The Efficient Market Hypothesis is perhaps the most prevalent, controversial and well-known market theory in the world. EMH is one of the arguments made in favour of the stock market. It was developed throughout the 20th Century however it became more prevalent once Eugene Fama penned the term Efficient Market Hypothesis in his thesis from 1970. Since then the theory has grown and evolved, however the basic concept has remained the same.
‘If new information comes onto the market concerning a business and its performance, this will be quickly and rationally transferred into the business’ share value. For example if an investment analyst found that in terms of its actual and expected dividends, a particular share was underpriced and thus represented a ‘bargain’, the analyst would advise investors to buy. As people then bought shares, their price would rise, pushing the value up to their full worth. So by attempting to gain from inefficiently priced securities, investors will encourage the market to become more efficient’ (Sloman 2009). The EMH further states that stock prices already reflect all known information and are therefore accurate, and that the future flow of news (that will determine future prices) is random and unknowable in the present. The Random Walk theory in its most primitive; ‘…says that stocks take a random and unpredictable path. The chance of a stock’s future price going up is the same as it going down. A follower of random walk believes it is impossible to outperform the market without assuming additional risk.’ (www.investopedia.com)
There are three forms of the EMH that show the structure of the theory:
Weak Form of Efficiency: Stock prices reflect all the past information in prices. Thus, current stock prices are the best estimated value, provided no change to the companies fundamental value. Fundamental analysis can be used to investigate if the stocks are undervalued or overvalued, as share prices move in cycles that do not reflect underlying performance, however as these techniques are used more and more knowledge/information becomes more perfect making the market more efficient and cycles withdraw. Consequences result in no excess return being made from investment strategies that based on historical stock price or financial information. Technical analysis can also be difficult to implement, but some fundamental analysts still make profits in the stock market.
Semi-Strong Form of Efficiency: Stock prices reflect all past and current publicly available information. The stock prices can be adjusted in an unbiased movement to any new public information; e.g. on business news on local newspaper. However, the adjustment is relatively small. The outcome of SSF is that not much gain can be earned by trading on this information. Though fundamental analysis is still useful, nonetheless the returns are normally not as high as in the weak form.
Strong Form of Efficiency: Stock prices reflect all relevant information, including data that is not yet disclosed to the general public such as insider information. The effect of this info is that almost nobody can earn high returns on investments over a long period of time. Unless people have access to ‘privileged’ information, such as CEO’s i.e. who know the company will release better than expected profit figures and buy shares prior to this knowledge being unrestricted, if this is the case large returns can be made.
Nevertheless it must be noted that the EMH theory relies on the fact that, ‘investors are assumed to be rational and subsequently value securities rationally’ (Shleifer 2000). Rational investors value each security for its elemental value. When these investors learn something about the value of securities they react quickly to the new information by pushing prices up when news is good and down when the news is bad, by buying securities they expect to have a higher-than-average return and selling those they expect to have lower returns.
So for a market to be efficient the current prices should reflect the net result of the entire buy and sell decisions by all investors based on their interpretation of all the information that is known about a company at that time, ‘The hypothesis that new information about a company’s current or future performance will be quickly and accurately reflected in its share price’ (Sloman 2009). Regardless of what one analyst or every investor believes, the market is always right according the EMH theory.
However there are cracks within the foundations of EMH that have formed over time.
Different investors have different judgements (random walk, rational/irrational) it is impossible to say how their judgements would affect a security to immediately go up or down on notable news. ‘Investor perception can be affected by an infinite number of developments, innumerable events happen every day throughout the world that impact a companies’ short term and long term earnings/growth rates and therefore, the price/earnings ratios that investors will be willing to pay for different securities.’ (Pike 1996)
Because of this many observers/academics/professionals argue against the concept that markets behave consistently within the efficient market hypothesis, especially in its stronger forms. Some economists, mathematicians and market experts cannot believe that man-made markets are strong/semi strong-form efficient when there are, under closer analysis, reasons for inefficiency i.e. the slow diffusion of information, the relatively great power of some market participants e.g. financial institutions and the existence of apparently sophisticated professional investors e.g. Peter Lynch, Warren Buffett, George Soros etc. The way that markets react to surprising news is perhaps the most visible flaw in the efficient market hypothesis. For example, news events such as surprise interest rate changes from central banks are not instantaneously taken account of in stock prices, but rather cause sustained movement of prices over periods from hours to months. Only a privileged few may have prior knowledge of laws about to be passed, new pricing controls set by "pseudo-government" agencies such as the Federal Reserve banks, and judicial decisions that effect a wide range of economic parties. The public must treat these as random variables, but those who act on such inside information can correct the market, generally in a discrete method to avoid detection.
Warren Buffett who has argued that the EMH is not correct, on one occasion saying "I’d be a bum on the street with a tin cup if the markets were always efficient" and on another saying, "The professors who taught Efficient Market Theory said that someone throwing darts at the stock tables could select stock portfolio having prospects just as good as one selected by the brightest, most hard-working securities analyst. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient." (www.moneyscience.com)
Secondly, to the extent that some investors are not rational, their trades are random and therefore cancel each other out without affecting prices.
Third, to the extent that investors are irrational in similar ways, they are met in the market by rational arbitrageurs who eliminate their influence on prices.
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