A market is considered efficient in relation to a specific set of information if abnormal profits cannot be achieved by utilizing this information to make buying and selling decisions. When investing in the stock market, the aim is not only to generate a return on the invested capital but also to surpass the market and achieve higher returns.
The concept of market efficiency, as defined by Eugene Fama in 1970 with his efficient market hypothesis (EMH), states that security prices promptly and completely incorporate all available information. This implies that investors cannot consistently generate profits that surpass the norm. In some instances, investors may earn excess returns by being the first to act based on new information, while in other cases they may experience losses.
Financial economists state that efficient markets prevent investors from earning above-average returns without taking above-average risks. To illustrate this, there is a commonly shared story about a finance professor and a student who discover a $100 bill on the ground. The professor argues that if it were an authentic $100 bill, it would not be present there. This anecdote effectively represents the idea of market efficiency.
We have faith in the effectiveness of financial markets, as they prevent investors from earning higher than average returns without taking on higher than average risks. Put differently, we don’t think that there are easy opportunities for investors, whether they are professionals or amateurs, to simply obtain $100 bills (Burton G Malkie, 2003). There exist three levels of efficiency that rely on the type of information incorporated into prices: weak, semi-strong, and strong.
Under weak form efficiency, the current price incorporates all information from past prices. This implies that using charts and technical analysis based solely on past prices would not be effective in identifying undervalued stocks. In an efficient market, no trader can capitalize on an opportunity for earning a return on a stock that exceeds the fair return considering the risk associated with that stock using technical analysis. The concept of weak form efficiency is tied to the notion of a ‘random walk’, suggesting that previous patterns or trends in stock prices or markets cannot predict their future movement.
The random walk idea suggests that if information flows freely and quickly affects stock prices, then tomorrow’s price change will only be influenced by tomorrow’s news and will have no relation to today’s price changes. As news is unpredictable, resulting price changes must also be random and unpredictable (Burton G Malkie, 1973). The weak form efficiency suggests that if everyone in the market can access price history, any predictable pattern will be quickly taken advantage of and the process of exploiting it will eliminate the pattern.
With numerous observers at work, any information encoded in past price movements would be embedded in the current price due to buying and selling activities. This would eventually compel prices towards their efficient values through arbitrage. The advent of computerized systems that analyze stock movements has led to a rise in automated investments. Computers possess the ability to instantly process all accessible information, and even convert such analysis into immediate trade execution. Thus, if there is any advantage in past price information, it would swiftly be eradicated by the presence of these active computers.
The concept of weak form efficiency suggests that the returns generated from purchasing a diverse set of securities without any expertise are similar to those acquired by a “technical analyst” who bases their selections on trading patterns and trends observed in share prices. Kendall (1953) discovered that stock and commodity prices behave randomly. If prices can be predicted, competition among investors will eliminate such opportunities and arbitrage will bring prices closer to their efficient values.
Prices will only change based on new information. Studies by Kendall & Alexander (Corhag 1987), Moore (Corhag,1987), Fama (1965), Jennergen (1975) measuring correlation of returns with returns in prior periods for various countries have also suggested that only a small portion of historic return can explain current return. Despite the strong evidence supporting the randomness of stock movements, a few data anomalies have raised doubts about whether share prices truly include all historic data.
Fran Cross (1973) and Gibbons and Hess discovered that share prices tend to decrease on Mondays and increase on Fridays, a phenomenon known as the day of the week effect. Additionally, Keim (1983) identified the January Effect, which is a calendar-related anomaly in the financial market where security prices typically rise in January. This presents an opportunity for investors to purchase stocks at lower prices before January and sell them after their value increases. These observed patterns in price behavior indicate that financial markets are not completely efficient.
According to De Bondt and Thaler (1985 and 1987), stocks that have experienced the largest price declines in the past three to five years generally yield higher returns in the subsequent three to five years. Conversely, stocks that have performed well in the previous three to five years tend to underperform in the following three to five years. These findings suggest that past price data may be beneficial for longer-term investment strategies, which contradicts the weak market hypothesis.
The identification of anomalies could imply the presence of valuable historical price data, potentially leading to highly profitable opportunities. Nonetheless, most financial economists contend that financial markets are only moderately efficient. In 2005, Citigroup, the world’s largest financial services firm, opted to abolish its entire team devoted to stock market technical analysis. The company proclaimed that there would be no successor for the technical analyst group (The Street, 2005).
