An observation that stocks with above average price-to-earnings ratios have consistently underperformed those with below average price-to earnings ratios least likely contradicts which form of the market efficiency?
A. Weak form
B. Strong form
C. Semi-strong form
The provided answer is B “strong form”, but I cannot understand …
Based on my understanding, the observation that stocks with above average price-to-earnings ratios have consistently underperformed those with below average price-to earnings ratios is a cross-sectional anomaly. This kind of information is publicly available thus such observation would indicate contradicts with semi-strong form EMH. In addition, we know that strong-form EMH assumes that stock prices fully reflect all the information from public and private sources. Thus I think this observation indicates contradicts with strong form EMH as well.
In this way, I chose “A” in the first place… Can anyone please explain why we should choose B (the “correct” answer as provided by the mock exam) instead of A?
Basically Strong Form Efficiency states that on top of using public information even insiders with priveledged material information cannot earn consistent excess returns. The situation clearly defies semi-strong form efficiency because you are using public information about the fundamentals of a company’s stock and finding a supposed consistent pattern which you could profit from if it were true. I do not see how it violates strong form efficiency as you described.
Does it also NOT violate weak form? Because in weak form you can earn consistent excess returns using public infomration about fundamentals of companies.
Or because it it contradicts semi strong EMH, it has to also contradict weak form??
Based on their answer (I wouldn’t have got it right because of the way the question is phrased… But it could mean that…
The underperformance of higher PE ratio is reflected in the prices through the underpformance (though I’m not sure why, if someone could explain that, it would help. or is it because of higher higher price for same amt of earning that why yield is lower?). Hence semi-strong is enforced. Since it doesn’t say anything about insider/private info, it would least likely violate the strong form.
How I interpreted it at first was the you can earn an abnormal profit because of the public information (underperformance of one of the securities) so that must mean that it violates semi-strong and reinforces weak.
Btw, as a final note, this is my opinion… Yes, opinion, not fact. This EMH is like a bunch of a baloney.
One thing I use for these types of questions is remembering the fact if something is Semi-Strong Form Efficient (Fundamentals) it is also Weak-Form (Technicals). This would mean that the statement contradicts A and C, leaving only B because there is no mention of private data being used.
“An observation that stocks with above average price-to-earnings ratios have consistently underperformed those with below average price-to earnings ratios”
Maybe it’s just this statement. It probably means that the market fully reflects the price of the public information and not that someone is making profit from it.
Yeah I will choose answer A weak form. What does the solution say though?
If choosing below-average P/E stocks can consistently earn abnormal returns, semi-strong form is violated, which means strong-form is violated also.
It doesn’t mean, however, the weak-form is violated since if you earn abnormal return with fundamental analysis, you are in weak-form efficient market.
The CFAI has similar question and did you check the errata?
The question is like after the public announcement of the merger of two firms, an investor makes abnormal returns by going long on the target firm and short on the acquiring firm. This most likely violates which form of efficiency? And the answer is it violates semi-strong and strong form.
At this point I am curious to know what your solution say about this problem?
Yes, a semi-strong form efficient market is also weak form efficient and an strong-form efficient market is both weak-form and semi-strong form efficient market.
But an individual cannot consistently earn abnormal returns using fundamental analysis in semi-strong efficient market, which suggests he cannot consistenly earn abnormal returns using fundamental analysis in strong form efficient market either. But in a weak form market, this individual CAN consistenly earn abnormal returns using fundamental analysis. So, I still think the correct answer is A: Using P/E ratio to earn abnormal returns is not contradicting weak-form, but is contradicting semi-strong and strong forms.
Whoa, that last bit confused me, after the public announcement abnormal returns violates semi-strong and weak form efficiency, according to q 88 of the am cfa mock.
I thought the P/E ratio one would have violated weak form efficiency as well, picked a myself.
answer should be Week form, as semi and semi-strong contradicts with fundamentals and week form only with technical(momentum) so it will least likely contradicts with week form.
