Forms of efficient market hypothesis

Forms of efficient market hypothesis

You might be wondering what is efficient market hypothesis (EMH) and it's applications in the world. Efficient market hypothesis is an investment theory in financial economics that was birthed by one Eugene Fama, stating that ‘at any given time, asset or share prices fully reflect all available information and trade at exactly their fair value.’ This implies that market prices are already adjusted to new information, and it is, therefore, impossible to sell stocks at inflated prices or purchase under-valued stocks. Trust is placed in the professionals who work in the financial market, who work to assign the fair amount to securities, based on the information available in the market. The reasoning behind this perfect pricing is that when the cost of a stock goes up, its demand decreases, causing the price to reasonably go down. The reverse is right in the case of a price decrease.

Efficient market hypothesis
Efficient market theory
According to the efficient market hypothesis
What is efficient market hypothesis?

This post expounds on what the efficient market hypothesis is all about, it's forms, tests, weaknesses, assumptions and more.

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What are alpha and beta and how are they useful in efficient market hypothesis?

1. Alpha

Alpha, as used in finance, is the measure of the performance of an investment vis a vis suitable market index. It is the rate of return that exceeds what is predicted by models such as the Capital Asset Pricing Model. A positive alpha is the sign of positive performance, attributable to good management decisions, while a negative alpha is attributed to poor performance, believed to have been as a result of poor management decisions. Today, where index funds are purchased widely, alpha is used as the benchmark of performance.

Alpha generation is, therefore, the generating of excess returns. It is used by investors to be able to measure the highest performance for minimal investment risk.

As per the efficient markets theory definition, the concept of alpha generation is unsupported, as the hypothesis holds that it is impossible to beat the market. Alpha generation, according to the efficient market hypothesis, is therefore attributed to only luck as opposed to skill, as it argues that managers have mostly failed to beat the market in the long-run.

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2. Beta

It is the measure of risk of exposure of an investment to general movements in the market. A security which has the same price as that of the market benchmark has a beta value of 1. One which has a beta value below 1 indicates that the security has minimal correlation to the market, and is also less volatile. A higher than one beta means that the investment has a high relationship to the market, and is highly unstable.

With the efficient market hypothesis, one cannot take on higher risk than that of the market as a whole, to earn excess returns. Trying to achieve excess returns by a method of active investing is not possible.

In EMH, fundamental and the technical analyses do not apply

Structural and theoretical analysis, are methods used to forecast future stock-price trends. The efficient market hypothesis is against these two methods of market analysis, which are done in a bid to determine future stock value. This is because of the theory that all available information is already reflected in the security prices.

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Fundamental analysis

This analysis uses real, available public data to evaluate the value of a security which includes revenues, profit margins, returns on equity, earnings, and so on, to determine the worth and growth potential of a company. This concept is opposed especially by the strong-form efficiency market, which states that no insider can gain by having individual access to some private information.

Technical analysis

Technical analysis involves the forecast of the future stock prices, based on past price movements. These include business cycles, indices, averages, regressions, and correlations. According to the efficient markets hypothesis, markets are efficient information wise, and hence all these aspects of history and subsequent expectations are already incorporated into the market price. Furthermore, the EMH argues that past prices and data on volume do not have any relationship with future movements in the prices of stocks.

Efficient market theory
According to the efficient market hypothesis
What is efficient market hypothesis?

Importance of the efficient market hypothesis to investors, and its practical implications

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A stock buyer or investor cannot, therefore, rely on expert stock selection, better market timing, research or stock analysis, to outperform the market and obtain higher returns. The only way you can get higher returns according to the efficient market hypothesis is by purchasing a riskier investment, or a low-cost passive investment, a suggestion which has been proved by a study such as the June 2015 Active/Passive Barometer study by Morningstar Inc. The study found out that only two groups of managers outperformed passive funds in the U.S small growth funds, and diversified emerging markets funds.

