The greatest blend in academic circles has been created by the results of volatility tests. These tests are designed to test for rationality of market behavior by examining the volatility of share prices relative to the volatility of the fundamental variables that affect share prices. The empirical evidence provided by volatility tests suggest that movements in stock prices cannot be attributed only to the rational expectations of investors, but also involves an irrational component (The irrational behavior has been emphasized by Shleifer and Summers (1990) in their exposition of noise trading).
Empirical tests to examine the “weak-form” efficiency of capital markets analyzed two kinds of problems. One group involved statistical tests, such as autocorrelation tests and runs tests. The Random Walk Theory implies that consecutive price movements should be independent and that returns are identically distributed over time; so if the EMH was true, we would expect zero correlation. Consistent with this theory, Fama (1965) found that the serial correlation coefficients for a sample of 30 Dow Jones Industrial stocks were too small to cover transactions costs of trading. Following studies have mostly found similar results, across other time periods and other countries.
The other group, tests the “weak-form” of market efficiency by examining the gains from technical analysis. While many early studies found technical analysis to be useless, recent evidence showed the opposite. They find that relatively simple technical trading rules would have been successful in predicting changes in the Dow Jones Industrial Average. However, subsequently research found that the gains from these strategies are inadequate to cover their transaction costs. Consequently, the findings are consistent with “weak-form” market efficiency.
The “semi-strong” form of the EMH is perhaps the most contentious, and thus, has attracted the most attention. Tests that analyze empirical data to prove or refute the “semi-strong” form EMH can be categorized as follows. One group of tests tries to predict future rates of return either in a time-series approach, or in a cross-sectional approach. The other group of tests examines how fast stock prices adjust to specific economic events.
Time series studies have indicated that the long-term prediction of market returns, in contrast to short-term forecast, can be successful. Studies have also shown that quarterly earning surprises and calendar patterns cause the market to be inefficient in the semi-strong sense. Cross-section studies have concluded that some variables, such as price-to-earnings ratios, size and book value-market ratios differentiated future return patterns. Share prices of neglected firms have also shown significant anomalies.
The “semi-strong” form 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.
To test the “strong-form” EMH investors were categorized into four specific groups, which possibly had private information. Groups consisted of corporate insiders, stock exchange specialists, security analysts and professional money managers. Tests were also performed for pension plans and endowment funds. Each group was analyzed whether it consistently received above-average returns.
Studies dealing with corporate insider trading have concluded that it is possible for this group to achieve a consistent superior return. Stock exchange specialists were tested to consistently achieve above-average returns in their transactions. These superior returns have decreased over time. Studies regarding security analysts have shown that anomalies exist, limited to a short period of time. The testing of professional money managers showed that even though they are fully trained and have superior research capabilities they did not outperform simple buy and hold policies.
Even though the tests had mixed results, the majority supported the “strong-form” EMH. The two groups of corporate insiders and stock exchange specialists represent market inefficiency in the strong-form sense. Hence the “strong-form” EMH is generally considered to be not true, however to a lesser degree than security analysts and professional money managers might wish.
However, researchers have documented some and numerous other that seem to oppose the efficient market hypothesis. The “January effect” is, possibly the best-known paradigm of anomalous behavior in security markets throughout the world, since stocks in general and small stocks in particular have historically generated abnormally high returns during that month. The “January effect” is particularly interesting because it doesn't appear to be retreating despite being well known for decades (Rozeff and Kinney in 1976 were the first to document evidence of higher mean returns in January as compared to other months). In addition, Gultekin & Gultekin (1983) studied 17 countries including the US and they also found that returns in January are substantially higher than in other months.
The “Weekend effect” is another return phenomenon that has persisted over unusual long periods and over a number of international markets. It refers to the differences in returns between Mondays and other days of the week. French (1980) analyzed daily returns of stocks for the period 1953-1977 and found that there was a tendency for returns to be negative on Mondays whereas they were positive on the other days of the week. He notes that these negative returns are “caused only by the weekend effect and not by a general closed-market effect”.
Internationally, Agrawal and Tandon (1994) find considerably negative returns on Monday in nine countries and on Tuesday in eight countries, yet large and positive returns on Friday in 17 of the 18 countries studied. However their data do not expand beyond 1987. Additionally, Steeley (2001) found that the weekend effect in the UK has disappeared in the 1990s.
Another significant anomaly is the anomaly known as “size-effect”. Banz (1981) published one of the earliest articles on the “size-effect”. His analysis of the 1936-1975 period shows that excess returns would have been earned by holding stocks of low capitalization companies. Supporting evidence is given by Reinganum (1981) who reports that the risk adjusted annual return of small firms was greater than 20%. If the market was efficient, one would expect the prices of stocks of these companies to go up to a point where the risk adjusted returns to future investors would be normal. But this did not happen.
Overall, the question of whether markets are efficient will always be a challenging one, given the implications that efficient markets have for investment management and research. If an efficient market is defined as one where the market price is an impartial estimate of the true value, it is quite clear that some markets will always be more efficient than others. The capacity of a market to correct inefficiencies quickly will depend, in part, on the simplicity of trading, the transaction cost and the attention of profit-seeking investors in the market.
Fama, E., Random Walks in Stock Market Prices, Financial Analysis Journal, September/October, 1965
. and , The January Effect: Still There after All These Years, Financial Analysts Journal, January-February 1996
