The document discusses tests and results related to the efficient market hypothesis (EMH). It covers the weak-form, semi-strong form, and strong-form EMH. For the weak-form, tests show mixed results that generally support the hypothesis. For the semi-strong form, event studies and tests of anomalies like the size effect, P/E ratios, and book-to-market ratios show some market inefficiencies. The strong-form is difficult to test directly. Overall, while some market anomalies exist, most results still provide general support for the EMH.

1. Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 6
Chapter 6
Efficient Capital Markets
Questions to be answered:
• What is meant by the concept that capital markets are
efficient?
• Why should capital markets be efficient?
• What are the specific factors that contribute to an
efficient market?
• Given the overall efficient market hypothesis, what
are the three sub-hypotheses and what are the
implications of each?
Chapter 6
Efficient Capital Markets
• How do you test the weak-form efficient market
hypothesis (EMH) and what are the results of the
tests?
• How do you test the semistrong-form EMH and what
are the test results?
• How do you test the strong-form EMH and what are
the test results?
• For each set of tests, which results support the
hypothesis and which results indicate an anomaly
related to the hypothesis?

2. 1

3. Chapter 6
Efficient Capital Markets
• What are the implications of the results for
– Technical analysis?
– Fundamental analysis?
– Portfolio managers with superior analysts?
– Portfolio managers with inferior analysts?
• What is the evidence related to the EMH
for markets in foreign countries?
Thị trường vốn hiệu quả
• Trong thị trường vốn hiệu quả, giá chứng
khoán điều chỉnh nhanh chóng khi có thông tin
mới, do vậy, giá chứng khoán hiện tại phản ánh
tất cả thông tin về chứng khoán.
• Thị trường có hiệu quả hay không là chủ đề
của nhiều nghiên cứu và vẫn còn là câu hỏi
gây tranh cãi.
Tại sao thị trường vốn phải hiệu quả?
Nền tảng của thị trường hiệu quả:
– Nhiều người tham gia (nhằm tối đa lợi nhuận và
cạnh tranh lẫn nhau) phân tích và đánh giá chứng
khoán một cách độc lập.
– Thông tin về chứng khoán đến với thị trường một
cách ngẫu nhiên.
– Nhà đầu tư tối đa hóa lợi nhuận điều chỉnh giá chứng
khoán để phản ánh hiệu quả của thông tin mới.
Kết luận: lợi tức kỳ vọng ẩn trong giá hiện tại
của chứng khoán phản ánh rủi ro của nó.

4. 2

5. Các giả thuyết thị trường hiệu quả
(EMH)
• Giả thuyết Bước ngẫu nhiên (Random Walk
Hypothesis) – giá chứng khoán thay đổi ngẫu
nhiên
• Mô hình chơi đẹp (Fair Game Model) – giá chứng
khoán hiện tại phản ánh tất cả thông tin có sẵn về
chứng khoán và lợi tức kỳ vọng dựa trên giá này
phù hợp với rủi ro của nó.
• Giả thuyết thị trường hiệu quả - Efficient Market
Hypothesis (EMH) – bao gồm 3 giả thuyết nhỏ
phụ thuộc vào các thông tin liên quan:
Giả thuyết thị trường hiệu quả (EMH)
• Weak-Form EMH – giá chứng khoán
phản ánh tất cả thông tin thị trường của
chứng khoán
• Semistrong-form EMH – giá phản ánh tất
cả thông tin công khai.
• Strong-form EMH – giá phản ánh tất
cả thông tin công khai và nội bộ.
Weak-Form EMH
• Giá hiện tại phản anh tất cả thông tin thị
trường của chứng khoán, bao gồm: giá quá
khứ, tỷ lệ lợi tức, dữ liệu về khối lượng giao
dịch, và các thông tin tạo ra bởi thị trường.
• Điều này ngụ ý rằng thông tin tỷ lệ lợi tức
trong quá khứ và các thông tin thị trường
khác không có liên hệ với tỷ lệ lợi tức
trong tương lai.