In other larger categories such as U.S large growths, it is said that better performance would have been observed by trading in Exchange traded funds or low-cost index funds. Generally, it is harder to beat operating funds, and one is safer with passive investment.

With this in mind, the tasking work of stock picking or the costs associated with hiring a professional to do the picking for you, is more often than not, not worth the value you expect to get in future stock value.

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The efficient market hypothesis controversy (support and criticism of the theory)

The theory has been supported in the past in the finance field, though receiving hot criticism in recent years, despite several tests, research findings, and publications done about the hypothesis.

There have been reports about investors such as Warren Buffet who have used some pre-knowledge to beat the market over a long period. This, however, has been disputed by the EMH supporters, as not being a strong case against the efficient market theory, as it only depends on the accuracy of these predictions. In some cases, these foreseen changes may or may not happen at the time they are expected to. If they do occur, then the price goes up for investors at that time, and if they fail, then the investors go at a loss. It is all a matter of the higher chances of an event happening, which is a risk that could create future profits or losses.

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A brief history of the efficient market hypothesis

The French mathematician Louis Bachelier first discussed the efficient market hypothesis in his 1900 Ph.D. thesis. He recognizes that past, present, and future events are reflected in the fair price of stocks or assets. He further states that even if the market may not predict price fluctuations, it assesses them as being more or less likely, which can be evaluated mathematically.

Similar research was also carried out in the 1930s and 40s by Cowles and Jones, coming to the same conclusions. These findings, however, faded at the time and were re-birthed in the 1960s by Eugene Fama and Paul Samuelson independent of each other.

Paul Samuelson in 1965 research also concluded that prices fluctuate randomly. Eugene Fama then developed the concept as an academic one, including the three forms of market hypothesis, in 1970, the firm, semi-strong, and weak forms of market hypothesis. The concept of the efficient market hypothesis was widely accepted until it began being faulted recently by empirical analysts.

Forms of efficient market hypothesis
According to the efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

Preconditions Fama based the EMH on

1. The cost of information is 0

According to the efficient market hypothesis, market participants can access all relevant information as soon as it is available, at no charge.

2. The market is perfectly competitive

A perfect market is one whereby there are no delays to the formation of fair prices, where prices at any given time reflect all the information available. This condition is met where:

  • There are numerous individual buyers and sellers in the market, making it impossible to manipulate prices to one’s advantage.
  • All the individual buyers and sellers can access all available information at no cost, as soon as it emerges.
  • There are no barriers to exit or entry.
  • Transaction costs are 0.

These include any of the numerous costs associated with investments such as broker commissions, exchange fees, stamp duties, tax regulations, regulatory constraints that prevent certain classes of investors from investing in particular stocks, adverse impact on market prices due to an anticipation of a good or bad change in the market, just to mention a few.

3. All investors are rational

According to the efficient market hypothesis, all investors would make sound judgments that would result in maximization of investment benefits. Aspects that make an investor logical include:

  • Investors preferring securities in their portfolios rather than those that are not
  • Risk aversion, in that an investor will always choose a less risky return compared to a riskier one.
  • The assumption that investors put all available information into consideration, having no bias.

Forms of efficient market hypothesis

There are three forms of efficient market hypothesis, which try to explain it. These forms differ in their definition of ‘available information.’ This information is what is used by financial market professionals to determine the fair prices of assets. The three forms of efficient market hypothesis include:

  • A weak form of efficient market hypothesis
  • Semi-strong form of efficient market hypothesis
  • Potent form of efficient market hypothesis
According to the efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

1. A weak form of the efficient market hypothesis or random walk theory

It is said to be the weakest form of the efficient market hypothesis. This form states that you cannot predict future stock prices based on prices of stock in the past, as prices are random. This implies that the pattern of price variations cannot be followed to tell what the stock prices could be in future. It was first written about by Professor Burton. G. Malkiel, in his book ‘A Random Walk Down Wall Street’ which also discusses the other forms of efficient market hypothesis.

