An analyst with Guffman Investments has developed a stock selection model based on earnings announcements made by high P/E stocks. The model predicts that investing in companies with P/E ratios twice that of their industry average that make positive earnings announcements will generate significant excess return.
If the analyst has consistently made superior risk-adjusted returns using this strategy, which form of the efficient market hypothesis has been violated?
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A. B. C.Explanation
The efficient market hypothesis (EMH) is a theory that suggests financial markets are efficient and that it is impossible to consistently achieve superior returns by using publicly available information. The EMH is typically divided into three forms: weak, semistrong, and strong.
Weak Form Efficiency: The weak form of market efficiency states that current stock prices reflect all past market information, including historical prices, trading volumes, and other market data. In other words, past price and volume data cannot be used to consistently predict future stock price movements. If the analyst's stock selection model consistently generates superior returns by using past earnings announcements, it implies that historical information is not fully reflected in stock prices, thereby violating the weak form of market efficiency.
Semistrong Form Efficiency: The semistrong form of market efficiency expands on the weak form and states that current stock prices reflect all publicly available information, including past market data as well as all publicly released news, earnings announcements, and other relevant information. If the analyst's stock selection model is consistently generating superior returns by using earnings announcements, it suggests that this public information is not fully reflected in stock prices, violating the semistrong form of market efficiency.
Strong Form Efficiency: The strong form of market efficiency is the most stringent form and asserts that current stock prices reflect all information, including both public and private information. If the analyst's stock selection model consistently generates superior returns using earnings announcements, it suggests that even private information is not fully incorporated into stock prices, thereby violating the strong form of market efficiency.
Based on the given information, the analyst's model predicts superior returns by investing in high P/E stocks that make positive earnings announcements. If this model consistently generates excess returns, it implies that the market is not fully efficient in incorporating this specific type of information. Therefore, the correct answer is B. Semistrong and weak forms of market efficiency have been violated.