6. 3

7. Semistrong-Form EMH
• Giá thị trường hiện tại phản ánh tất cả thông
tin công bố công khai, bao gồm thông tin thị
trường và thông tin không phải thị trường.
• Điều này ngụ ý: quyết định đầu tư dựa trên
thông tin mới sau khi được công bố không
đem lại lợi nhuận sau khi điều chỉnh rủi ro
trên trung bình từ những giao dịch đó.
Strong-Form EMH
• Giá chứng khoán phản ánh tất cả thông
tin nội bộ và công khai.
• Điều này ngụ ý không có nhóm nhà đầu
tư nào có thể kiếm được tỷ lệ lợi tức điều
chỉnh rủi ro trên trung bình một cách liên
tục.
• Điều này giả sử rằng thị trường hoàn hảo
trong đó tất cả thông tin đều miễn phí và
sẵn có với tất cả mọi người cùng một lúc.
Tests and Results of
Weak-Form EMH
• Statistical tests of independence
between rates of return
– Autocorrelation tests have mixed results
– Runs tests indicate randomness in prices

8. 4

9. Tests and Results of
Weak-Form EMH
• Comparison of trading rules to a buy-and-hold
policy is difficult because trading rules can be
complex and there are too many to test them all
– Filter rules yield above-average profits with small
filters, but only before taking into account
transactions costs
– Trading rule results have been mixed, and most have
not been able to beat a buy-and-hold policy
Tests and Results of
Weak-Form EMH
• Testing constraints
– Use only publicly available data
– Include all transactions costs
– Adjust the results for risk
Tests and Results of
Weak-Form EMH
• Results generally support the weak-form
EMH, but results are not unanimous

10. 5

11. Tests of the Semistrong Form of
Market Efficiency
Two sets of studies
• Time series analysis of returns or the cross
section distribution of returns for individual
stocks
• Event studies that examine how fast
stock prices adjust to specific significant
economic events
Tests and Results of
Semistrong-Form EMH
• Test results should adjusted a security’s rate of
return for the rates of return of the overall market
during the period considered
Arit = Rit -
Rmt where:
Arit = abnormal rate of return on security i during
period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
Tests and Results of
Semistrong-Form EMH
• Time series tests for abnormal rates of return
– short-horizon returns have limited results
– long-horizon returns analysis has been quite
successful based on
• dividend yield (D/P)
• default spread
• term structure spread
– Quarterly earnings reports may yield abnormal
returns due to
• unanticipated earnings change

12. 6

13. Tests and Results of
Semistrong-Form EMH
• Quarterly Earnings Reports
– Large Standardized Unexpected Earnings
(SUEs) result in abnormal stock price changes,
with over 50% of the change happening after
the announcement
– Unexpected earnings can explain up to 80% of
stock drift over a time period
• These results suggest that the earnings
surprise is not instantaneously reflected
in security prices
Tests and Results of
Semistrong-Form EMH
• The January Anomaly
– Stocks with negative returns during the prior
year had higher returns right after the first of
the year
– Tax selling toward the end of the year has been
mentioned as the reason for this phenomenon
– Such a seasonal pattern is inconsistent with the
EMH
Tests and Results of
Semistrong-Form EMH
• Other calendar effects
– All the market’s cumulative advance occurs
during the first half of trading months
– Monday/weekend returns were significantly
negative
– For large firms, the negative Monday effect
occurred before the market opened (it was a
weekend effect), whereas for smaller firms,
most of the negative Monday effect occurred
during the day on Monday (it was a Monday
trading effect)
7

14. Tests and Results of
Semistrong-Form EMH
• Predicting cross-sectional returns
– All securities should have equal risk-adjusted
returns
• Studies examine alternative measures
of size or quality as a tool to rank stocks
in terms of risk-adjusted returns
– These tests involve a joint hypothesis and are
dependent both on market efficiency and the
asset pricing model used
Tests and Results of
Semistrong-Form EMH
• Price-earnings ratios and returns
– Low P/E stocks experienced superior risk-
adjusted results relative to the market, whereas
high P/E stocks had significantly inferior risk-
adjusted results
– Publicly available P/E ratios possess valuable
information regarding future returns
– This is inconsistent with semistrong efficiency
Tests and Results of
Semistrong-Form EMH
• Price-Earnings/Growth Rate (PEG) ratios
– Studies have hypothesized an inverse
relationship between the PEG ratio and
subsequent rates of return. This is inconsistent
with the EMH
– However, the results related to using the PEG
ratio to select stocks are mixed