In 2005, Prudential equity group closed its technical research group and terminated Ralph Acampora, an industry veteran who was recognized as the first analyst to predict that the Dow Jones Industrial Average would reach 10,000 (Market watch, 2005). Despite the reliance of many companies on technical analysis for forecasting future price movements, these actions by major players in the financial services sector suggest that weak form efficiency is prevailing and it is not feasible to forecast future prices based on historical price data.
The Efficient Market Hypothesis (EMH) suggests that relying on technical analysis is futile and that average investors cannot generate abnormal returns if efficiency is maintained. Under semi-strong form efficiency, the current price reflects past prices as well as all public information, including financial statements and news reports. Any approach to using and manipulating this information would be useless in identifying undervalued stocks.
The semi strong form efficiency suggests that both fundamental and technical analysis cannot lead to better profits. To test for this efficiency, analysts often examine how stock prices are affected by announcements. According to the Efficient Market Hypothesis (EMH), if it holds true, any news would swiftly be reflected in the share price, causing an immediate jump upon announcement. However, one reason for deviating from EMH is that investors may not always respond adequately to new information.
In certain situations, investors may overreact to performance, selling stocks that have recently incurred losses or purchasing stocks that have recently enjoyed gains. On the other hand, if the market does not sufficiently react to news, the stock price will gradually increase towards its new fundamental value, indicating that the information has not been factored into the stock. If there is a consistent tendency in the market to either overreact or underreact to new information, it would suggest the existence of excessive profit opportunities (k Pilbeam, 2005).
I have personally invested in the market and gained insights about semi strong efficiency. Recently, I invested in a company called Kopane diamond developments plc, which is involved in diamond exploration and production in Lesotho. In September 2009, the company’s share price significantly increased after news broke about their discovery of a deposit worth over ?1.5bn at their Lesotho site. The market immediately reacted to this news and the share price jumped upon the announcement.
This indicated that the stock price appeared to change rapidly upon news being disseminated, indicating the validity of semi-strong form efficiency. Despite the immediate impact of news on the share price, investors appear to have overreacted to the news, resulting in a subsequent decline. However, Fama (1998) argues that it is possible for an efficient market to produce events that individually indicate an overreaction of prices to information, whether positively or negatively.
In an efficient market, both underreactions and overreactions are equally likely. Many studies have been done to analyze the impact of various announcements, and most of them show a noteworthy price movement on the announcement day, supporting the semi strong form efficiency. Fama, Fischer, Jensen, and Roll (1969) conducted a study on the stock market’s reaction to stock split announcements. Generally, stock splits are seen as positive news for investors, but the reasons behind their impact may be unclear.
According to them, one reason for this is that 72% of companies in their sample announced dividend increases above average in the year following the split. It appears that stock splits served as a signal for future dividend increases. Their research indicated that the market quickly and accurately adjusted share prices based on this new information, supporting the efficient markets hypothesis. Similar results were found in studies on earnings announcements (Ball and Brown, 1968) and merger announcements (Kevin and Pinkerton, 1981).
In an analysis of the effects of announced stock building, Firth (1975) found that it often leads to subsequent takeover bids at a premium price. He concluded that this supports the argument for semi strong efficiency. Watts (1973) and Pettit (1972) have separately studied the market’s response to dividend announcements and discovered that all price adjustments occurred immediately after the announcement. This indicates that the market quickly evaluated the information. Nonetheless, similar to weak form efficiency, there are anomalies that challenge the semi strong form.
The ‘size effect’, an anomaly in the stock market, was first discovered by Banz (1981). It refers to the tendency of small-cap stocks to have higher expected returns compared to larger firms, regardless of risks involved. Keim (1983), Roll (1983), and Rozeff and Kinney (1976) conducted additional research on this phenomenon, confirming that small-cap stocks consistently outperform large-cap stocks at the beginning of every year.
