MARKET EFFICIENCIES, ACCA

12. Market Efficiencies

The theory behind share price movements can be explained by the three forms of the efficient
market hypothesis.
Weak form efficiency implies that prices reflect all relevant information about past price
movements and their implications.
 It does not react to much of the information that is available about a company.
 Instead, when stock market efficiency is weak, share prices respond to all available
historical published information and information about past changes in the share price.

Semi-strong form efficiency implies that prices reflect past price movements and publicly
available knowledge.
 If a stock market displays semi-strong efficiency, current share prices reflect:
 All relevant information about past price movements and their implications
 All publicly available knowledge about companies and market returns
 Share prices respond quickly to new information as it becomes available.
 This means that individuals cannot 'beat the market' by reading the newspapers or annual
reports, since the information contained in these will already be reflected in share prices.

Strong form efficiency implies that prices reflect past price movements, publicly available
knowledge and inside knowledge.
 If a stock market displays a strong form of efficiency, share prices reflect all information,
whether it is publicly available or not:
 From past price changes
 From public knowledge or anticipation
 From specialists' or experts' insider knowledge (eg the inside knowledge of
investment managers about unpublished facts)
 If a stock market has strong form efficiency, share prices will respond to new
developments and events before they even become public knowledge.

Definition of market efficiency

a. Allocative efficiency: If financial markets allow funds to be directed towards firms
which make the most productive use of them, then there is allocative efficiency in these
markets.
b. Operational efficiency: Financial markets have operational efficiency if transaction
costs incurred by participants in financial markets are kept as low as possible.
Transaction costs are kept low where there is open competition between brokers and
other market participants.
c. Information processing efficiency: The information processing efficiency of a stock
market means the ability of a stock market to price stocks and shares fairly and quickly.
An efficient market in this sense is one in which the market prices of all securities reflect
all the available information.

Features of efficient markets

Stock markets that are efficient (or semi-efficient) are therefore markets in which:
a) The prices of securities bought and sold reflect all the relevant information available to
the buyers and sellers, and share prices change quickly to reflect all new information about
future prospects.
b) No individual dominates the market.
c) Transaction costs of buying and selling are not so high as to discourage trading
significantly.

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d) Investors are rational and so make rational buying and selling decisions, and value
shares in a rational way.
e) There are low, or no, costs of acquiring information.

Impact of efficiency on share prices

If the stock market is efficient, share prices should vary in a rational way.
(a) If a company makes an good investment with a positive net present value (NPV), the
market price of its shares will rise in anticipation of future dividend increases.
(b) If a company makes a bad investment, shareholders will find out and so the price of its
shares will fall.
(c) If interest rates rise, shareholders will want a higher return from their investments, so
market prices will fall.

The valuation of shares

 Fundamental analysis is based on the theory that share prices can be derived from a rational
analysis of future dividends.

 Technical analysts or chartists work on the basis that past price patterns will be repeated,
therefore future price movements can be predicted from historical patterns of share price
movements in the past, and there are some patterns that continually reappear.

 Random walk theory is based on the idea that share prices will alter when new information
becomes available. The key feature of random walk theory is that, although share prices will
have an intrinsic or fundamental value, this value will be altered as new information
becomes available, and that the behaviour of investors is such that the actual share price will
fluctuate from day to day around the intrinsic value without any technical pattern.

Share prices are also affected by:

 marketability and liquidity of shares,
 availability and sources of information,
 market imperfections and
 pricing anomalies, market capitalization and investor speculation.
The marketability of shares in a private company, particularly a minority shareholding, is
generally very limited, a consequence being that the price can be difficult to determine.

Market imperfections and pricing anomalies

(a) Seasonal month of the year effects, day of the week effects and also hour of the day effects
seem to occur, so that share prices might tend to rise or fall at a particular time of the year,
week or day.
(b) There may be a short-run overreaction to recent events. For example, during the stock
market crash in 1987, the market went into free fall, losing 20% in a few hours.
(c) Individual shares or shares in small companies may be neglected.
The paradox of efficient markets is that an efficient market requires people to believe that the
market is inefficient so that they trade securities in an attempt to outperform the market.

Noise Trader
A noise trader is a trader who buys and sells irrationally and erratically; for example,
overreacting to good or bad news. Noise traders can cause prices and risk levels to change from
expected levels.

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Market capitalization
 The market capitalization is the market value of a company's shares multiplied by the
number of issued shares.
 The market capitalization or size of a company has also produced some pricing anomalies.
 The return from investing in smaller companies has been shown to be greater than the
average return from all companies in the long run.
 This increased return may compensate for the greater risk associated with smaller
companies, or it may be due to a start from a lower base.

Behavioural finance
 Speculation by investors and market sentiment is a major factor in the behaviour of share
prices.
 Behavioural finance is an alternative view to the efficient market hypothesis.
 It attempts to explain the market implications of the psychological factors behind investor
decisions and suggests that irrational investor behaviour may significantly affect share
price movements.
 These factors may explain why share prices appear sometimes to overreact to past price
changes.

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