15. 8

16. Tests and Results of
Semistrong-Form EMH
• The size effect (total market value)
– Several studies have examined the impact of
size on the risk-adjusted rates of return
– The studies indicate that risk-adjusted returns
for extended periods indicate that the small
firms consistently experienced significantly
larger risk-adjusted returns than large firms
– Firm size is a major efficient market anomaly
– Could this have caused the P/E results
previously studied?
Tests and Results of
Semistrong-Form EMH
• The P/E studies and size studies are
dual tests of the EMH and the CAPM
• Abnormal returns could occur
because either
– markets are inefficient or
– market model is not properly specified and
provides incorrect estimates of risk and
expected returns
Tests and Results of
Semistrong-Form EMH
• Adjustments for riskiness of small firms
did not explain the large differences in rate
of return
• The impact of transactions costs of investing in
small firms depends on frequency of trading
– Daily trading reverses small firm gains
• The small-firm effect is not stable from
year to year

17. 9

18. Tests and Results of
Semistrong-Form EMH
• Neglected Firms
– Firms divided by number of analysts following
a stock
– Small-firm effect was confirmed
– Neglected firm effect caused by lack of
information and limited institutional interest
– Neglected firm concept applied across size
classes
– Another study contradicted the above results
Tests and Results of Semistrong-
form EMH
• Trading volume
– Studied relationship between returns, market
value, and trading activity.
– Size effect was confirmed. But no significant
difference was found between the mean returns
of the highest and lowest trading activity
portfolios
Tests and Results of
Semistrong-Form EMH
• Ratio of Book Value of a firm’s Equity to Market
Value of its equity
– Significant positive relationship found between
current values for this ratio and future stock
returns
– Results inconsistent with the EMH
• Size and BV/MV dominate other ratios such as
E/P ratio or leverage
• This combination only works during expansive
monetary policy

19. 1
0

20. Tests and Results of
Semistrong-Form EMH
• Firm size has emerged as a major
predictor of future returns
• This is an anomaly in the efficient
markets literature
• Attempts to explain the size anomaly in
terms of superior risk measurements,
transactions costs, analysts attention, trading
activity, and differential information
have not succeeded
Tests and Results of
Semistrong-Form EMH
• Event studies
– Stock split studies show that splits do not result
in abnormal gains after the split announcement,
but before
– Initial public offerings seems to be underpriced
by almost 18%, but that varies over time, and
the price is adjusted within one day after the
offering
– Listing of a stock on an national exchange such
as the NYSE may offer some short term profit
opportunities for investors
Tests and Results of
Semistrong-Form EMH
• Event studies (continued)
– Stock prices quickly adjust to unexpected world
events and economic news and hence do not
provide opportunities for abnormal profits
– Announcements of accounting changes are
quickly adjusted for and do not seem to provide
opportunities
– Stock prices rapidly adjust to corporate events
such as mergers and offerings
– The above studies provide support for the
semistrong-form EMH
1

21. 1

22. Summary on the
Semistrong-Form EMH
• Evidence is mixed
• Strong support from numerous event
studies with the exception of exchange listing
studies
Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets
are not semistrong efficient
Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets
are not semistrong efficient
– Dividend yields

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2

24. Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets
are not semistrong efficient
– Dividend yields, risk premiums
Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets
are not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns
Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets
are not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns, and earnings surprises

25. 1
3

26. Summary on the
Semistrong-Form EMH
• Studies on predicting rates of return for a
cross-section of stocks indicates markets
are not semistrong efficient
– Dividend yields, risk premiums, calendar
patterns, and earnings surprises
• This also included cross-sectional
predictors such as size, the BV/MV ratio
(when there is expansive monetary policy),
E/P ratios, and neglected firms.
Tests and Results of
Strong-Form EMH
• Strong-form EMH contends that stock
prices fully reflect all information,
both public and private
• This implies that no group of investors has
access to private information that will
allow them to consistently earn above-
average profits
Testing Groups of Investors
• Corporate insiders

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4

28. Testing Groups of Investors
• Corporate insiders
• Stock exchange specialists
Testing Groups of Investors
• Corporate insiders
• Stock exchange specialists
• Security analysts
Testing Groups of Investors
• Corporate insiders
• Stock exchange specialists
• Security analysts
• Professional money managers

