L8 - Market Efficiency

F303 - Intermediate Investments

Professor Mathias S. Kruttli

Spring 2026

8 – Market Efficiency

Review Questions

  • Participants engage with Top Hat for review questions.

Stock Covariances with Fama-French Factors

  1. SMB (Small-Minus-Big) Factor

    • A stock that covaries positively with SMB is likely:

      • A. A large firm

      • B. A small firm

      • C. A high growth firm

  2. HML (High-Minus-Low) Factor

    • A stock that covaries negatively with HML is likely:

      • A. A small firm.

      • B. A firm with a high book-to-market ratio (value firm).

      • C. A firm with a low book-to-market ratio (growth firm).

Calculating Walmart's Alpha

  • Given Data:

    • Risk premium of Walmart: 8%

    • Market risk premium: 5%

    • SMB: 3%

    • HML: 1%

    • Betas:

      • βiM = 2

      • βiSMB = -0.5

      • βiHML = 2

  • Alpha Calculation:

    • Walmart’s alpha can be derived from the following formula:
      ext{Alpha} = ext{Risk Premium} - ( ext{Market Risk Premium} imes eta_iM + ext{SMB} imes eta_iSMB + ext{HML} imes eta_iHML)

    • Choices:

      • A. 5%

      • B. -3%

      • C. -2.5%

Motivation for Market Efficiency Examination

  • Key Questions:

    • How do prices behave?

    • Are there patterns that investors can use to make abnormal profits?

    • How is information incorporated into prices?

    • Does it pay to invest in research of stocks for abnormal profits?

    • Can trading rules produce abnormal profits? Is there any sense in putting money in active funds?

Outline of Topics Covered

  1. Random walks (of prices)

  2. Versions of the efficient market hypothesis (EMH)

  3. Testing EMH

  4. Evidence in favor of EMH

  5. Evidence against EMH

Early Financial Research

  1. Researcher: Maurice Kendall

    • Findings:

      • Prices exhibit random evolution:

      • No predictable patterns in stock prices.

      • Prices are equally likely to rise or fall any given day.

    • Implication: Prices follow a random walk.

    • Reference:** A Random Walk Down Wall Street, Burton G. Malkiel.**

Coin-Tossing Game Example

  • Game Details:

    • Initial stake: $100

    • Outcomes:

      • Heads = $103.00

      • Tails = $97.50

      • Heads, Heads = $106.09

      • Heads, Tails = $100.43

      • Tails, Heads = $100.43

      • Tails, Tails = $95.06

    • Explanation of outcomes:

      • Heads = Up 3%

      • Tails = Down 2.5%

Random Walks and Information

  • Key Concept: Prices react only due to the arrival of new information and should reflect all available information at any time.

Definition of Efficient Market

  • An efficient market is defined as:

    • Efficiently processes information: Prices fully reflect all available information.

    • Prices are based on a “correct” valuation of information.

    • Rapid and accurate reactions to new information.

    • If positive information exists, market participants trade based on that leading to immediate price adjustments.

    • Result: Prices align with expected returns based on risk.

Efficient Market Hypothesis (EMH)

  • Predictions of EMH:

    • New information is unpredictable.

    • Stock prices adjust without a predictable pattern in response to new information.

    • Changes in stock prices reflect a random walk.

Forms of Market Efficiency

  1. Weak-form Efficiency:

    • Prices reflect all information contained in past trading history.

  2. Semi-strong Form Efficiency:

    • Prices reflect all past trading and public information.

  3. Strong-form Efficiency:

    • Prices incorporate all past trading, public, and private information.

Technical Analysis

  • Overview: Examines historical prices and volumes to find exploitable patterns.

    • Assumes prices reflect supply/demand responsiveness slowly, allowing for potential pattern exploitation.

Resistance Levels - Example

  • Case Study: Stock XYZ

    • Traded for months at $72, then dropped to $65.

    • If price rises again, $72 becomes a resistance level due to prior buyers eager to regain costs, creating sell pressure at that level.

Weak-form Market Efficiency and Technical Analysis

  • Key Consideration:

    • Can recognized technical analysis strategies generate abnormal profits?

    • If recognized strategies fail persistently, supports weak-form market efficiency.

Self-destruction of Trading Rules Scenario

  • Graphical Representation: Stock price trends post upswing recognition reflect immediate price behaviors.

Fundamental Analysis Overview

  • Components of Analysis:

    • Evaluates earnings information, dividend prospects, and interest rate expectations.

