The strong form EMH is that private information or private information is quickly incorporated by market prices and therefore cannot be used to get abnormal trading profits. Thus, all information is fully reflected in a security's current market price. That's mean, even the company's management (insider) are not able to make gains from inside information they hold. They are not able to take the advantages to profit from information such as take over decision which has been made ten minutes ago. However, a few privileged individuals ( for example directors) are able to trade in shares, as they know more than the normal investors in the market.
2. Evidence Of EMH
2.1 Supportive Evidence of EMH
- Weak form of EMH is supported by the data.
- Technical trading rules are not consistently profitable.
S&P 500 Index (1980-1984) versus Coin-tossing
Source: R. Brealey and S. Myers, Principles of Corporate Finance.
2. Serial correlation in daily stock returns is close to zero
Serial Correlation of Daily Returns on Nine Stock Markets
Source: B. Solnik, “A Note on the Validity of the Random Walk for European
Stock Prices.” Journal of Finance (December 1973).
- Semi-strong form of EMH is generally supported by the data.
Prices react to news quickly.
Cumulative Abnormal Returns (CAR) befor and after Dividend Announcements
Cumulative Abnormal Returns (CAR)before and after Takeover Attempts: Target Companies
Source: A. Keown and J. Pinkerton, “Merger Announcements and InsiderTrading Activity.” Journal of finance (1981).
- Strong-form of EMH has mixed evidence:
Money managers cannot consistently outperform.
Mutual Fund Performance (Gross of Expenses)
Source: M. Jensen, “Risks, the Pricing of Capital Assets, and the Evaluation of
Investment Performance.” Journal of Business (April 1969).
Performance of Average Equity Mutual Funds
2.2 Negative Evidence
- Stock Market Crash of 1987.
(a) Facts:
• No apparent news
• Huge and dis-continuous price drop
• Worldwide
• No immediate bouncing back.
(b) Suspects:
• Index arbitrageurs
• Portfolio insurance
– failed under collective mass selling
• Institutional selling (one institution sold $1.7 billion).
1987 Stock Market Crash — U.S. Market
- Smooth dividends but volatile prices (Shiller).
Real S&P Index p versus Ex Post Rational Price p* (1871-1979)
Source: R. Shiller, “Do Stock Prices Move Too Much to be Justified by
Subsequent Changes in Dividends?” American Economic Review (Vol. 71,
1981).
- Whether or Not EMH Holds—EMH In Reality
- Weak form of EMH almost always holds
- Semi-strong form of EMH almost always holds
- Strong form of EMH seldom holds
i. Are markets weak-form efficient?
Empirical tests to examine the weak-form efficiency of capital markets analyzed two kinds of problems. One group involved statistical tests of the independence between different historical rates of return, such as autocorrelation tests (e.g. Fama, 1965) and runs tests. In the other group, rates of return of traditional buy and hold policies and technical trading rules policies were compared on a risk adjusted basis, to find whether the latter empowered the investor to gain consistent superior returns. Neither autocorrelation tests nor runs tests have shown a general dependence in returns or price changes, e.g. correlations were insignificant. Some exceptions were found in results of older tests, where small-cap shares had a relatively higher correlation than other shares. Most evidence derived from trading rules tests did not support the weak-form EMH, Exceptions were found in few tests with rules on the basis of non-price market data (see above). A research by Alexander (1961) showed that if transaction costs were ignored, using the filter rules with small filters enabled the investor to gain consistently higher than average returns. Taking the transaction costs into account, however, superior turned into consistently inferior returns. In summary, tests have shown little minor inefficiency, which are not enough to enable consistent superiority in returns.
