Efficient Market Hypothesis by Eugene Fama

`A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions. ’ Critical Analysis When we invest money into the stock market we do it with the intention of generating a return on the capital invested. Many investors try not only to make a profitable return, but also to outperform, or ‘beat the market’.

However, market efficiency – championed in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that security prices instantly and fully reflect all available information and that it would not be possible for an investor to make consistent excess profits. When new information arrives in the market, investors on some occasion will make an abnormal return by being the first ones to trade on it and in other cases they will lose.

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On average investors will make a normal return and efficient markets will not allow investors to earn above-average returns without accepting above-average risks. A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, “Don’t bother—if it were really a $100 bill, it wouldn’t be there. ” The story well illustrates what financial economists usually mean when they say markets are efficient.

We believe that financial markets are efficient because they don’t allow investors to earn above average returns without accepting above average risks. In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor. (Burton G Malkie, 2003) There are three different levels of efficiency according to the type of information which is reflected in prices and they can be identified as weak, semi strong and strong.

Under weak form efficiency, the current price reflects the information contained in all past prices, suggesting that charts and technical analysis that use past prices alone would not be useful in finding under valued stocks. In an efficient market no trader will be presented with an opportunity for making a return on a share that is greater than a fair return for the riskiness associated with that share through technical analysis. The weak form efficiency is associated with the idea of a ‘random walk’ which suggests that past movement or trend of a stock price or market cannot be used to predict its future movement.

The logic of the random walk idea is that if the flow of information is unhindered and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. Since news is by definition unpredictable then resulting price changes must also be unpredictable and random (Burton G Malkie, 1973). The simple idea behind the weak form efficiency is that everyone in the market can see the history of prices, any predictable pattern will soon be exploited and the very process of trying to exploit it will eliminate the pattern.

There are so many observers at work that if any information were contained in past price movements it would be impounded in the current price as a result of buying and selling and thus arbitrage would force prices to their efficient values. Especially with the rise of computerized systems which analyze stock movements, investments are becoming increasingly automated and computers can immediately process all available information, and even translate such analysis into an immediate trade execution. If there exists any past price information advantage it would be quickly eliminated by all such computers at work.

Thus weak form efficiency tries to establish that an inexperienced purchase of a large, broadly based portfolio of securities produces returns the same as those purchased by a ‘technical analyst’ focusing over share price data and selecting shares on the basis of trading patterns and trends. Kendall (1953) found that stock and commodity prices follow a random walk. If prices are predictable then competition between investors will eliminate them and arbitrage will force prices to their efficient values.

Prices will only change on the basis of new information. Other evidence from studies measuring correlation of returns with returns in prior periods for various countries by Kendall & Alexander (Corhag 1987), Moore (Corhag,1987), Fama (1965), Jennergen (1975) suggested that only a very small element of historic return can explain current return. Despite the strong evidence that stock movements are largely random there have been a few data anomalies exposed that call into question whether share prices do incorporate all historic data.

Fran Cross (1973) and Gibbons and Hess found statistically significant evidence that share prices tend to fall on Mondays and rise on Fridays. This is popularly known as day of the week effect. The January Effect noted by Keim (1983) is a calendar-related anomaly in the financial market where financial security prices increase in the month of January. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases. This type of pattern in price behavior in the financial market supports the fact that financial markets are not fully efficient.

De Bondt and Thaler (1985 and 1987) found that stocks that have fallen most in price during the previous three to five years will tend to yield excess returns over the following three to five years. While stocks that have been best performers in the preceding three to five years will tend to underperform in the subsequent three to five years. The results of this winner loser problem imply that past price information can be potentially useful for longer term investment strategy posing a challenge to the weak market hypothesis.

The anomalies that have been uncovered suggest the possibility that there may be useful past price information that could yield potential excess profit opportunities. However the majority of the evidence discovered by the financial economists as mentioned above is indicative of the fact that financial markets are weak form efficient. In 2005 the world’s biggest financial services firm Citigroup dismissed its entire stock market technical analysis team. At the time the company said that the technical analyst group would not be replaced (The Street, 2005).

In the same year Prudential equity group shut its technical research group and laid off industry veteran Ralph Acampora who had been credited as the first analyst to say the Dow Jones Industrial Average would reach 10,000 (Market watch, 2005). Although there are many companies which rely on technical analysis to predict future price movements, the aforementioned moves by a few of the biggest players in financial services provide a slight indication that weak form efficiency holds and it is not possible to predict future prices using historical price information.

The implication of EMH is that technical analysis is a waste of money and that so long as efficiency is maintained the average investor will not be able to generate an abnormal return by relying on such analysis. Under semi-strong form efficiency, the current price reflects the information contained not only in past prices but all public information (including financial statements and news reports) and no approach that was taken to using and manipulating this information would be useful in finding under valued stocks.

