SP1202 SUJA Controversies

In the previous posts, I summarized the arguments and empirical evidence about the Efficient Market Hypothesis. I will briefly restate them and highlight the controversies.

The strong form of efficiency is the least contentious among the three because it does not seem to be substantiated by the evidence. Also, governments over the world generally restrict insider trading. If the investors are not allowed to trade based on the insider information, it is believable that the stock price does not reflect insider information. Whether the market is weakly efficient may be an issue, but majority of the arguments are on the semi-strong form of efficiency. This form states that stock prices always reflect the public information and one implication is that the prices adjust immediately when new information is available.

Of the theoretic basis for market efficiency, rationality, independent deviation, and presence of the professional investors, the first one does not seem to hold. Behavioral finance proponents argue against independent deviation using the two principles from psychology, representitiveness and conservatism. However, their arguments may seem contradictory. Representitiveness predicts over reaction and conservatism implies under reaction. In addition, proponent of EMH Eugene Fama reviewed the anomalies and found out about half of them showing over reaction and half showing under reaction and suggested this evidence was consistent with EMH that anomalies are chance events. On the other hand, a theory with so many anomalies is hardly satisfactory.

Next, whether the professional investors will correct the stock price is contentious. It really depends on who dominates the market. But is that possible for me to claim that there are more professionals in today's market than say 50 years ago? Firstly, many universities offer courses in corporate finance teaching future investors stock valuation. Books on this topic are also accessible to the general public. Secondly, a lot of investors put their money with the mutual funds whose managers are believed to be well taught and trained.

While it is evident that mutual funds do not outperform the market as the EMH implies, there are individual investors who consistently beat the market. Warrent Buffett and George Soros are among the star investors. Again, proponents of EMH may treat them as anomalies, or even expected anomalies. I read a book titled "fooled by randomness" last time saying that out of millions of investors, even if they invested randomly, it could be expected to have some star performers. Buffett definitely denies that his success is by pure luck. Anyway, I would like to suggest another explanation for the performance of mutual funds and star investors. Mutual fund managers tend to be guided by modern portfolio theory and diversify the portfolio, while Buffett does not. Diversification helps to reduce risk in the sense that the losers will be offset by the winners, but it also reduces the return. I could not verify this suggestion because I could not access the portfolios the mutual funds under these studies had held.

I tend to favour behavioural finance points of view. But if we reject EMH, then what is the reality of the market or if there is one? May be we have to view the evolving market instead of a snap shot of it. EMH is an elegant mathematical model that describes an ideal market. But how close it is to our real one or will the real market ever become closer to the ideal one? I need a focus.

SP1202 SUJA Arguments and evidence against EMH

Some arguments against EMH

Rationality does not apply to all investors. In fact many of them are irrational. For example, rational investors minimize tax payments by selling losers and holding onto winners. However, according to Brad Barber and Terrance Odean's 1999 paper, many are doing the opposite.

Independent Deviations from rationality may not hold in the real market as well. Supporters of behaviourial finance base the arguments on two principles from psychology. The first one is representativeness which says that people tend to draw conclusions from insufficient data. An implication in finance is bubbles resulted from markets dominated by representativeness, the internet stocks or the US housing market for example. Another principle is conservatism which says that people are slow to adjust their beliefs to new information. Indeed, many studies suggest stock prices seem to adjust slowly to the information contained in earning announcement. If there are some universal rules which determine how people deviate from rationality, then it is very likely that the deviations are not random.

Lastly, markets may stay irrational longer than an investor could stay solvent. If the positions from amateurs are large, professionals may have to take huge risk to correct the price.

Empirical challenges to market efficiency
Deviation from parity
Royal Dutch petroleum and shell transport merger
3Com and Palm Inc
etc.

