EFFICIENT MARKETS THEORY

Introduction
The basis for any rigorous theoretical and empirical analysis of financial markets is the group of
theories known as the ‘efficient markets hypothesis (EMH)’. The important conclusions from
this theory is that if markets are efficient then prices will contain enough of the information and
its interpretation about securities so as to make trading systems and traditional security analysis
superfluous. If share prices reflect the available information about the underlying companies,
then changes must be produced by new information. Thus analysis of published information
cannot be expected to produce super performance as by definition, that information has already
been reflected in the current price. In this case prices may be described as ‘fair’ indicators of the
market value.

The willingness of investors to exchange their money for financial securities is partially
dependant on their ability to sell those assets in the market for what they consider to be a ‘fair
price’. Thus a secondary market which prices financial assets and provides a mechanism for their
exchange is essential to the operation of the primary market

The macroeconomic theory of perfect competitive markets gives the study of financial markets a
firm basis for rigorous analysis from which testable propositions may be developed. In such a
model price is both a rationing device and a signaling device to producers informing them of the
state of demand for their products and the state of competition for sales of those products.

Assumptions of the Theory

The five principal a-priori assumptions of the perfect competition model holds.
(1) However the first assumption concerning maximization of gains is a reasonable working
hypothesis in the case of financial markets if it is amended as follows; ‘the maximization of
investors’ wealth consistent with the state of their preferences (or otherwise) for risk’. This
broader definition is of more use in finance, as it makes no assumption about the distribution
of profits between dividends and retained earnings and any risk differential that may be
perceived between the two types of rewards.

(2) The second assumption is almost fulfilled by capital markets as financial assets may only be
differentiated by the rights and privileges attached to the various types of ownership and debt
and the combination or risk and return that each asset is perceived to have by the investor and
market intermediaries.

(3) Each and every participant in this market assumed to be a price taker as nobody is large
enough to influence prices by manipulating demand and supply of financial securities.
However it doesn’t necessarily require a large number of players. The assumption in
financial markets may certainly be held where there are a larger number of shares being
actively traded.
(4) Apart from the obvious capital requirements and practice examinations of the various
governing bodies, there are no barriers to entry into the financial market. For the private
investor, the only factor that might effectively bar entry is their own ignorance of the market
and their lack of funds.
(5) However the theory of perfect competition also assumes that all participants in the market
have perfect knowledge.

The EMH is concerned with the speed with which markets incorporate information into price as
such research into the EMH has been concentrated on the information content of share prices.
Thus knowledge has not been assumed to be perfect as under perfect competition. It has also
sought to determine the extent to which future prices are predictable by various means

Random Walk Hypothesis

The random walk hypothesis asserts that markets are informationally efficient and the following
assumptions ensure this efficiency.

(1) A large number of competing profit-maximizing participants analyze and value securities,
each independently of each other.
(2) New information regarding securities comes to the market in a random fashion, and the
timing of an announcement is generally independent of each other.
(3) The competing investor attempts to adjust security prices rapidly to reflect the effect of the
new information.

The combined effect of 1, 2 and 3 means that one would expect price changes to be independent
and random. Thus the security price that prevails at any point in time should be an unbiased
reflection of all currently available information including the risk involved in owning the
security.

Weak-Form Efficient Market Hypothesis

The weak-form EMH assumes that the current stock price fully reflects all security market
information, including the historical sequence of prices, rates of return, trading volume data, and
other market generated information, as such all trading systems based on historical price patterns
are useless.

Semi-Strong Efficient Markets Hypothesis

The semi-strong form EMH asserts that security prices adjust rapidly to the release of all public
information. The hypothesis assumes that prices contain all publicly available information in a
market where there are no transaction costs, all public information is free to all and everybody is
agreeable to the interpretation of the information. However even in the absence of this
frictionless market, it’s still possible for prices to reflect all publicly available information so
long as the transaction costs do not inhibit trading on new information, and if ‘sufficient’
numbers of investors have access to information, it will not matter if investors disagree on the
interpretation as long as no investor can show a consistently superior performance over the rest.
This variant of the EMH has been tested by looking at the way in which the market reacts to
announcements of new information. Unlike the weak form EMH, which examines the serial
correlations between successive returns
Strong Efficient Markets Hypothesis
This hypothesis contends that stock prices fully reflect all information from public and private
sources. Thus no group of investors has monopolistic access to information relevant to the
formation of prices. Therefore no group of investors should be able to consistently derive above
average profits. The strong-form EMH encompasses both the weak form and the semi-strong
form EMH. Furthermore the strong form EMH extends the assumption of efficient markets in
which prices adjust rapidly to the release of new public information, to assume perfect markets in
which all information is cost free and available to everyone at the same time.

Empirical Test of the Efficient Markets Theory

The weak-form hypothesis was consistently supported by the results of most studies carried out
so far.

Tests of the semi-strong EMH either examined the opportunities to predict future rates of return
(either a time series or a cross section), or they involved event studies in which investigations
analyzed whether investors could derive above average returns from trading on the basis of
information. The test results for these hypotheses were clearly mixed. On the one hand the
results for almost all the event studies related to such events as stock splits, initial public
offerings, economic announcements, and accounting changes consistently supported the semi-
strong hypothesis. In contrast several studies that examined the ability to predict differential rates
of return on the basis of unexpected quarterly earnings, P/E ratios, size, neglected stocks and the
BV/MV ratio as well as several calendar effects generally did not support the hypothesis.

Studies that examined the results for corporate insiders and stock exchange specialists do not
support the strong form EMH. An analysis of individual analysts as reported by Value Line or by
recommendations published in the Wall Street Journal gives mixed results. The results indicated
that the Value Line rankings have significant information but it may not be possible to profit
from it after transaction costs, whereas recommendations by analysts indicated the existence of
private information by some superior analyst.

In contrast, the performance by professional money managers generally supported the EMH. The
vast majority of money managers performance studies which have typically examined the
performance of mutual funds managers, have indicated that the investments by these highly
trained fulltime investors could not consistently outperform a simple ‘buy and hold’ policy on
risk adjusted basis. This has been consistently true for mutual funds, with mixed results for
pension funds and endowment funds. Because these money managers are similar to most
investors who do not have consistent access to inside information, these results are considered
more relevant to the hypotheses. Therefore there appears to be overall support for the strong
form EMH as applied to investors.

Implications of the Efficient Markets Theory

Having reviewed the numerous studies related to different facets of the EMH, the important
question is what does this mean to individual investors, financial analysts, portfolio managers
and institutional investors?
Overall the results of numerous studies indicate that the capital markets are efficient related to
numerous sets of information. At the same time a growing number of studies have uncovered a
substantial number of instances where the market apparently does not adjust to public
information. Given the mixed results regarding the existence of efficient markets, it’s very
important to consider the implications of this contrasting evidence of market efficiency.

The EMH indicates that technical analysis should be of limited value. All forms of fundamental
analysis are useful, but they are difficult to implement because they require the ability to estimate
future values for relevant economic variables. Superior analysis is possible but is very difficult
because it requires superior projections of the relevant variables i.e. you need to be accurate and
different. Those who manage portfolios should constantly evaluate investment advice to
determine whether it is superior.

Without access to superior analytical advice you should run your portfolio like an index fund. In
contrast, those with superior analytical ability should be allowed to make decisions but they
should concentrate their efforts on mid-cap firms and neglected firms where there is a higher
probability of discovering mis-valued stocks.

NB. Students should be familiar with market anomalies, particularly calendar anomalies
(weekend effect, holiday effect, January effect, turn-of-the month effect).