In other words neither fundamental nor technical analysis can be used to achieve superior gains according to semi strong form efficiency. The most popular means of testing for semi strong form efficiency is to analyze the impact of an announcement on stock prices and if EMH holds then the effect of news will be immediately and instantly reflected into the share price which will jump on the announcement. However a common explanation for departure from the EMH is that investors do not always react in proper proportion to new information.

For example, in some cases investors may overreact to performance, selling stocks that have experienced recent losses or buying stocks that have enjoyed recent gains. Alternately if the market under reacts to the news, the stock price will rise but only slowly towards its new fundamental value suggesting the information has not been priced into the stock. If there was a consistent tendency in the market to over react or under react to new information this would imply excess profit opportunities. (k Pilbeam, 2005)

I am personally involved in investing and from my experience have gathered some information about the semi strong efficiency in markets. I invested not so long ago in a company called Kopane diamond developments plc which is engaged in diamond exploration and production in the Kingdom of Lesotho. In September 2009 its share price more than doubled in value on news that it had a deposit at its Lesotho site valued at more than ? 1. 5bn. When the news of the find hit the market, its effect was immediately and instantly reflected into the share price which jumped on the announcement.

This showed that the stock price seemed to move swiftly when news reached the market suggesting that semi strong form efficiency is valid. Although the news is instantly reflected in the share price the investors seem to have over reacted to the news which is represented in the subsequent fall. However Fama (1998) alleges it’s possible that an efficient market generates categories of events that individually suggest that the prices over-react to information, either positively, either negatively.

The important thing is that in an efficient market an apparent under reaction will be about as frequent as an overreaction. There have been numerous event studies conducted analyzing the impact of different types of announcement and most such studies show a significant price movement on the day of the announcement which is consistent with the semi strong form efficiency. Fama, Fischer, Jensen and Roll (1969) studied the stock market reaction to announcements of stock splits. Typically, stock splits are believed to be seemingly inexplicable good news for investors.

One possible reason reported by them was that they found 72% of firms in their sample announced above-average dividend increases in the year after the split. Stock splits seemed to “signal” future dividend increases. According to their findings, the market adjusted the share prices instantaneously and accurately for the new information. This evidence is consistent with the efficient markets hypothesis. Similar findings were reached regarding earnings announcements (Ball and Brown 1968) and merger announcements (Kevin and Pinkerton 1981).

Firth (1975) in an analysis of the effects of announced stock building which often results in a subsequent takeover bid at a premium price found that the semi strong efficiency argument was supported. Watts (1973) and Pettit (1972) have investigated the market’s reaction to dividend announcements and both found that all price adjustments were over immediately after the announcement and thus the market had acted quickly in evaluating the information. Like the weak form efficiency there are some anomalies that that pose a challenge for the semi strong form.

For instance, one of the most enduring anomalies is the ‘size effect’ first discovered by Banz (1981) which noted the excess expected returns that accrue to stocks of small-capitalization companies in excess of their risks compared to those of the largest firms. Keim (1983), Roll (1983), and Rozeff and Kinney (1976) discovered a related anomaly which suggested that small capitalization stocks tend to outperform large capitalization stocks by a wide margin over the turn of the calendar year.

Basu (1977) examined the performance of various portfolios on the basis of their price to earning ratios and found that return on company stocks with low P/E ratios is significantly higher than return on companies with high P/E ratios. The EMH has difficulty dealing with the P/E effect. There has also been the observation that share prices continue to rise or fall following the release of positive or negative information (Beechey et al. 2000). Such evidence implies that market is not semi strong form efficient since it allows an investor the opportunity to make abnormal returns.

After all, most of these anomalies can be exploited by relatively simple trading strategies, and, while the resulting profits may not be riskless, they seem unusually profitable relative to their risks (Lehmann, 1990). Although the evidence in favour of semi-strong efficiency is not as strong as that for weak form efficiency, the evidence significantly shows that prices do tend to react to new information instantly as suggested by the theory. Under strong form efficiency the current price reflects all information, both public and private.

It implies that even traders, directors or analysts with access to privileged insider information should not be able to make consistent excess returns on securities by using such information. The evidence for strong form efficiency in markets is weak suggesting that managers and directors with access to privileged information can obtain excess returns for their trades. However obtaining an adequate proxy for inside information is far from easy.

If the markets were strong form efficient then there would have been no reason for insider trading laws that currently exist. Grossman and Stieglitz (1980) have argued that perfectly informational efficient markets are impossibility because if the markets are perfectly efficient, there is no profit to gathering information, in which case there would be little reason to trade and markets would eventually collapse and that the degree of market inefficiency determines the effort investors are willing to exercise to gather and trade on information.