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5

30. Corporate Insider Trading
• Insiders include major corporate
officers, directors, and owners of 10%
or more of any equity class of securities
Corporate Insider Trading
• Corporate insiders include major corporate
officers, directors, and owners of 10% or
more of any equity class of securities
• Insiders must report to the SEC each
month on their transactions in the stock of
the firm for which they are insiders
Corporate Insider Trading
• Corporate insiders include major corporate
officers, directors, and owners of 10% or
more of any equity class of securities
• Insiders must report to the SEC each
month on their transactions in the stock of
the firm for which they are insiders
• These insider trades are made public about
six weeks later and allowed to be studied

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6

32. Corporate Insider Trading
• Corporate insiders generally
experience above-average profits
especially on purchase transaction
Corporate Insider Trading
• Corporate insiders generally
experience above-average profits
especially on purchase transaction
• This implies that many insiders had private
information from which they derived above-
average returns on their company stock
Corporate Insider Trading
• Studies showed that public investors who
traded with the insiders based on
announced transactions would have
enjoyed excess risk-adjusted returns (after
commissions), but the markets now seem to
have eliminated this inefficiency (soon after it
was discovered)

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34. Corporate Insider Trading
• Other studies indicate that you can
increase returns from using insider trading
information by combining it with key
financial ratios and considering what group
of insiders is doing the buying and selling
Stock Exchange Specialists
• Specialists have monopolistic access to
information about unfilled limit orders
Stock Exchange Specialists
• Specialists have monopolistic access to
information about unfilled limit orders
• You would expect specialists to derive
above-average returns from this information

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8

36. Stock Exchange Specialists
• Specialists have monopolistic access to
information about unfilled limit orders
• You would expect specialists to derive
above-average returns from this information
• The data generally supports this expectation
Security Analysts
• Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
Security Analysts
• Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
• This looks at whether, after a stock
selection by an analyst is made known, a
significant abnormal return is available to
those who follow their recommendations

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38. The Value Line Enigma
• Value Line (VL) publishes detailed financial
information on about 1,700 stocks
The Value Line Enigma
• Value Line (VL) publishes financial
information on about 1,700 stocks
• The report includes a timing rank from
1 down to 5
The Value Line Enigma
• Value Line (VL) publishes financial
information on about 1,700 stocks
• The report includes a timing rank from
1 down to 5
• Firms ranked 1 substantially outperform
the market

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40. The Value Line Enigma
• Value Line (VL) publishes financial
information on about 1,700 stocks
• The report includes a timing rank from
1 down to 5
• Firms ranked 1 substantially outperform
the market
• Firms ranked 5 substantially
underperform the market
The Value Line Enigma
• Changes in rankings result in a fast
price adjustment
The Value Line Enigma
• Changes in rankings result in a fast
price adjustment
• Some contend that the Value Line effect is
merely the unexpected earnings anomaly
due to changes in rankings from
unexpected earnings

41. 2
1

42. Security Analysts
• There is evidence in favor of existence
of superior analysts who apparently
possess private information
Professional Money Managers
• Trained professionals, working full time
at investment management
• If any investor can achieve above-
average returns, it should be this group
• If any non-insider can obtain inside
information, it would be this group due
to the extensive management interviews
that they conduct
Performance of
Professional Money Managers
• Most tests examine mutual funds
• New tests also examine trust
departments, insurance companies, and
investment advisors
• Risk-adjusted, after expenses, returns
of mutual funds generally show that
most funds did not match aggregate
market performance

43. 2
2

44. Conclusions Regarding the
Strong-Form EMH
• Mixed results, but much support
• Tests for corporate insiders and stock
exchange specialists do not support the
hypothesis (Both groups seem to have
monopolistic access to important
information and use it to derive above-
average returns)
Conclusions Regarding the
Strong-Form EMH
• Tests results for analysts are concentrated on
Value Line rankings
– Results have changed over time
– Currently tend to support EMH
• Individual analyst recommendations seem to
contain significant information
• Performance of professional money managers
seem to provide support for strong-form EMH
Behavioral Finance
It is concerned with the analysis of
various psychological traits of individuals
and how these traits affect the manner in
which they act as investors, analysts, and
portfolio managers

