Chapter 11 - The Efficient Market Hypothesis
ii. The semistrong form states that a firm’s stock price reflects all publicly available information about a firm’s prospects. Examples of publicly available information are company annual reports and investment advisory data.
Evidence strongly supports the notion of semistrong efficiency, but occasional studies (e.g., identifying market anomalies such as the small-firm-in-January or book-to-market effects) and events (e.g. stock market crash of October 19, 1987) are inconsistent with this form of market efficiency. There is a question concerning the extent to which these “anomalies” result from data mining. iii. The strong form of the EMH holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm.
Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before public release to enable them to profit from trading on this information.
b.
i. Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule.
ii. Fundamental analysis uses earnings and dividend prospects of the firm,
expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns.
In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no
technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes.
c.
Portfolio managers have several roles and responsibilities even in perfectly
efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor’s constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor’s needs, rather than to beat the market, which requires identifying the client’s return requirements and risk tolerance. Rational portfolio management also requires examining the investor’s constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and employment.
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Copyright ? 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 11 - The Efficient Market Hypothesis
10. a.
The earnings (and dividend) growth rate of growth stocks may be consistently overestimated by investors. Investors may extrapolate recent growth too far into the future and thereby downplay the inevitable slowdown. At any given time, growth stocks are likely to revert to (lower) mean returns and value stocks are likely to revert to (higher) mean returns, often over an extended future time horizon.
In efficient markets, the current prices of stocks already reflect all known relevant information. In this situation, growth stocks and value stocks provide the same risk-adjusted expected return.
b.
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Copyright ? 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
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