Kolasinski and Li's study on earnings surprise

Stocks with high book value to stock price ratio outperfom stocks with low ratios (Fama and French 1998 paper)

SP1202 SUJA Arguments and evidence for EMH

I have been reading the materials about Efficient Market Hypothesis. I found that there had been lots of studies on this topic, as expected. Many of the studies deal with one aspect or one implication of the theory, but there is no clear conclusion. I am unable to read and comprehend all the materials, so I guess I will study only some of the papers.

In this post, I will present some arguments for the EMH as well as several pieces of empirical evidence.

The EMH was probably first formulated by  a French Mathematician in the 1900s. The hypothesis was made prominent in the 1960s by Eugene Fama. His 1970 paper reviewed the theory and extended it to include three forms of market efficiency and I elaborated them during the last tutorial. Briefly, there is a weak form of efficiency, stating that the current price of a financial asset incorporates all the past information. An implication of this form of efficiency is that technical analysis which is based on historical stock prices cannot sustain an excess return. The second form is the semi-strong form of efficiency which states that current price of an asset incorporates all publically available information, past and present, or in another words, prices adjust immediately to the newly available information to the public. An implication is that fundamentalists cannot sustain excess return. The last form is the strong form of efficiency which claims that prices reflect all information, public and private, insider information for example. There is not much contention on third strong form which seems far from reality.


Here are some arguments for EMH, and I reserve my judgement on them.


In almost all the courses on financial math, we are taught to assume rational investors. If the assumption is valid, the market is efficient. For example, when new information is released, investors adjust their estimates of stock prices rationally (in a way we are taught in the courses I suppose). Of course they will get the "correct" price of the stock. Buyers are willing to bid for price no more than the "correct" one and sellers are willing to offer a price no less than the "correct" one. If there is any transaction, the price will therefore be the true value of the stock.


As you may observe that the first argument is highly ideal. In reality, even when investors receive the same information, they can interpret it in different ways, so here comes the second argument. Investors analyse information independently. Some may overprice the stock while others could underprice it. Market efficiency is achieved when there is equal number of irrational optimists and irrational pessimists.


Offsetting irrationalities at all times may still be unrealistic, so there is a third argument. Assuming there are professional investors who study companies methodologically and price the stock "correctly". And because of their confidence, they are willing to investment large sum when they observe mispriced stocks. For example if the stock is underpriced, they will buy in a large sum therefor bidding up the price and "correct" the stock price.


Now I shall present some evidence supporting the hypothesis. In the book 'Modern Financial Management' by Ross, there is a serial correlation studies on eight stocks. Since there is no acknowledgment, I suppose it was done by the author. The results show the highest correlation is 0.0409, where +-1 implies perfect correlation and 0 indicates no correlation. This means there is almost no correlation between return of a particular stock over different time periods. The finding supports weak form of efficiency.


The second piece of evidence is that the average return of mutual funds over the period 1963-1998 is lower than the market return. Since mutual fund managers rely on public information, just as ordinary investors do, they will not outperform the market index. The result is consistent with the semistrong form of efficiency.


There are some event studies supporting the semistrong as well. For example, the work by Szewczyk, Tsetsekos on dividend omissions, indicates that dividend omission has a significant impact on the stock price only before and on the day of announcement.

SP1202 SUJA

I am thinking of writing on the Efficient Market Hypothesis. Roughly speaking, the hypothesis claims that our market is one in which the asset prices fully reflect available information. With respect to a stock market, the stock prices adjust immediately to the new information. The claim has some implications. Investors are unable to reap abnormal returns from analysing the price histories or financial reports for example. Further, many theories and pricing models in modern finance are based on the hypothesis. There is some empirical evidence supporting the claim and the the hypothesis went unchallenged 20 or 30 years ago. However, in recent years, there is some opposing evidence and some academics have formulated theory based on the behavioural finance. Until now, the academics divided into three camps, those supporting EMH, those supporting behavioural finance and majority left undecided. In my view, the EM is sort of an ideal limit which could never be achieved in real markets at all times. We can argue to which extent the real market resemble the hypothetical one. I also feel that markets are different in different parts of the world and in different time. Other factors such as law enforcement can also contribute towards the ideal market.