Technical analysis and the weak-form EMH make contradictory premises. Technical analysts assume that markets are informational inefficient concerning the speed of the reflection of information. The gradual adjustment to new information moving from the more informed to the less informed and involved investor generates a trend in prices which can be exploited. Only one assumption can be true; empirical data, generally supports the weak-form EMH
ii. The semi-strong form of EMH
Tests that analyze empirical data to prove or refute the semi-strong-form EMH are as follows. One group of tests tries to predict future rates of return either in a time-series approach, i.e. forecasting aggregate market returns via historical data, or in a cross-sectional approach, i.e. forecasting the distribution of returns or other characteristics of individual shares. The other group of tests examines how fast stock prices adjust to specific economic events. The emphasis of the analysis in both groups is on abnormal rates of return deviating from long-term expectations or on risk adjusted performance differences between individual shares and the market. There is a sheer number of tests and studies that fall into either of the two categories because of the difficulty and complexity of fundamental analysis. Not only has the successful investor to have superiority in selecting variables that are relevant, he also must be superior in estimating these variables and estimating the effect they have on the price of the share. Time series studies have indicated that the long-term prediction of market returns, in contrast to short-term prediction, can be successful
The semi-strong-form EMH is wholly supported by event studies that examined the speed of price adjustment. The only mixed results can be found with stock exchange listing events. A particularly significant study by Dann, Mayers and Raab (1977) concluded that at the New York Stock Exchange large block trades are reflected in the share price within 15 minutes.
iii. The strong form of the EMH
Holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm. Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before public release to enable them to profit from trading on this information.
Vi Implications of EMH
1. Trust market prices.
• Buying and selling assets are zero NPV activities, giving
only risk-adjusted returns.
• Market prices give best estimate of value for projects.
• Firms receive “fair” value for securities they issue.
2. Read into prices.
• If market price reflects all available information, we can
extract information from prices.
3. There are no financial illusions.
• Market price reflects value only from an asset’s payoff.
• It is not easy to trick the market.
4. Value comes from economic rents such as
- Superior information
- Superior technology
- Access to cheap resources
- Conclusion And Recommendations
To conclude: The equity markets are generally very efficient, but the person with superior analytical ability, knowledge, dedication and creativity can be rewarded with abnormally high returns.
Recommendations
Strategies for investors:
Investors are suggested to use a passive investment strategy, which makes no attempt to beat the market. Investors should not select securities randomly according to their risk aversion or the tax positions. This dose not means that there is no portfolio management. In an efficient market, it would be superior strategy to have a randomly diversifying across securities, carrying little or no information cost and minimal execution costs in order to optimize the returns. There would be no value added by portfolio managers and investment strategists. An inflexible buy-and-hold policy is not optimal for matching the investor's desired risk level.
Strategies for companies or managers:
Managers need to keep in mind that markets would under react or over react to information, the company's share price will reflect the information about their announcements (information).
The historical share price record can be used as a measure of company performance and management bear responsibility for it. When share are under priced, managers should avoid issuing new shares.
- Reference And Readings
R.Shiller (1981). ‘Do stock prices more too much to be justified by subsequent changes in dividends’. American economic Review, Vol. 71, Nos 1-3, p.p 421-423
B.Solnik (1973). ‘Note on the validity of the random walk for european stock prices’. Journal of Finance, Vol. 28. p.p 1151-1152
A.Keown and J.pinkerton (1981). ‘Merger announcements and insider trading activity’. Journal of Finance, Vol. 36, No. 4, p.p 860-861
M.Jensen (1969). ‘risks, the pricing of capital assets, and the evaluation pf investment performance’. Journal of Business, Vol. 42. p.p 216-221
Richard A. Brealey, Stewart C. Myers. ‘Principles of corporate finance’
7th edition. McGraw-Hill/Irwin, 2003.
Glen Arnold. ‘Corporate financial management’ 2nd edition Prentice Hall, Financial Times 2002
John.J.clark, Margaret.T.Clark, Pieter.T.Elgers. ‘Financial Management-a capital market approach’ Holbrook press 1976
George.C.Philippatos. ‘Financial Management-Theory and techniques’
Holden-Day, Inc. 1973
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