Efficient Markets Hypothesis

B

The efficient markets hypothesis (EMH) is a theory that suggests that financial markets are efficient in reflecting all available information. The EMH is categorized into three forms: weak, semistrong, and strong.

The weak form of the EMH states that current stock prices reflect all historical price and volume information. In other words, the weak form assumes that it is not possible to consistently outperform the market by using past price and volume data. This implies that technical analysis, which relies on historical data patterns, would not be able to generate consistently superior returns. However, the weak form allows for the possibility of outperforming the market through the use of fundamental analysis or insider information.

The semistrong form of the EMH builds upon the weak form and asserts that current stock prices reflect all publicly available information. This includes not only historical price and volume data but also information such as financial statements, news releases, and other publicly disclosed information. The semistrong form assumes that it is not possible to consistently outperform the market by trading on publicly available information alone.

The strong form of the EMH is the most comprehensive and asserts that current stock prices reflect all public and private information. This means that even insider information cannot be used to consistently outperform the market.

In the given scenario, the marketing associate argues that the stock market is totally efficient based on academic research that shows actively managed mutual funds do no better than a buy-and-hold strategy. By investing solely in index funds, the marketing associate is aligning with the EMH. This aligns with the semistrong form of the EMH, which states that publicly available information is already incorporated into stock prices. Therefore, the correct statement regarding the EMH in this context is:

B. The semistrong form of the EMH is not supported by academic research on low P/E stocks.

This statement is correct because Lynn Smith argues that low P/E ratio stocks provide superior risk-adjusted returns based on academic research. If the semistrong form of the EMH were supported, it would imply that all publicly available information, including research on low P/E stocks, would already be reflected in stock prices. Therefore, the idea that low P/E ratio stocks provide superior returns would contradict the semistrong form of the EMH.

Option A is incorrect because the strong form of the EMH, which encompasses both public and private information, is not specifically supported by academic research on low P/E stocks. The strong form assumes that even insider information cannot be used to consistently outperform the market, but the discussion does not touch on the use of insider information.

Option C is also incorrect because the statement refers to academic research on mutual funds, which relates to the performance of actively managed funds compared to a buy-and-hold strategy. It does not directly address the support or lack of support for the strong form of the EMH.

In summary, based on the discussion between Lynn Smith and the marketing associate, the correct statement regarding the EMH is option B, as it highlights a disagreement regarding the semistrong form of the hypothesis in relation to academic research on low P/E stocks.