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Lecture 6: Efficient Markets and

Excess Volatility

The Efficient Markets Hypothesis

History of the Hypothesis

Reasons to think markets are efficient
Reasons to doubt markets are efficient
Technical analysis
Empirical evidence in literature
Homework assignment and regressions

Earliest Known Statement

When shares become publicly known in an
open market, the value which they acquire
there may be regarded as the judgement of
the best intelligence concerning them.
- George Gibson, The Stock Exchanges
of London Paris and New York, G. P.
Putnman & Sons, New York, 1889

Intuition of Efficiency
Reuters pigeons and the telegraph
Beepers & the internet
Must be hard to get rich

Textbook Version Today

As one of the six most important ideas in
Security prices accurately reflect available
information, and respond rapidly to new
information as soon as it becomes available
Richard Brealey & Stewart Myers,
Principles of Corporate Finance, 1996

Harry Roberts, 1967

Weak form efficiency: prices incorporate
information about past prices
Semi-strong form: incorporate all publicly
available information
Strong form: all information, including
inside information

Price as PDV of Expected

If earnings equal dividends and if dividends grow at longrun rate g, then by growing consol model P=E/(r-g),
P/E=1/(r-g). (Gordon Model)
So, efficient markets theory purports to explain why P/E
varies across stocks
PEG ratio is popular indicator = g/(P/E), where g is
short-run growth rate; popular rule of thumb: buy if
PEG rule of thumb makes sense only if g bears a certain
relation to g; not a sensible rule.
Efficient markets denies that any rule works

Reasons to Think Markets Ought

to Be Efficient
Marginal investor determines prices
Smart money dominates trading
Survival of fittest

Reasons to Doubt these Reasons

Marginal investor: wealth matters
Smart money: matter of degree. Limits to
arbitrage theory
Survival of fittest: life cycle renews

Psychological Factors
Gambling behavior
Slowness to make money, futility of career
trying to prove others of ones ability
Siegel and Peter Lynch

Popular Doubters of Efficiency

Peter Lynch: Elementary school children
beat professionals
Beardstown Ladies
Robert Kiyosaki Rich Dad, Poor Dad
Motley Fool

Raskob on the Market

Suppose a man marries at the age of twenty-three
and begins a regular saving of fifteen dollars a
month almost anyone who is employed can do
that if he tries. If he invests in good common
stocks and allows the dividends to accumulate, he
will have at the end of twenty years at least eighty
thousand dollars. . .I am firm in my belief that
anyone not only can be rich but ought to be rich.
John J. Raskob, Ladies Home Journal, 1929

Raskobs Calculation
Annuity formula (converted to terminal value)
shows that Raskob assumed 26% per year
1 5 ( 1 .0 1 9 6 ) 2 4 0
8 0 ,0 0 0

.0 1 9 6
.0 1 9 6

Technical Analysis
Robert D. Edwards & John Magee,
Technical Analysis of Stock Trends, 1948.
Hand drawing of charts, judgmental
interpretation of patterns
Difficult to test success of technical analysis
Harry Mamaysky, SOM finds some success
in their methods.

Head & Shoulders Pattern

Initial advance attracts traders, upward momentum.
Smart money begins to distribute stock, trying not to
kill demand.
Eventually downturn, but smart money comes in to
support demand, manipulation. (left shoulder)
Upward momentum resumes, ends when smart
money has distributed all shares; market drops.
New traders try to exploit well-known tendency to
rally. New weak rally, right shoulder, then a
breakout. (Edwards & Magee)

Random Walk Hypothesis

Karl Pearson, Nature, 72:294, July 27,
1905. Aug 10, 1905, walk of drunk
Burton Malkiel, A Random Walk Down Wall
Street, 1973.

Random Walk & AR-1 Models

Random Walk: xt=xt-1+t
First-order autoregressive (AR-1) Model:
xt=100+(xt-1-100)+t. Mean reverting (to
100), 0< <1.
Random walk as approximate implication of
unpredictability of returns
Similarity of both random walk and AR-1 to
actual stock prices

Random Walk & AR-1(=.95)


Random Walk


Time Period










Obvious Examples of

Jeremy Siegel Nifty-fifty did well

Most closed out
Polaroid and Edwin Land


Holland, 1630s.
Peter Garber, Famous First Bubbles
Mosaic virus, random-walk look
Free press began in Holland then.

Dot Com Bubble

Toys.com: Had disadvantage relative to
bricks & mortar retailers starting web sites
Lastminute.com: travel agency, sales in
fourth quarter of 1999 were $650,000,
market value in IPO ins March 2000 was $1

Problem Set #3: Forecast the

Step 1: Get stock price data on spreadsheet,
as from yahoo.com.
Step 2: Create new column showing
percentage price changes
Step 3: Create new Column(s) containing
forecasting variables
Step 4: Test for significance and interpret

Significance Test in Regression

Use the R2 which is the fraction of the
variance of the dependent variable that is
explained by the regression.
Compute F statistic (k, n-k-1 degrees of
freedom, and check that it is above critical
value for significance at 5% level.
Issues of data mining, etc.

F Statistic
F statistic with k, n-k-1 degrees of freedom,
where k = number of independent
(forecasting) variables and n = number of

1 R 2 / ( n k 1 )

Regression Output - Excel

Intercept, X Variable, X Variable

T statistic, P value
F statistic, P value
R squared