Efficient Market Hypothesis: P/E Ratio, Insider Trading, and Stock Performance, Exams of Investment Theory

Download Efficient Market Hypothesis: P/E Ratio, Insider Trading, and Stock Performance and more Exams Investment Theory in PDF only on Docsity! Chapter 08 - The Efficient Market Hypothesis Chapter 8 The Efficient Market Hypothesis 1. The correlation coefficient should be zero. If it were not zero, then one could use returns from one period to predict returns in later periods and therefore earn abnormal profits. 2. c This is a predictable pattern in returns, which should not occur if the stock market is weakly efficient. 3. c This is a classic filter rule, which would appear to contradict the weak form of the efficient market hypothesis. 4. b This is the definition of an efficient market. 5. c The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory. 6. b Public information constitutes semi-string efficiency, while the addition of private information leads to strong form efficiency. 7. a The information should be absorbed instantly. 8. b Since information is immediately included in stock prices, there is no benefit to buying stock after an announcement. 9. c Stocks producing abnormal excess returns will increase in price to eliminate the positive alpha. 8-1 Chapter 08 - The Efficient Market Hypothesis 10. c A random walk reflects no other information and is thus random. 11. d Unexpected results are by definition an anomaly. 12. Assumptions supporting passive management are: a. informational efficiency b. primacy of diversification motives Active management is supported by the opposite assumptions, in particular, that pockets of market inefficiency exist. 13. a. The grandson is recommending taking advantage of (i) the small firm anomaly and (ii) the January anomaly. In fact, this seems to be one anomaly: the small-firm-in- January anomaly. b. (i) Concentration of one’s portfolio in stocks having very similar attributes may expose the portfolio to more risk than is desirable. The strategy limits the potential for diversification. (ii) Even if the study results are correct as described, each such study covers a specific time period. There is no assurance that future time periods would yield similar results. (iii) After the results of the studies became publicly known, investment decisions might nullify these relationships. If these firms in fact offered investment bargains, their prices may be bid up to reflect the now-known opportunity. 14. No, this is not a violation of the EMH. Microsoft’s continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments. 8-2 Chapter 08 - The Efficient Market Hypothesis b. 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. 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. 20. Implicit in the dollar-cost averaging strategy is the notion that stock prices fluctuate around a “normal” level. Otherwise, there is no meaning to statements such as: “when the price is high.” How do we know, for example, whether a price of $25 today will be viewed as high or low compared to the stock price in six months from now? 21. No, it is not more attractive as a possible purchase. Any value associated with dividend predictability is already reflected in the stock price. 22. The market responds positively to new news. If the eventual recovery is anticipated, then the recovery is already reflected in stock prices. Only a better-than-expected recovery (or a worse-than-expected recovery) should affect stock prices. 8-5 Chapter 08 - The Efficient Market Hypothesis 23. Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.03% per day), so that on any day the price is virtually equally likely to rise or fall. However, over longer periods, the small expected daily returns cumulate, and upward moves are indeed more likely than downward ones. 24. You should buy the stock. In your view, the firm’s management is not as bad as everyone else believes it to be. Therefore, you view the firm as undervalued by the market. You are less pessimistic about the firm’s prospects than the beliefs built into the stock price. 25. The negative abnormal returns (downward drift in CAR) just prior to stock purchases suggest that insiders deferred their purchases until after bad news was released to the public. This is evidence of valuable inside information. The positive abnormal returns after purchase suggest insider purchases in anticipation of good news. The analysis is symmetric for insider sales. 26. The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment. 27. a. Some empirical evidence that supports the EMH is: (i) professional money managers do not typically earn higher returns than comparable risk, passive index strategies; (ii) event studies typically show that stocks respond immediately to the public release of relevant news; (iii) most tests of technical analysis find that it is difficult to identify price trends that can be exploited to earn superior risk-adjusted investment returns. b. Some evidence that is difficult to reconcile with the EMH concerns simple portfolio strategies that apparently would have provided high risk-adjusted returns in the past. Some examples of portfolios with attractive historical returns: (i) low P/E stocks; (ii) high book-to-market ratio stocks; (iii) small firms in January; (iv)firms with very poor stock price performance in the last few months. Other evidence concerns post-earnings-announcement stock price drift and intermediate-term price momentum. 8-6 Chapter 08 - The Efficient Market Hypothesis c. An investor might choose not to index even if markets are efficient because he or she may want to tailor a portfolio to specific tax considerations or to specific risk management issues, for example, the need to hedge (or at least not add to) exposure to a particular source of risk (e.g., industry exposure). 28. a. The earnings (and dividend) growth rates of growth stocks may be consistently overestimated by investors. Investors may extrapolate recent earnings (and dividend) 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. b. 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. 8-7