Efficient Market Hypothesis

University Degree Business and Administrative studies

Finance 1

‘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’

This report will discuss the Efficient Market Hypothesis (hereafter EMH) with reference to technical and fundamental analysis. An efficient market, according to Eugene Fama (1970) is defined as one which securities prices reflect all relevant information. Efficient Market Hypothesis is concerned with how quickly such information (both public and private) affects the securities price. EMH states that there is no link between past prices and future prices, and no relationship between the price of one stock and that of another stock. Within the hypothesis it shows that it is not always possible to ‘beat the market’ by using any source of additional information. The aim of a ‘fair game’ within the hypothesis is to follow a particular condition to which ‘no stock market investor is to earn above abnormal return from buying or selling a company’s stock by making use of available information about the company at a particular point in time’.

There are three forms of market efficiency; weak form efficiency, semi – strong form efficiency and strong form efficiency.

Weak form efficiency states that only past prices of securities are reflected on prices at present. Abnormal profit cannot be achieved by predicting prices based on past history data.

Weak form efficiency states that it is possible to use historical price movement to predict future prices and consistently make superior returns. There are various trading strategies to which investors may adopt and a Technical Analysis would be of most favour to weak form efficiency.

Technical Analysis is the ‘process of analysing a security’s historical prices in effort to determine probable future prices’. Technical Analysts can use past data to successfully predict the future behaviour of a securities price by studying charts and trends and other tools which may help identify any patterns. Detecting such patterns and behaviours can help predict future activity. Two relevant factors which determine the future direction would be price and volume, this technique enables a Technical Analyst the ability to forecast the future direction of prices.

There are two ways of testing weak form efficiency; Correlation and Run tests. By using a Correlation test, the study is trying to find if there is a linear relationship between prices from previous returns and current returns. The test will show whether there is a change to one variable to another and will only work amongst the assumption that the market is in equilibrium. Run tests are based on analysing the number of runs of increase or decrease in prices. When a run test shows consecutive repeated patterns this will suggest predictability, thus contradicting Efficient Market Hypothesis. When a run test shows fewer sequences this suggests that there is less predictability and disallows any theory that prices may predicted by past prices, supporting the Efficient Market Hypothesis. This shows that it is not possible to make abnormal returns for results in run tests can prove that there can be a small chance of predictability in future prices, making it more difficult to beat the market and have any advantage over other investors.

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Various studies in regards to the weak form efficiency appear to support the theory of past data being valuable in making decisions on buying and selling. Technical Analysis in particular goes against the theory of weak form efficiency, Technical Analysts believe that sufficient information may aid in beating the market whereas the weak form efficiency states that past data is useful but will not allow investors to make abnormal profits. Studies carried out by Maurice Kendall (1953) suggested that the movement of shares on the stock market is random. Technical Analysts do not follow this theory and strongly doubt that past data may allow for abnormal profits. The study of Maurice Kendall is closely linked to the concept of the Random Walk Hypothesis, Louis Bachelier (1900), this stating that stock market prices cannot be predicted and that stock prices are completely random because of the efficiency of the market. Other studies which support the weak form efficiency is Eugene Fama (1965) and Griffiths (1970).

There are several anomalies to the weak form efficiency theory, to where recent studies illustrate the weak form efficiency to be invalid. Such studies include: McQueen and Thorley (1997) and Yu (1996). In the study of McQueen and Thorley it states that it is possible to predict future returns from past returns. Within this study it was in regards to the gold returns.

Semi- strong efficiency states that the prices of securities reflect not only past historical data but the addition of publicly available information. It should not be possible of investors to make consistent excess returns within this form. Semi strong efficiency states that efficient current prices, fully and instantly reflect all publicly available information plus past historical data. Semi strong efficiency consists of analysing public information such as company reports, company announcements and economic forecasts. The theory will not be able to make excess profits and will still allow for a ‘fair game’. Although there is further information provided, the market will only react to ‘news’, especially announcements. According to the theory if bad news was to be announced, share prices will fall therefore will be less attractive to investors. If there was an announcement regarding good news, the share price will increase and will interest investors. In terms of the semi strong efficiency the only way to beat the market is by insider training. This is additional information from private sources which will enable to buy and sell on the basis of its effect on risk or profitability.

