Question

Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly.

a. Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year.

b. Money managers that outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year.

c. Stock prices tend to be predictably more volatile in January than in other months.

d. Stock prices of companies that announce increased earnings in January tend to outperform the market in February.

e. Stocks that perform well in one week perform poorly in the following week.

Short answer

The correct answers for the above sub-parts are as follows:

a. Consistent

b. Violation

c. Consistent

d. Violation

e. Violation

Step-by-step solution

Explanation

a. Consistent: It would be consistent where about half of the managers must outperform the market based on luck.

Explanation

b. Violation: Based on the investment of the last year’s managers, this might trigger easy money and hence could be termed as violation.

Explanation

c. Consistent: Based on the predictable volatility one cannot make abnormal profits. Hence it is consistent.

Explanation

d. Violation: Based on the announcement of increased earnings in January, it is quite predictable to have an abnormal earning which is violation.

Explanation

e. Violation: Through reversals, one can buy last week’s losers and earn easy money. This is therefore violation.