2. Forms of Market Efficiency
d. contrast weak-form, semi-strong-form, and strong-form market efficiency;
e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management;
What is the weak-form hypothesis of the Efficient Market Hypothesis (EMH)?
The weak-form hypothesis asserts that stock prices already reflect all the information that can be derived by examining market trading data, such as the history of past prices, trading volume, or short interest.
What is the semi-strong-form hypothesis of the Efficient Market Hypothesis (EMH)?
The semi-strong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price.
What is an Event Study?
Event studies examine how fast stock prices adjust to specific significant economic events. The results for most of these studies have supported the semi-strong-form EMH.
What is the strong-form hypothesis of the Efficient Market Hypothesis (EMH)?
The strong-form hypothesis states that stock prices reflect all information (from public and private sources) relevant to the firm, including information available only to company insiders. It implies that no investor has monopolistic access to information that influences prices. Thus, no investor can consistently derive risk-adjusted excess returns.
What are the three assumptions of technical analysis traders?
1. The process of disseminating new information takes time.
2. Stock prices move to new equilibriums in a gradual manner.
3. Hence, stock prices move in trends that persist.
What is the implication of Efficient Market Hypothesis (EMH) for technical trading analysis?
Technical analysts believe that good traders can detect the significant stock price changes before others do. However, as confirmed by most studies, the capital market is weak-form efficient as prices fully reflect all market information as soon as the information becomes public. Though prices may not be adjusted perfectly in an efficient market, it is unpredictable whether the market will over-adjust or under-adjust at any time. Therefore, technical analysts should not generate abnormal returns and no technical trading system should have any value.
What are the three assumptions that fundamental analysts believe?
1. At any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities;
2. These values depend on underlying economic factors such as cash flows and risk variables;
3. Though market price and the intrinsic value may differ over time, the discrepancy will get corrected as new information arrives.
How do fundamental analysts make money?
By accurately estimating the intrinsic value, a fundamental analyst can achieve abnormal returns by making superior market timing decisions or acquiring undervalued securities.
How does a portfolio manager with access to superior analysts attempt to beat the markets?
On many occasions the market fails to adjust prices rapidly in response to public information. If a portfolio manager has access to superior analysts, he or she can manage a portfolio actively, looking for undervalued securities based upon superior fundamental analysis (including predicting earnings surprises) and attempting to time the market when asset allocation is shifted between aggressive and defensive positions.
How does a portfolio manager with NO access to superior analysis achieve a market rate of return?
tl;dr: Invest in index funds.
If companies don't have superior analysts who can beat the market, then the analysts should simply attempt to match the market at the lowest cost. To achieve a market rate of return, diversification in numerous amounts of stocks is required, which may not be an option for a smaller investor. Index funds (also referred to as market funds) are security portfolios designed to duplicate the composition and therefore the performance of a selected market index series.