM purposes, then its predicted position on the security market line will be lower than it should be. Therefore, it will appear to be offering high risk adjusted returns although this is not actually the case.
Tests based on neglected firms that are not following by analysts indicate that they have abnormally high returns. However, this may be due to the fact that the measured beta understates the risk of these firms. If this is adjusted for, the return achieved will not be beyond the required on a risk adjusted basis. For example, investors may require a higher return on such firms to compensate for poor information.
Tests based on the ratio of book value to market value have indicated that firms with a high book value relative to market value earn superior returns, regardless of their size. Stocks with high book to price ratios (or low price to book ratios) are referred to as value stocks while stocks with low book to price ratios are referred to as growth stocks. Once gain, there is an argument that stocks with high book to market ratios are riskier and hence have to earn a higher rate of return to compensate.
Fa ma and French have found that the size and book to price variables are both significant when included together in a test. Other ratios (such as leverage) became insignificant when tested along with size and price to book.
Events Tests.
These tests consider whether it is possible to take advantage of a profit window after information has been published.
Tests based on announcements of stock splits have concluded that the announcement has no impact on stock returns in either the short or the long term, supporting the EMH. It may be that the share price raised after announcement of a stock split, but tests have identified that this is related to the linked increase in dividend rather than the split itself.
When there is a initial public offering, it is often perceived that the stock will be priced too low, meaning that superior returns can be achieved by investing in IPOs. Tests indicate that any under pricing is corrected in the first day of trading, supporting the EMH. Buying securities after the end of the first day will not give abnormal gains.
It is also suggested that obtaining an exchange listing will increase the stock price due to testing prestige, liquidity, etc. Tests have indicated that an exchange listing has no long run impact on value or risk. However, they do suggest that is its possible to make abnormal profits after the announcement of the decision to obtain a listing has been made.
Tests based on unexpected world events have indicated that prices react rapidly to this information.
Tests based on the announcement of accounting changes by companies have indicated that stock prices respond quickly to such announcements.
Where are corporate events such as mergers take place, stock prices move rapidly to reflect the new information. The new stock price tends to reflect economic reality of transactions rather than any accounting effect.
Generally, all the above events tests indicate that stock prices react quickly to the new information such that it is not possible to earn superior risk adjusted returns after the information becomes publicly available.

Monday, February 9, 2009


Empirical testing of the EMH.
(1).Anomalies or regularities.
An anomaly or regularity is where empirical evidence contradicts the EMH. For example, it may be the case that if a share price rises one day, it is more likely to rise the nest day and if it falls one day it is more likely to fall the nest day. This knowledge would enable us to predict future price movements with some accuracy it would contraband's the EMH and as a result would be referred to as an anomaly.
(2).Tests of the weak form of the EMH.
Statistical tests of independence.

the weak form argues that there should be no correlation of price movements over time. This can be tested statistically.
One form of statistical test would look for auto –(or serial ) correlation. Auto correlation describes the situation where the stock price movement for one period of time is related to the price movements in a previous period. For example, are stock price movements today linked to price movements yesterday or the day before?

Tests have found that usually there is not significant level of auto correlation, except in the case of some portfolios of small shares. Even this may be due to measurement problems when collating stock price information. It is difficult to rely on prices for small stocks since they are often infrequently traded (the problem of non-synchronous trading).
Alternatively, a run test can look at the changes in price through time and compare the actual changes to what would be expected for a random series. For example, it is possible to look at whether the price has risen (+) or fallen (-) each day and look at the results.

A series such as the following would indicate that a rise is likely to be followed by a fall.
+ - + - + - + - + - + - + - + - + - + - + - + - + - + - + - + - + - +
A series such as the following would indicate that a rise is likely to be followed by a rise and a fall is likely to day followed by a fall.
+ + + + + + + + + - - - - - - - - - - - - - - - - - + + + + + + + + + + +
A series such as the following would indicate that there is no link in price movements from day to be and the movements are random.
+ - - - + + - + + - + + + - - + + - + - - - + + + - + - + + - + +
Tests have shown that price changes fall within the range for a random series. Supporting the idea of weak form efficiency. This relates to testing for both the public market and the OTC market.
Both of the above types of statistical test support the view that price movements are a random series, with no correlation from one period to the next. A small doubt may be present for small stocks, but even this may be explained by infrequent trading, as noted above.
Some tests in the past have examined individual transactions on the NYSE and found significant serial correlation. This could indicate an anomaly. It may be due to the activities of specialists in relevant stocks. However it should be noted that knowledge of the dependency across different transactions could not be used to earn excess risk adjusted returns due to the high transaction cost any trading would involve.

Friday, February 6, 2009


The efficient market hypothesis.(EMH)

(1).Stock prices follow a random walk.

When researchers have examined stock prices movement for quoted companies they have observed that the price movements seem to follow a random pattern. In other words, stock price movements cannot be predicated.
From their observations, a hypothesis was developed which stated that stock prices are fairly valued on the basis of all existing information and stock prices quickly react to any new information. Being fairly valued means that expected returns equal required returns, taking into account the level of risk. This is referred to as an efficient capital market.
This would be expected given the large number of profit seeking investors analyzing stocks independently of one another. In may be referred to as the fair game model.

(2).Stock prices respond to new information .

Stock prices will move new when new information is received and will fairly reflect that new information since new information must, by definition, be unpredictable and random (otherwise it would not be new information) ,it follows that stock price movements will also be random. Stock prices adjust rapidly to new information according to the efficient market hypothesis (EMH).
This is referred to as informational efficiency.

(3). Assumptions underlying efficient capital markets.

The premises underlying the hypothesis that prices adjust rapidly to reflect all information are as follows,
  1. A large number of market participants are competing to analyze and value securities in order to make profits.

  2. Information comes to the market in a random fashion. Timing of an announcement is independent of other announcements.

  3. Competing investors quickly react to this new information in setting stock prices. The reaction may be imperfect, leading to an over or under-reaction to the new information. However there is no bias in one direction.

Generally, efficient capital markets therefore imply a minimum number of investors and a high degree of trading.

(4). The three forms of the EMH.
1. To what information do stock prices respond?Various levels of the EMH have been developed which state that markets take accounts of different levels. These are usually referred to as the weak. Semi strong and strong forms of the EMH.
2. Weak from of the EMH.The weak form of the EMH stats that all securities market information has already been incorporated into the current stock price. Market information includes share price movements, volumes, the nature of buyers and selves, etc.
What this implies is that it is impossible to use past stock price movements and other historic market information to predict future price movements.
This form of the EMH directly contradicts technical analysis assumptions implicitly, technical analysts believe that markets are not efficient, since they are using market information to make investment decisions.
3. Semi-strong from of the EMH.
The semi-strong form of the EMH stats that current stock prices not only reflect the market information referred to In the weak form but also rapidly move to incorporate any non market information that has been published about a company, i.e. the price reflects all public information.
For example, Release of preliminary figures by the company constitutes new information and the stock price will move to reflect this. Other public information is incorporated in ratios such as price to book value, P/E ratios. Ext.
This suggests that investors who base investment decisions on information after the information has been made public will not make excess returns on average.

4. Strong form of the EMH.The strong form of the EMH stats that, in addition to published information, a company’s stock price reflects all information that can be gleaned about the company itself, its markets and general economic factors. It includes those facts that are meant to be secret and confidential to the company itself.
Effectively, the strong form extends the efficient market to encompass the perfect market, where information is freely available to all investors at not cost and at the same time.
This form of the EMH is very extreme and few people actually believe that it applies in practice. The very fact that stock prices move when previously confidential information is published indicates that it is not the case.