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3

46. Implications of
Efficient Capital Markets
• Overall results indicate the capital
markets are efficient as related to
numerous sets of information
• There are substantial instances where
the market fails to rapidly adjust to
public information
Efficient Markets
and Technical Analysis
• Assumptions of technical analysis directly
oppose the notion of efficient markets
• Technicians believe that new information
is not immediately available to everyone,
but disseminated from the informed
professional first to the aggressive
investing public and then to the masses
Efficient Markets
and Technical Analysis
• Technicians also believe that investors
do not analyze information and act
immediately - it takes time
• Therefore, stock prices move to a new
equilibrium after the release of new
information in a gradual manner, causing
trends in stock price movements that persist
for periods

47. 2
4

48. Efficient Markets
and Technical Analysis
• Technical analysts develop systems to
detect movement to a new equilibrium
(breakout) and trade based on that
• Contradicts rapid price
adjustments indicated by the EMH
• If the capital market is weak-form
efficient, a trading system that depends on
past trading data can have no value
Efficient Markets
and Fundamental Analysis
• Fundamental analysts believe that there is
a basic intrinsic value for the aggregate
stock market, various industries, or
individual securities and these values
depend on underlying economic factors
• Investors should determine the intrinsic
value of an investment at a point in time
and compare it to the market price
Efficient Markets
and Fundamental Analysis
• If you can do a superior job of
estimating intrinsic value you can make
superior market timing decisions and
generate above-average returns
• This involves aggregate market
analysis, industry analysis, company
analysis, and portfolio management
• Intrinsic value analysis should start with
aggregate market analysis

49. 2
5

50. Aggregate Market Analysis with
Efficient Capital Markets
• EMH implies that examining only past economic
events is not likely to lead to outperforming a buy-
and-hold policy because the market adjusts rapidly
to known economic events
• Merely using historical data to estimate future
values is not sufficient
• You must estimate the relevant variables that
cause long-run movements
Industry and Company Analysis
with Efficient Capital Markets
• Wide distribution of returns from
different industries and companies
justifies industry and company analysis
• Must understand the variables that
effect rates of return and
• Do a superior job of estimating future
values of these relevant valuation
variables, not just look at past data
Industry and Company Analysis
with Efficient Capital Markets
• Important relationship between
expected earnings and actual earnings
• Accurately predicting earnings surprises
• Strong-form EMH indicates likely
existence of superior analysts
• Studies indicate that fundamental
analysis based on E/P ratios, size, and
the BV/MV ratios can lead to
differentiating future return patterns

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6

52. How to Evaluate Analysts or
Investors
• Examine the performance of numerous
securities that this analyst recommends
over time in relation to a set of randomly
selected stocks in the same risk class
• Selected stocks should consistently
outperform the randomly selected stocks
Efficient Markets
and Portfolio Management
• Portfolio Managers with Superior Analysts
– concentrate efforts in mid-cap stocks that do
not receive the attention given by institutional
portfolio managers to the top-tier stocks
– the market for these neglected stocks may be
less efficient than the market for large well-
known stocks
Efficient Markets
and Portfolio Management
• Portfolio Managers without
Superior Analysts
– Determine and quantify your client's risk
preferences
– Construct the appropriate portfolio
– Diversify completely on a global basis to
eliminate all unsystematic risk
– Maintain the desired risk level by rebalancing
the portfolio whenever necessary
– Minimize total transaction costs

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7

54. The Rationale and
Use of Index Funds
• Efficient capital markets and a lack of
superior analysts imply that many portfolios
should be managed passively (so their
performance matches the aggregate market,
minimizes the costs of research and trading)
• Institutions created market (index) funds
which duplicate the composition and
performance of a selected index series
Insights from Behavioral Finance
• Growth companies will usually not be
growth stocks due to the overconfidence
of analysts regarding future growth rates
and valuations
• Notion of “herd mentality” of analysts
in stock recommendations or quarterly
earnings estimates is confirmed
Efficiency in
European Equity Markets
• Studies indicate a level of efficiency
similar to that of U.S. markets

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56. The Internet
Investments Online
www.bloomberg.com
www.ft.com www.cnbc.com
www.wsj.com www.abcnews.com
www.pointcast.com www.nbcnews.com
www.cnnfn.com www.msnbc.com
www.cnn.com
Future topics
Chapter 8
• Portfolio management
• Alternative measures of risk
• Computing expected return
• The risk-return efficient frontier

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