  • Objective: To determine the present value of expected cash flows.

    • Buy stock if calculated value exceeds current market price.

Questions on Market Efficiency

  1. If high-level managers achieve superior returns, does it contradict weak or strong-form efficiency?

  2. How does weak-form efficiency correlate to strong-form efficiency?

Abnormal Returns through Fundamental Analysis

  • Question: Can fundamental analysis produce abnormal returns under weak-form efficiency?

    • A. Yes

    • B. No

Consequences of Semi-strong Efficiency on Technical Analysis

  • Question: If semi-strong efficient, does technical analysis yield abnormal returns?

    • A. Yes

    • B. No

Consequences of Semi-strong Efficiency on Fundamental Analysis

  • Question: If semi-strong efficient, does fundamental analysis yield abnormal returns?

    • A. Yes

    • B. No

Investor Beliefs and EMH Forms

  • If believing in ________ form of EMH, stock prices include all historical and public firm data, excluding insider information.

    • A. Semi-strong

    • B. Strong

    • C. Weak

Momentum Strategy Abnormal Returns

  • Scenario: Positive performances in the past generate positive abnormal returns.

  • Implications: Violate which EMH forms?

    • A. Weak, not semi-strong or strong

    • B. Strong and semi-strong, not weak

    • C. All three forms

Market Efficiency and Resource Expenditure

  • Catch 22 Scenarios:

    • Efficient markets discourage extensive security analysis efforts.

    • If no effort is made, how can market information be correctly valued?

    • Introduces Grossman-Stiglitz Paradox.

Reasons Supporting EMH

  • Market Dynamics:

    • Competition among investors leads to information analysis and market corrections, ensuring prices reflect current data.

Price Reactions to Announcements

  • Graph of cumulative abnormal returns reflects target companies' behavior prior to acquisition announcements.

Evidence Supporting EMH

  1. **Short-term Returns:

    • Stock prices behave as random walks.**

    • Stock return predictability is low.

    • Portfolio managers fail to consistently outperform the market.

Mutual Fund Performance Metrics

  1. Four-factor model:

    • Incorporates:

      • Market returns

      • SMB

      • HML

      • Momentum Factor

    • Formula employed:
      E[r_F] - r_f = \alpha_F + eta_{F,M} MKT + eta_{F,SMB} SMB + eta_{F,HML} HML + eta_{F,MOM} MOM

Performance Analysis of Mutual Funds

  • Examine alphas to establish fund viability and distinctions from normative average performance.

Consistency and Performance Trends

  • Reference to studies by Carhart and Berk & Green regarding consistency and manager success diminishing over time leading to a convergence towards zero alphas.

Risk-adjusted Performance Ranking

  • Analysis of performance persistence by initial funding year, observing returns categorized by performance deciles.

Market Effects and Anomalies

  1. Momentum: Good or bad performance continues in short timeframes.

  2. Returns Over Long Horizons: Experiences of overshooting and corrections observed.

  3. Weak-form Tests: Momentum and reversal patterns prospected.

Semi-strong Tests for Anomalies

  1. Price reactions to earnings announcements.

  2. January effect and size-based returns.

  3. Evidence of consistent book-to-market ratios.

Post-Earnings Announcement Drift

  • Performance Metrics: How stocks react in terms of cumulative average excess returns based on earnings surprises.

Small Firm Premium Evidence

  • Graph showcasing average annual returns across size-based portfolios from 1926-2018.

  • Key Finding: Smaller firms showing higher returns than larger counterparts.

Value Premium Observation

  • Annual return analysis as per book-to-market ratio percentile delineation, revealing value firms tend to produce superior returns.

Interpreting Anomalies in Market Efficiency

  • Discuss the contrasting views of Fama & French and Lakonishok et al. regarding risk premiums and evidence of inefficiency in market phenomena.

Market Return Predictors

  1. Higher dividend payout ratios linked to aggregate returns (Fama & French).

  2. Earnings yield as a reliable predictor (Campbell and Shiller).

  3. Bond spreads showing correlation with market returns (Keim & Stambaugh).

Strong-form Tests: Insider Trading

  • The examination of insider trading's legalities and the related obligation to disclose trading activities, noting that illicit trading can occur outside of regulatory oversight.

Phil Mickelson Case Study

  • Review the instance of Phil Mickelson's insider trading lawsuit highlighting the potential loopholes in regulatory frameworks preventing insider trading.

Transition to Next Topic

  • Next Topic: Bonds - Discussion expected in subsequent classes.