Also sceptics of EMH argue that there are a small number of investors like Peter Lynch, Warren Buffett, George Soros, and Bill Miller who have outperformed the market over long periods of time, in a way which is difficult to explain by attributing it to luck. These investors’ strategies are to a large extent based on identifying markets where prices do not accurately reflect the available information which is in direct contradiction to the efficient market hypothesis which clearly implies that no such opportunities exist.

Supporters of the EMH argue that the hypothesis does not exclude but indeed it predicts the existence of unusually successful investors or funds occurring through chance. There are a few misconceptions about the EMH which commonly results in it being rejected by the general public. An amateur investor choosing a portfolio of shares for a buy and hold strategy is nearly, but not quite what EMH suggests as a strategy likely to be as rewarding as one selected by the brightest, most hard-working securities analyst.

The amateur investor does not possess the financial expertise needed to create a broadly based portfolio which fully diversifies away any unsystematic risk. A selection of shares in just one or two sectors may expose the investor to excessive risk. Therefore EMH evidence doest not suggest that irrespective of what the investor does any portfolio will make an equal return. Rather it implies that after eliminating unsystematic risk by holding a broadly based portfolio and then adjusting for the residual systematic risk, investors will not achieve abnormal returns.

Another misconception is relating shares which are believed to be efficiently priced by the EMH but which fluctuate every day even when there is no announcement concerning the particular company. Prices fluctuate because new information which may have some influence on the performance of a specific company is hitting the market by the minute. For example, if the Bank of England increases quantitative easing, gold company shares being a traditional inflation hedge rise. Another misconception is that EMH advocates that a security’s price is a correct representation of the value of that business, as calculated by what he business’s future returns will actually be and that a stock’s price correctly predicts the underlying company’s future results. Since stock prices clearly do not reflect company future results in many cases, many people reject EMH as clearly wrong. However, EMH does not represent that belief. Rather, it suggests that a stock’s price represents an aggregation of the probabilities of all future outcomes for the company, based on the best information available at the time. Whether that information turns out to have been correct is not taken into consideration required by EMH i. . EMH does not require a stock’s price to reflect a company’s future performance, just the best possible estimate of that performance that can be made with publicly available information. That estimate may still be grossly wrong without violating EMH. Various studies carried out have suggested that advanced share markets like the ones in the UK and the US and a few others are quick in responding accurately to new information and that abnormal gains are only possible through insider dealing.

Since there are strict legal rules against insider dealing, such incidences are very limited and it is likely that such capital markets are at least semi-strong form efficient. The efficient market hypothesis was widely acknowledged before 1980s but since then skepticism has prevailed due to incomplete explanation of share price behavior and the existence of anomalies. Thus the efficient market hypothesis continues to be the most debated topic in all of finance. Bibliography Barr, A. ‘Prudential Equity ends tech research. ’ Market Watch. http://www. marketwatch. om/story/prudential-equity-group-shuts-technical-research-unit (25th November 2009). Cunningham A, L. How to think like Benjamin Graham and invest like Warren Buffet. USA: McGraw-Hill, 2002. Davidson, P. Markets, Money and The Real World. Cheltenham: Edward Elgar Publishing Ltd, 2002. ‘Financial Analysis revised. ’ http://cbdd. wsu. edu/kewlcontent/cdoutput/TR505r/page4. htm (29th October 2009) Goldstein, M. ‘Citigroup Eliminates Stock Technical Analysis Group. ’ The Street. http://www. thestreet. com/stocks/brokerages/10209532. html. (25th November 2009).

Jensen, M. ‘Some Anomalous Evidence Regarding Market Efficiency’ Journal of Financial Economics, Vol. 6, Nos. 2/3 (1978) 95- 101. Kevin, S. Security Analysis and Portfolio Management. New Delhi: Prentice Hall of India Private Limited, 2006. ‘Kopane diamond development. ’ The Sharecentre. http://www. share. com/cgi-bin/oicgi. exe/inet_tsc_dl2? epic=KDD (1st December 2009) L. Blume and S. Durlauf, The New Palgrave: A Dictionary of Economics. New York: Palgrave McMillan, 2007. Madur, J and Fox, R. International Financial Management. London: Thomson Learning, 2007. Market efficiency: definition, tests and evidence. ’ (9th November 2009). Pilbeam, K. Finance and Financial Markets. Hampshire: Palgrave Macmillan, 2005. ‘The Efficient Market Hypothesis. ’ Money Science. http://www. moneyscience. com/Information_Base/The_Efficient_Markets_Hypothesis_(EMH). html (9th November 2009) Watson, D and Head A. Corporate finance: principles & practice. Essex: Pearson education limited, 2007. Interview, Eugene Fama, February 1997. Efficient Markets Hypothesis (EMH) The Efficient Markets Hypothesis (EMH) ———————– Price jump on announcement net

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