Breakdown of the weak theory of market hypothesis

  • Stock prices are random, and hence it is impossible to find price patterns and consequently take advantage of price movements.
  • Day to day stock changes are independent of each other, and price momentum is non-existent.
  • The growth of past earnings does not do anything to predict future earnings as they are considered to be independent.
  • It does not take into consideration technical analysis but partially incorporates fundamental analysis, stating that it could at times be flawed.
  • Considering the assertions of the weak theory of market hypothesis it makes it impossible to beat the market. It also is pointless to hire a professional stock picker or advisor as the future is expected to be unpredictable.

Example: How to know if a market is weak form efficient

An example of a weak form market is whereby, say, you have a regular increase of stock value on a particular day of the week such as Friday, and a decrease on a specific day of the week say Wednesday. If a stock buyer decides to take advantage of this and buys stock on Wednesday in anticipation of selling it on Friday, but the trend fails in that the stock prices fail to increase on Friday, then it means the price changes are random, and the patterns cannot be relied on, making it a weak form efficient market.

Tests of the weak form efficiency

Tests that can be performed to attempt to prove that the best price of an asset is the current price include:

  • Autocorrelation tests to confirm that returns are not correlated
  • Run checks to determine the independence of stock prices over time
  • Trading tests which show that past returns cannot indicate future costs, hence traders cannot rely on a specific rule
  • Filter tests technique which identifies significant long-term relationships in share-price fluctuations, by filtering out short-term movements of share prices.

Examples of tests that have been carried out include:

  1. Analysis by a French mathematician known as Bachelier, in 1900, while writing his Ph.D. Thesis, the “The Theory of Speculation.” His finding was that past, present, and future events are reflected in market prices, but also concluded that price changes are random.
  2. In a 1937 research, Cowles and Jones performed the Random Walk Test, where they tested the frequency of sequences and reversals. This meant that they studied the occurrence of consecutive positive or negative results in one case, and in another case, the interchanging of those results. They concluded that there was no consistent pattern, and therefore investors cloud not make decisions based on price patterns.
  3. Kendall in his 1953 study also determined that prices of stocks were changing randomly, after examining 22 stocks and prices of commodities in the UK by use of statistical analysis.
  4. In their 1998 findings, Dimson and Mussavian also spoke of the near-zero correlation between price changes.
  5. In 1959, the data on US stock prices were analyzed by one Osborne. He said that the price changes of stocks were similar to the random movement of molecules.

Arguments against the weak form efficient market hypothesis

  • The weak form of market efficiency is theoretical, and advocates suggest that fundamental analysis can be used to identify over or undervalued stock.
  • Evidence also indicates that it is possible to use technical analysis, specifically the ‘Chartism’ method of analyzing historical data. This method involves the use of charts to perform technical analysis and identify future trends and identify the future price of shares by using past information such as recent movements of share prices.

Trends that can be used here include the most popular and reliable head and shoulders pattern. It resembles the human body. There is also the double top and double bottom trends and the cup and handle directions, to mention a few.There even exists computer software that has gained popularity in the stock market due to their ability to promote algorithm trade.

In light of all this, however, it is evidenced that predictability based on technical analysis is much stronger in small firms than in larger firms, hence making the economic impact minimal.

According to the efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

2. Semi-strong market efficiency form

This type of efficiency states that security prices adjust to newly obtained information, making the use of technical or fundamental analysis inapplicable in getting a higher return. It indicates that all the current data in a market is reflected in the price of a stock. The semi-strong market efficiency form also encompasses the weak-form efficiency, in that it supports the use of past information.

A breakdown of the semi-strong form of market hypothesis:

  • As soon as information is available, it reflects quickly or immediately in the prices of stocks.
  • It incorporates past or historical data.
  • It assumes that investors or traders who trade their securities based on newly available information can expect an average risk of return.

