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Chapter One | Overview of Financial Statement Analysis 45

Analysis Research
IS THE STOCK MARKET EFFICIENT?

The efficient markets hypothesis buy-and-hold (which assumes you ratios—suggest the potential of
(EMH) has driven many investment can’t time the market) and indexing value-based strategies to beat the
strategies for the past three decades. (which assumes you can’t identify market. Also, there are a number of
While Wall Street has not embraced winning stocks) strategies. accounting-based market anomalies.
EMH as wholeheartedly as the aca- Still, there is growing evidence The best known is the post-earnings
demic community, it has won many suggesting the market is not as ef- announcement drift, where stock
converts. While no one maintains ficient as presumed. This evidence prices of companies with good (bad)
that markets are strong form efficient, on market efficiency, called anom- earnings news continue to drift
there is a wealth of evidence suggest- alies by EMH believers, began sur- upward (downward) for months
ing that the stock markets (at least in facing in the past decade. Consider after the earnings announcements.
the United States) are both weak form some of the more intriguing bits of Recent evidence also suggests that
and semistrong form efficient. That is, evidence. First, stock markets exhibit managers might be able to “fool” the
stock prices are serially uncor- some weak form inefficiency. For market with accrual manipulations—
related—meaning there are no pre- example, the market exhibits sys- a strategy of buying stocks with low
dictable patterns in prices. Stock tematic “calendar” patterns. The accruals and selling stocks with high
markets seemingly respond rapidly to well-known January effect, where accruals beats the market. Further-
information, such as earnings an- stock prices (especially those of more, evidence suggests the residual
nouncements and dividend changes. small companies) increase abnor- income valuation model can identify
The markets also seem to filter infor- mally in the month of January, is the over- and undervalued stocks (as
mation, making it difficult to fool the best known example. Another ex- well as over- and undervaluation of
market with cosmetic accounting ample is that the average return on the market as a whole). Evidence
changes. For example, the markets the Dow Jones Industrial Average also suggests that investment strate-
seem to understand the implications for the six months from November gies using analysts’ consensus ratings
of alternative accounting choices, through April is more than four can beat the market.
such as LIFO and FIFO. Probably times the return for the other six- These findings of market inef-
the strongest evidence in favor of month period. Still another is that ficiency give rise to an alternative
market efficiency is the dismal per- stock returns show patterns based paradigm, called behavioral finance,
formance of investment managers. A on the day of the week—Monday is suggesting that markets are prone to
majority of investment funds under- the worst day, while Wednesday and irrationalities and emotion. While
perform market indexes such as the Friday are best. Second, there is evi- the proliferation of evidence sug-
S&P 500. Moreover, even those man- dence of semistrong form inefficiency. gesting inefficiency does not neces-
agers who outperform the indexes The P/E anomaly and the price-to- sarily imply that markets are irra-
show little consistency over time. book effects—where stocks with low tional and chaotic, it does suggest
Further evidence that Wall Street has price-to-earnings or price-to-book that blind faith in market efficiency
embraced EMH is the popularity of ratios outperform those with high is misplaced.

the efforts and resources to create an information mosaic. Also, timing is crucial in the
market.
Movement of new information, and its proper interpretation, flows from the well-
informed and proficient segment of users to less-informed and inefficient users. This is SELLING SHORT
A short-seller sells shares
consistent with a gradual pattern of processing new information. Resources necessary for that are borrowed, either
competent analysis of a company are considerable and imply that certain market seg- from an institutional
ments are more efficient than others. Securities markets for larger companies are more investor or from a retail
efficient (informed) because of a greater following by analysts due to potential rewards brokerage firm, and then
hopes to replace the
from information search and analysis compared to following smaller, less-prominent
borrowed shares at a
companies. Extreme proponents of EMH must take care in making sweeping general- lower price, pocketing
izations. In the annual report of Berkshire Hathaway, its chairman and famed investor the difference.