Lecture on the Efficient Market Hypothesis (EMH) My Twist on Ch 13

2014-09-22/Bo Sjö

Lecture on The Efficient Market Hypothesis (EMH) My twist on Ch 13.

Since the textbook is a bit weak on Efficient Markets, let us clarify some basics.

First, asset pricing is about looking forward, estimate future cash flows and calculate their present value conditional on (undiversifiable) risk factors.

If we take stock prices, the price today is made up by expectations of future dividends coming from expected free cash flows of the firm. Formally, we can say that investors make expectations of the future price conditional on the information set ) they have today: = The expected future price (which by definition includes all future free cash flows and dividends determined conditionally on relevant information today.

If the market participants make efficient use of all relevant information for the future cash flows and the discount factor including risk, so that today’s price ( includes all that information,

We have to be exact here and use mathematics because it is a very exact language. Otherwise we will soon be lost in the discussions. The type of statistical process we describe above is called a martingale; today’s value is the best prediction of all future values.

It follows that the difference between the future price and today’s price, the change is unpredictable,

Since P is know today it we can also write,

Thus, given all relevant information today the expected change in the price is zero (or unpredictable), because all relevant and predictable information is already included in today’s price.

Eugene Fama has focused on this in his research and explained that there are three levels of information leading to three forms of market information efficiency. For participating any informed discussion about market (information) efficiency it is necessary to know and understand the implications of Fama’s research.

Weak form efficiency

The information includes historical prices and market information such as order volume, spreads between bid-asked prices.

Semi-Strong Efficiency

Include all information included above all relevant and publicly known company and macroeconomic data.

1 Strong form efficiency

Include all information above and insider information, not publicly available information about the firm.

If we ask the question is it possible to use historical prices etc. to predict future prices, the answers is generally no.

Is it possible to all sorts of publicly available data to predict future prices the answer is also no.

Can you use insider information? Yes of course. The question is do insider information “slip out” before it is publicly announced. It might do that sometimes.

Over-all financial markets appear to be information efficient. You cannot by studying time series statistics, look for patterns, study financial statement and use macroeconomic data etc. predict future stock prices in general.

Do stock price change with when new relevant information is announced? Yes.

Do stock prices move in the right direction then regarding bad and good news when these news are announced? Yes.

Do they move in the right amount- Yes in nearly all case they do. There might be some signs of overreaction.

If try to statistically model stock prices you will find that they tend to follow a random walk. A random walk is a process such that today’s price is best explained by the previous price. And, the difference between today’s price and the historical price is a White noise. The latter is a zero mean process that cannot be predicted from its own past and has no structure. Formally a random walk is

It follows that

where is the unpredictable white noise. If you try to explain exchanges in stock prices you cannot do it basically. Especially not in the short run.

However, if you do find something that is significantly that can predict stock prices, Fama says that is mostly likely a risk premium or something mimicking the risk premium. In that case you have to test whether you have found a risk premium, which is a bit more difficult.

The textbook present a number of anomalies. But, we can question their relevance, and again perhaps it is risk.

Robert Schiller says that the variation (the volatility) in the prices are too be to be explained. He talks about “irrational exuberance”. Fama’s answers are (my interpretation) it is risk which we don’t fully

2 understand, and it does not matter because the relative prices are right, and decisions are the best considering the information.

And, in finance the relevant question is who has the better information tan the market? The answer is nobody, because the missing information is asymmetric information. Politicians, and the lobby groups behind politicians, do not have that information. We are not living in a perfect word. We life perhaps in the third best world and have to do the best we can with the information we have.

Conclusions

As an over-all conclusion, financial markets are relatively good informationally efficient over time. We can trust the relative prices.

If you think you have some opinion about a firm or a stock and future dividends and prices, you have to ask yourself just one question: “What do I know that is not known by everybody on the market already?“ Are you smart enough to be smarter than the rest of the market, and be able to achieve risk adjusted profits (real economic profits, higher return than compensation for risk?)

No research supports the hypothesis that active investors can beat passive investors.

It is very difficult, not possible to do better than the market portfolio. The exception is (perhaps) among the small firms. Here we find that portfolios of small firms can beat the market, and yield higher than risk adjusted return. Again, Fama might deny that and say it is simply risk in the end.

Should stock prices follow the business cycle and growth of the economy? Yes, the follow first of the expected growth. If you look for statistical correlation between economic macro variables, such as GDP, that will come out if you look at time spans over two years.

So, I know of no way to make risk adjusted profits more than: use insider information (which is unethical and illegal), be exceptionally smarter or outstandingly luckier than other investors.