Example: How to know a market is semi-strong efficient

If a company shares are currently trading at $40 per share, the company experiences some strong results, and the share price goes up to $45 per share. After a week, the price drops to $39. Such a case shows that the market is semi-efficient, adjusting quickly to any newly available information.

For an investor who already holds shares in such a company, once you see that the prices of stocks have gone up, you need to sell the shares for example in this case at $45, to gain from that rise in price. If you hold on to the shares, you could end up incurring a loss as the stocks may go down, in this case to $39.

Tests of the semi-strong form of market efficiency

The events test, which analyzes the security both before and after an event, implying that an investor will not be able to gain an above average return by trading on an event. Time series or regression tests that provide forecasts based on historical data, also implying that an investor cannot gain abnormally using this method. The general rule is that adjustment must be sizable and instantaneous.

The following are the tests carried out:

  • The Fama et al. study in 1969 tested how fast stock prices adjusted to new information, concluding with evidence that changes in the rates are fully reflected “at least by the end of the split month but almost immediately after the announcement date.”
  • Ball and Brown study (1968) also supported the semi-efficient market model.
  • The Jensen study (1969), a test of the portfolios of 115 open-end mutual funds concludes that current prices of assets conclusively capture all effects of presently available information.
  • Frank et al. (1977) study found out that even though merger benefits had been anticipated by the capital markets as early as three months before their announcement; the share prices still reflected this change.

Arguments against the semi-strong form of market hypothesis

  • Financial analysts have performed fundamental analysis to determine the real value of shares basing on future returns. Their argument that the market is less than perfectly efficient evidenced by the fact that smaller firms seem to produce higher returns in the long run vis a vis larger firms. A study by Beechely et al. (2000) revealed above-average returns by investing in smaller firms due to the higher risks associated with the investment.
  • The value-investing concept also used by financial analysts also challenges the semi-strong market from, by stating that investing in shares which have a low price-earnings ratio can lead to abnormal gains.
  • Slow or under-reaction to information by investors may also lead to the generation of abnormal returns, as a study by Bernard and Thompson (1989) suggests.

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According to the efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

3. A strong form of market efficiency

According to the efficient market hypothesis, the most potent form of stock market efficiency, as it incorporates past, present, and future information into the pricing of a stock. It encompasses the weak type of efficiency and the semi-strong form of market efficiency. Stock prices reflect all public as well as private information; hence even insiders cannot benefit by gaining more in the stock market unless there is a legal barrier to private information becoming public.

Breakdown of the strong form of market efficiency

  • Information known to any market participant reflects in the market prices of stocks
  • Fair market prices reflect all information available even by insiders; hence no one can gain an undue advantage to earn excess returns
  • It is impossible to obtain excess returns by any means

Example: How to know a market is robust efficient

A company invents a new line of its product or just a single product that is sure to gain instant success in the market upon launching. The makers of the products are confident in this, and hence purchase shares in the company in anticipation of increased prices. This, however, turns out not be the case as shares prices stagnated, even after the launching caused instant, widespread success.

This shows that the market could have been strong form as the inside information about the new product had already reflected in the share price.

Tests of the strong form of efficient market hypothesis

Tests mainly focus on a group of insiders who might have excess information that could benefit them. This is because it is difficult to access insider information and hence the need to study data provided by expert users, and how it performs vis a vis any measure of stock performance in the market.

Experts include:

  • Insiders who might have excess information are forbidden to use it to their advantage by existing regulation
  • Institutional money or fund managers who operate pensions and mutual funds have not been found to have a specific position in the market
  • Exchange specialists who recall runs on orders of particular equities have however been found to have some advantage as they could achieve power with the specific order information in their hands.
  • Analysts also cause movements in the assets they deal with, as investors are keen to act on investments that have been pinpointed by the analysts.