Another trading strategy an investor may adopt may be Fundamental Analysis. Fundamental Analysis ‘involves of delving into financial statements’. Fundamental Analysts use economic and accounting information to predict stock prices. This allows the examination of company’s and , especially , , potential, , , , , and . Fundamental takes into only those that are directly related to the itself, rather than the overall state of the . With regards to Fundamental Analysis, factors other then past security prices are relevant in determining future prices. This method is believed to provide a better understanding of the business as a whole, possibly allowing investors to beat the market.

In order to test the semi strong form efficiency theory, Event Studies needs to be conducted. This is the analysis of impact on the announcement on stock prices, to see how quickly and accurately news is incorporated into the share price. Event Studies analyses the impact of a particular announcement on the share price, for a period prior to or after the announcement. Event studies examine the behaviour of firms’ stock prices around corporate events. This will illustrate any significant movements on the day of announcement, the ‘news’ is unpredictable and therefore no forecast can be made. Announcements such as ‘dividend policy announcement’ Watts (1973) and Pettit (1972), found that there are market price movements and returns, making the study consistent with semi strong form efficiency.

There is evidence supporting semi strong efficiency. Stock split is one method which does so. This is the process of splitting shares to improve marketability. This increases the number of shares in a public company which is a sign of improved dividend. Stock price is affected by stock splits; after the stock is split the stock price will be reduced since the number of shares outstanding has increased. The stock split announcement is usually seen as a positive, as it is usually an indication that the business is expected to do well in the future. This was a proven study by Fama, Fisher, Jensen and Roll (1969) when they researched further into stock splits on NYSE during 1929 – 1959. Other tests which are in favour of semi strong form efficiency are the study of Watts (1973) with regards to the dividend policy announcement and earning announcements, Ball and Brown (1968). Within this test, firms were studied prior to and after the announcement resulting to stock prices anticipating the announcement.

There is evidence contradicting the semi strong form efficiency theory and these studies consist of those of Bernard and Seyhun (1997), the further studies of Ball (1974) and Watts (1978). These studies challenge the theory that the market is not semi strong efficient. Overall the only possible way to out smart the market is to have inside information and using it to your own advantage.

There are certain anomalies to the EMH and these include:

Earning announcements also act as an anomaly to the EMH, for it suggests that stock prices react to announcements. Studies such as Rendleman, Jones and Latane (1982) shows that reactions to stock prices are not consistent with semi strong form efficiency. All news is not priced into the market as expected from Efficient Market Hypothesis, and therefore markets seem to under react to good or bad news.

Another anomaly is the January Effect, the study of the US Stock market 1963 – 1979, Keim (1983). This illustrates the returns on the stocks in January are relatively high compared to other months within the year. In January, stocks out perform the performance of the market as a whole. Stocks both small and large appear to rise in January in comparison to other months. This allowing investors to have extra information in which can make an excess profit, if they were to buy securities at the end of December and sell them at the end of January. By investing in low-capitalisation stock enables the investor to earn excess returns.

A final anomaly to the EMH is the day-of-the-week effect, tested by Fran Cross (1973), Gibbons and Hess (1981) they statistically found evidence that share prices tend to fall on Monday and rise on Friday. Within the studies of Gibbons and Hess it showed that there were significant differences in the expected percentage change for stock prices. The study revealed a trading strategy to which you buy on Monday and sell on Friday. With this theory, it is possible to make abnormal profits. The additional information is informing investors when securities are at its prime and when securities are best to be sold on.

Strong form efficiency states that information present, both private and public reflect the current price of securities. The access of extra information should not be able to make consistent excess returns and should follow the conditions of a ‘fair game’. The additional information should not be used to an investors favour but should be revealed to the public in order to maintain the ‘fair game’ within the market.

Capital asset pricing model (CAPM):

This was developed by financial economists, in particular Sharpe (1963, 1964). CAPM is about how shares in a company are priced in relation to risk. This explains the relationship between risk and return on a financial security. This relationship can be used to determine the appropriate price for the security the key idea of CAPM is that an efficient market.

In conclusion, Efficient Market Hypothesis states that security’s prices reflect all relevant information and that there is no link between past and future prices. As for Technical analysts, they believe that shares should be bought in reference to looking at existing share prices. The use of charts will allow investors to seek information on future market prices allowing for abnormal returns. As for Fundamental analysts, the prediction of future prices can only be calculated when looking further into the economy and into the companies’ financial information on a heavier scale. By doing so this will enable investors to know an extensive amount of knowledge, which will later be possibly beneficial on gaining an overview of the whole company rather then a small sector. Although there are certain anomalies to the Efficient Market Hypothesis theory, the weak and semi –strong form suggest that abnormal returns cannot be made with the use of pubic information and past history data.