SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

TOPIC- Empirical tests of EMH & Negative evidence of EMH

GROUP-C

GROUP MEMBER

PURVI SHAH KALYANI SHAH JALPA BHUVIR

MAMTA JADEJA

WHAT IS EMH?

An investment theory that states it is impossible To "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments

Empirical Tests of EMH

There are some methods which are useful in empirical tests of EMH. EMH via testing of correlations, relative strengths, stock spilt, earnings announcements, book value, time series test etc.

Methods of testing

1.Semi-strong method

The semi-strong form can be tested in two ways. 1. Trying to predict future price movements by

using currently available public information. These tests can be based on time series analysis of returns for individual stocks or cross-sectional data for different stocks.

2. Seeing how quickly stock prices react to new information, to establish if there is a profit window. These tests are known as event studies.

2.Time series tests1. Test based on ratio Time series test have indicated that it is possible to

predict returns and make superior profits by looking at various ratios such as price to book, dividend yields, yield spreads of lower grade bonds over high grade bonds.

2. Tests based on earnings reports. Tests have looked at factors such as quarterly earnings

report, aiming to establish whether it is possible to predict future stock price returns based on published earnings reports.

It has been found that it is possible to make abnormal returns when there are positive abnormal surprises in earnings.

More recent tests have looked at the difference between actual earnings and predicated earnings as a percentage of the estimate, based on a regression line predicting earnings using time series analysis.

These studies suggest that it is possible to make abnormal returns through trading based on earnings surprises. This evidence goes against the Efficient market hypothesis.

3.Calendar studies Other tests have looked at whether it is possible to

make superior profits by following rules such as buying stocks in December and selling them in January.

This is to make advantage of tax-based trading in

the market around the year-end when investors sell stocks in December and repurchase them in January.

This is referred to as the January effect (or anomaly), stating that stock prices fall in December and then rise in January. It has been established that this is possible, but any gain may be eliminated by transaction costs.

The effect worked for stocks that had suffered large declines in the previous year, but not for those which had large gains, supporting the tax motivation for this trading.

A weekend effect that has been tested is that returns on Mondays' are negative, whereas returns on the other four working days are positive.

4.Cross-sectional tests

Cross-sectional tests are based on the assumption that in an effect market all stocks should earn a risk adjusted return given their betas.

Tests based on the size of the companies have indicated that small firms earn consistently higher risk adjusted returns than large firms.

If the small firm actually has a higher beta than that measured for capital asset pricing model purposes, then its predicted position on the security market line will be lower than it should be. Therefore, it will appear to be offering high risk adjusted returns although this is not actually the case.

5. Information Announcements

Information announcements can trading in share immediately following announcements of new information. E.g.- announcement on dividends or profit.

6. Stock splits

When stock splits are made. No new money raised by the company and existing shareholders receive more shares in proportion to the number of shares that they hold.

Researchers have shown that share price rise by abnormal amount before the split. following the split, they observed no evidence of abnormal stock price performance. Investors would not be able to profit by purchasing the stock on split date. This evidence is consistent with the ‘efficient market hypothesis.’

7. Manipulation of earnings

market efficiency tests have shown that investors are aware of the nature of the accounting change, but doubts have been raised about market efficiency if there is wholesale creative accounting.

The accounts that are published are an important sources of information about a company.