Actual research tests

  • An empirical study by Keown and Pinkerton (1981) concluded that the announcement of insider information about mergers did not give investors the chance to make abnormal profits as it was quickly incorporated into the share price.
  • The space shuttle crash that occurred on 28th January 1986 is a good test example of the strong form of market efficiency, provided by Maloney and Mulherin (2003). The news of the crash though not available to the public till much later, a lot of stock variations in the four firms involved was witnessed before the announcement of the accident. Some already knew the O-ring problem that was said to be the cause of the crash, and this private information caused the change in prices also on the explosion day. Evidence also indicates that before shuttle launches despite the prior knowledge of the O-ring problem, there was no abnormal stock price movements or short sales.

The above scenario also proved that information processing by market participants is not exactly directly related to public and private components, but arriving at price discovery can involve an intricate pattern.

Efficient market hypothesis
According to the efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

Arguments against the strong market efficient form

  • Individuals have access to insider information before other investors can get wind of it, and if they can manage to conceal this information from the public, they will end up making abnormal gains. A few litigations have been there dealing with cases of insider dealings, though these are said to be minimal concerning the many transactions that take place in the market.
  • Shrewd individuals can always find ways of exploiting insider information without exposing themselves.

General arguments for and against efficient market hypothesis explained

The critics of this theory have several points of their cases to prove that market prices are predictable, though these arguments have been disputed. These critical points include:

1. Size effect

Studies by Banz and Reiganum (1981) found out that firms which are smaller in size tended to earn more returns than larger companies over a long period, therefore presenting a predictable pattern which can allow investors to make a profit. These were unusually small firms on the New York Stock Exchange, which beat the predicted return to earn more.

Malkiel in his 2003 research also supported this size effect, stating that if the Capital Asset Pricing Model is accepted as the right method of risk measurement, then the side effect will cause market inefficiency, as firms with smaller stocks will gain excess risk-adjusted returns.

This argument is ,however, said to be fading, as there have been minimal gains from holding smaller stocks since 1983, in contrast to the period between the 1920s and 1982.

2. Excess volatility

This critic point of view states that fluctuations in stock prices are much higher than changes in fundamental value, which has been beaten down by the Szafarz 2010 argument which says that stability does not constitute efficiency as much as rationality and information. Market efficiency can therefore not be done away with on the basis of excess volatility.

3. Season and day of the week

This argument goes with certain months of the year such as January where it is observed that during the first two weeks, stock returns are usually very high. There is also the French study in 1980, which proves that there are generally higher effects on Mondays. This trend has however not persisted in different periods and has therefore shown to be unreliable. Investors today rarely buy stocks at the end of the year, in anticipation of price hikes at the beginning of the year.

4. Short run effects and long-run return reversals

This argument uses study evidence that there is a positive correlation when stock prices are measured in the short-run, for days or weeks. Other studies have however shown a negative correlation, indicating that poorly doing stocks can better in the future. However, the association in these cases was quite un-uniform, being stronger in some periods than others.

The most robust results of the reversals were found during the Great Depression period, where there was a strong negative correlation though not one that would enable investors to make excess returns.

Forms of efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

The significant weaknesses of the efficient market hypothesis

  • It fails to explain economic bubbles adequately

This has so far been presented as the most significant evidence against the efficient market hypothesis. Events such as the stock market crash of 1987, which saw the Dow Jones Industrial average, fall in a single day by 20%, showing that prices can significantly deviate from their fair values. EMH does not explain this, because it would argue that these bubbles are inexistent.

This happens when the fair value of assets rise above their value, then experience a rapid fall as in the case of the stock market crash. The EMH would state that a bubble is just a notable change in the fundamental expectations about the return of an asset.

Fama, one of the pioneers of this theory would argue that such a scenario presented the onset of a recession rather than the burst of an economic bubble. He further stated that the existence of a bubble must be predictable (which is debatable), yet there is no formula of predicting a bubble. Bubbles, therefore, only reflect rapid changes in expectations due to emergence of new information.

