Market Efficiency Market efficiency - championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests

that at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. The assumption of market efficiency is central to capital market research. Why is the assumption if information efficiency so important for capital market research in accounting because unless such an assumption of efficiency is accepted, it is hard to justify effort to link security price movements to information releases. A great deal of capital market research considers the relationship between share prices and information releases.

The Effect of Efficiency: Non-Predictability The nature of information does not have to be limited to financial news and research alone; indeed, information about political, economic and social events, combined with how investors perceive such information, whether true or rumored, will be reflected in the stock price. According to EMH, as prices respond only to information available in the market, and, because all market participants are privy to the same information, no one will have the ability to outprofit anyone else.

How Does a Market Become Efficient? In order for a market to become efficient, investors must perceive that a market is inefficient and possible to beat. Ironically, investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient. A market has to be large and liquid. Information has to be widely available in terms of accessibility and cost and released to investors at more or less the same time. Transaction costs have to be cheaper than the expected profits of an investment strategy. Investors must also have enough funds to take advantage of inefficiency until, according to the EMH, it disappears again. Most importantly, an investor has to believe that she or he can outperform the market.

Degrees of Efficiency Accepting the EMH in its purest form may be difficult; however, there are three identified classifications of the EMH, which are aimed at reflecting the degree to which it can be applied to markets. 1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage.

2. Semi-strong efficiency - This form of EMH implies that all public information is calculated into a stock's current share price. Neither fundamental nor technical analysis can be used to achieve superior gains.

3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today's stock price. Therefore, technical analysis cannot be used to predict and beat a market.

The Relationship between Earnings and Stock Returns

The relation between earnings and contemporaneous stock returns is based on the fundamental equality in finance that prices are discounted cash flows. Positive earnings news generate higher expected cash flows and in turn higher prices, i.e. positive stock returns. Indeed, one of the key findings in the accounting literature, first documented by Ball and Brown (1968), is that higher earnings changes are associated with higher stock returns. This result is mostly reflected in firm-level and portfolio-level estimations, using both cross-sectional (Ball and Brown, 1968) and time-series (Teets and Wasley, 1996) analyses. While firm-level observations con.rm the hypothesized positive relation between earnings changes and returns, aggregate-level tests do not. In fact, several recent studies (Kothari, Lewellen, and

Warner, 2006, and Sadka, 2007) document that aggregate earnings changes are negatively correlated with contemporaneous aggregate stock returns. This surprising result stands in contrast with robust firm-level results. If the market expects higher cash flows then stock prices should increase. Yet, the empirical evidence suggests that good news about future cash flows result in a negative market reaction. While Kothari, Lewellen, and Warner (2006) allude discount-rate explanations to reconcile this con.ict, this paper provides an alternative rational explanation that relies on the markets ability to predict earnings and returns. The first possible relation, that is, earnings changes are associated with changes in expected returns, can be explained through the following example. Assume an annuity with payments of $100 and 10% discount rate. The value of the annuity is $1,000 (=100/0.10). If the expected payment increases by $20 to $120 and at the same time the discount rate increases by 10% to 20%, the value of the annuity will decline to $600 (=120/0.20). Thus, if higher earnings changes re.ect both higher future cash flows and higher expected returns, it is possible that earnings changes will be negatively correlated with stock returns. The second possible relation is that earnings changes at time t and expected returns at time t-1 are negatively correlated. Such a relation can be interpreted as when investors expect high future earnings changes, they also demand a low risk premium (and therefore expected returns are low). Sadka (2007) finds evidence consistent with this interpretation, in that a high dividend-price ratio (dividend yield) predicts both high future returns and low future profitability. Sadka also finds that longrun earnings and returns are highly negatively correlated.

Earnings/return relationmarket model Used to separate out firm-specific share price movements from market-wide movements derived from the Capital Asset Pricing Model assumes investors are risk averse and have homogeneous expectations its use allows the researcher to focus on share price movements due to firm-specific news Total or actual returns can be divided into: abnormal returns used as an indicator of information content of announcements normal (expected) returns given market-wide movements abnormal (unexpected) returns due to firm-specific share price movements

abnormal returns used as an indicator of information content of announcements