Basu (1977) conducted a study to analyze the performance of different portfolios based on their price to earning ratios. The results indicated that stocks with lower P/E ratios generate higher returns compared to those with higher P/E ratios, challenging the effectiveness of the Efficient Market Hypothesis (EMH) in incorporating the P/E effect. Additionally, Beechey et al. (2000) and other researchers have observed that share prices continue to rise or fall after positive or negative information is released. This evidence suggests that the market does not operate efficiently in a semi-strong form, enabling investors to achieve abnormal returns.
Despite the potential risks involved, many of these anomalies can be taken advantage of through fairly straightforward trading strategies. Even though there may still be some debate regarding the level of efficiency in the market, there is substantial evidence indicating that prices do respond promptly to new information, supporting the theory. In the case of strong form efficiency, the current price incorporates all available information, whether it is publicly known or privately held.
It is suggested that individuals possessing privileged insider information, such as traders, directors, or analysts, should not be able to consistently earn additional profits on securities through the use of such information. However, the evidence supporting the notion of markets being strongly efficient is unconvincing. This implies that managers and directors with access to privileged information can indeed achieve excess returns for their trades. Nonetheless, finding a suitable substitute for insider information is not a straightforward task.
According to Grossman and Stieglitz (1980), the existence of insider trading laws suggests that the markets are not perfectly efficient. They argue that if the markets were perfectly efficient, there would be no profit in gathering information, which in turn would lead to little trading and the eventual collapse of markets. Therefore, the degree of market inefficiency determines the effort investors are willing to make in gathering and trading on information.
Opponents of the efficient market hypothesis (EMH) claim that a few investors, such as Peter Lynch, Warren Buffett, George Soros, and Bill Miller, have consistently outperformed the market for extended periods. This exceptional performance cannot be solely attributed to luck, making it challenging to explain within the framework of EMH. These successful investors primarily rely on identifying market situations where prices do not accurately reflect the available information, contradicting the core principle of EMH that states such opportunities do not exist.
The EMH advocates believe that the hypothesis does not deny but rather anticipates the presence of unexpectedly successful investors or funds arising due to luck. There are several misunderstandings about the EMH, which often leads to its dismissal by the public. An inexperienced investor opting for a portfolio of stocks for a long-term approach is almost, though not entirely, aligned with the strategy proposed by the EMH that is likely to be as profitable as one chosen by the most talented and diligent securities analyst.
The average investor does not possess the financial knowledge needed to build a diversified portfolio that effectively eliminates specific risk. Concentrating investments in only a few sectors may result in an excessive level of risk for the investor. Consequently, the Efficient Market Hypothesis (EMH) evidence does not support the idea that any portfolio will generate identical returns regardless of the actions taken by the investor. Instead, it implies that investors can achieve normal returns by maintaining a diversified portfolio that mitigates specific risk and considers the remaining systematic risk.
There are several misconceptions about the Efficient Market Hypothesis (EMH) and the fluctuation of share prices. One of them is the belief that shares, which are thought to be priced efficiently by the EMH, still fluctuate daily even when there is no announcement about the company. However, these price fluctuations occur because new information, which can significantly impact the performance of a specific company, constantly enters the market. For example, if the Bank of England decides to increase quantitative easing, shares of gold companies (which act as a traditional inflation hedge) will rise.
Another misconception is that EMH advocates for a security’s price to accurately represent the value of a business based on its future returns. This belief is flawed because stock prices often do not reflect a company’s future results. Consequently, many people reject the EMH as being incorrect. However, it is important to note that the EMH does not uphold this belief. Instead, it suggests that a stock’s price reflects an aggregation of the probabilities of all future outcomes for the company based on the best available information at that time. The EMH does not consider whether that information ultimately proves to be correct or not. It simply requires a stock’s price to reflect the best possible estimate of the company’s performance using publicly available information.Despite adhering to the Efficient Market Hypothesis (EMH), it is possible that the aforementioned estimate is significantly incorrect. Several studies indicate that share markets, particularly those in the UK, US, and several others, promptly and accurately react to new information. Consequently, any abnormal profits would likely stem from insider trading.
According to strict legal rules against insider dealing, incidences of such behavior are limited, suggesting that these capital markets are at least semi-strong form efficient. The efficient market hypothesis was widely recognized prior to the 1980s, but skepticism has since increased due to incomplete explanations of share price behavior and the existence of anomalies. As a result, the efficient market hypothesis remains a highly debated topic in finance.
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