The bone of contention remains, if the information to indicate that there would be a crash was fully accessible to the market, then the market bubble need not have occurred. This brings us to the second weakness:

  • It is practically impossible to have full and immediate access to all information. This is because there are usually delays in the spreading of information.
  • An investment market that meets all the attributes of a perfect market doesn’t exist. For example, taxes and transaction costs are the order of the day in any healthy economy. Government regulation is also paramount for the performance of investment markets.
  • Other factors that underlie price changes such as irrational investment behavior and different behavioral patterns are not put into perspective.

The fact is that investor behavior is not always rational. According to behavioral finance, there are biases in individual and market investment decision making such as lack of consideration of specific information by some investors, optimism, herding behavior, or tendency to follow the crowds, and loss aversion, to mention a few, can lead to an economic bubble.

Biases of behavioral finance

1. Overconfidence

This is the tendency of an investor to over-estimate their ability to interpret information and pick stocks that will earn them high returns.

2. Hindsight bias

This bias rationalizes past errors and believes that they need not have occurred if something was done about them then, hence the tendency to be overconfident about their actions concerning the future.

3. Anchoring

This is the tendency to stick to a specific initial point of view and refuse completely to deviate from it, despite the emergence of any new convincing information available.

4. Gambler’s fallacy

Investors can choose to invest based on past prices or performances of assets, failing to recognize that at times recent events are independent of future events.

Determining the level of bias is however not an easy concept. The price offered by the EMH concept does not, therefore, provide consensus among differently biased investors.

The assumption that there is 0 cost of obtaining information is unrealistic. This is because the costs of obtaining information do exist,

According to the efficient market hypothesis
What is efficient market hypothesis?
Stock market efficiency
Efficient markets theory definition

The efficient market hypothesis supports the idea that no one can benefit from excess gains in the market, as the price of stocks at any given time already incorporates all information available in the market. There have been several controversies about the EMH hypothesis, some like the economic bubble, which has strongly challenged the EMH.

In most of these anomalies that support an investor having some due advantage in the market, the investor has to be willing to incur an extra cost to obtain that information that they believe may help them obtain excess returns, which the efficient market hypothesis thinks is counterproductive counter-productive in most cases.

The behavioral argument though being critical of the EMH is partially seen as a support system for the EMH as it suggests that individual biases consequently fewer influence prices.

Is the EMH right or wrong?

Yes and no.

Yes, the hypothesis does have aspects that are agreeable with the market, even being supported by research, findings, and occurrences. Evidence from some market actions has indicated that a release of ‘bad’ news has not been consequently followed by a decrease in price, but by a ‘no-reaction,’ and later the price increases. The argument that the effects of the ‘bad news’ had already been incorporated into the stock price has been used to explain this, further strengthening the efficient market hypothesis.

However, there are relevant aspects that are questionable, for example, the idea that an investor cannot beat the market. The assumption is that even stock that may be thought to be lowly valued is valued at the right price, as it has already incorporated all the information available in the market.

This is controversial as there have been numerous pieces of evidence of ‘market-beating’; say with the use of passive stocks. Personalities such as John Templeton, George Soros, Warren Buffet, and Paul Tudor Jones are such that have been able to beat the market. Just because the prices are always at fair value, doesn’t mean that an investor cannot profit from, say, a previously held investment that has gone through many market price changes. This conclusion from the efficient market hypothesis is therefore erred.

Furthermore, the efficient market theory does not explicitly state how a person cannot benefit from fundamental analysis and gain big by predicting a company’s future success. It is very much possible to buy a share at a particular value in anticipation of a price rise.

The efficient market hypothesis does happen in some cases. However, because of its weaknesses, it cannot be accepted in its totality.

Stock portfolios have been developed over the years by skillful investors, beating the semi-strong market form. The existence of the strong-market form is even said to be unlikely, as the likelihood of insider information exploitation in this day is high. The weak-form seems to be the most reliable of the three, as far as stock market efficiency is concerned. Suggestions are that the EMH cannot be used solely but in conjunction with other theories of investment to achieve harmony when it comes to the investment question.

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