EFFICIENT MARKET HYPOTHESIS (EMH)

A. INTRODUCTION
Market efficiency is a description of how prices in competitive markets respond to new
information. An efficient capital market is one whereby at any given time security prices
adjust rapidly to the arrival of new information and, therefore, the current prices of
securities reflect all the available information about the security. It ’s a market where there
are large numbers of rational, profit maximising investors actively competing, trying to
predict future market values of individual securities, and where important current
information is readily and freely available to all participants.

Assumptions
 Stock prices are determined solely by forces of demand and supply.
 There are large numbers of profit-maximising participants analysing and valuing
securities, each independently of the other.
 New information regarding securities comes to the market in a random fashion
each generally independent of the others, and
 Investors adjust security prices rapidly to reflect the effect of new information.

In an efficient market competition among the many intelligent participants leads to a

situation where, at any one time actual prices of individual securities already reflect the
effects of information based on both events that have already happened and on events as
of now the market expects to take place in the future. This means that in an efficient
market at any point in time the actual price of a security will be a good indicator of its
intrinsic value therefore there is a “fair game” with respect to the information set.

Investors can be confident that asset prices fully reflect all available information and are
consistent with the risk involved. For example if Intel announces that it has invented a
new way of manufacturing computer chips that will make computers run 10 times faster
at half the cost, and that it will take at least a year to be implemented in all their
manufacturing plants. In an efficient market this would imply that the stock prices will
immediately rise after the announcement (i.e when the information is available not a year
later when the technology is implemented or even later when extra profits are received)

B. FORMS OF MARKET EFFICIENCY

Eugene Fama, a leading researcher on efficient markets, divided the overall efficient
market hypothesis (EMH) into 3 sub-hypotheses depending on the information set
involved;
(i) Weak Form EMH
(ii) Semi-Strong Form EMH and
(iii) Strong Form EMH.

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Weak Form EMH
The weak-Form EMH assumes that current stock prices fully reflect all security-market
information, including the historical sequence of prices, rates of return, trading volume
data and other market information.

It therefore, implies that the past rates of returns and other market data should have no
relationship with future rates of return should be independent). You should hardly gain
from any trading rule that decides whether to buy or sell a security based on past rates of
return or any other past market data. This implies that under this form of market,
technical analysis is of no value.

Semi-Strong Form EMH

This form of efficiency asserts that security prices adjust rapidly to the release of all
public information. Current prices reflect all public information. It encompasses the weak
form hypothesis with its market information such as stock prices, rates of return, trading
volume but also includes non-market public information such as earnings and dividend
announcements, P/E ratios, dividend-yield, book value-market value ratios, stock splits,
news about the economy and political news.
Thus investors who base their decisions on important new information after it is public
should not derive above-average profits from their transactions, considering the cost of
trading, because the security price already reflects all such new public information. This
implies that fundamental analysis is of no use.

Strong Form EMH

This form of EMH contends that current stock prices fully reflect all information from
public and private sources. This implies that no group of investors has monopolistic
access to information relevant to the formation of prices and thus no group can
consistently derive above-average profits. That is, no investor can beat the market by
generating abnormal profits in the market. The implication of this form is that even
insider information is of no use.

Private (Non-public) information is held by directors and managers of companies,

together with those companies' professional advisors. Much of this information would be
"price-sensitive", i.e. likely to have an effect on the price of a company's securities if it
was to become known.

However, the risk here is that these directors, managers and professional advisors would
use their greater degree of knowledge about a company to trade on the capital markets.
As they have information that is not generally available, they would have a much better
chance of trading successfully. This is known as "insider dealing" and is seen as being a
misuse of the capital markets.

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The strong form encompasses both the weak form EMH and the semi-strong form EMH.
In addition, all information is cost-free and available to everyone at the same time.

C. IMPLICATIONS OF EFFICIENT CAPITAL MARKETS

Numerous studies indicate that the capital markets are efficient as related to numerous
sets of information. At the same time, studies have uncovered a substantial number of
instances where the market apparently does not adjust rapidly to public information.
Given these mixed results, market professionals arm themselves with against the
academic onslaught with one or two tools or techniques called fundamental analysis and
technical analysis. It is important to consider the implication of the EMH for technical
analysts, investment analysts and portfolio managers.

Technical analysts

The Technical analysts believe the principle that stock prices tend to move in trends.
They assume that a stock that is rising will continue rising and that that is stagnant will
remain stagnant. These analysts (at times called chartists) are traders not long term
investors. Clearly their assumptions of technical analysis directly oppose the notion of
efficient markets. Technicians hypothesise that stock prices move to a new equilibrium
after the release of new information in a gradual manner, which causes trends in stock
price movements that persist for certain periods. This belief contradicts with the
advocates of the EMH who believe that security prices adjust to new information very
rapidly. EMH advocates do not claim that prices adjust perfectly - which means there is a
chance of over-adjustment or under-adjustment. Still because it is not certain whether the
market will over or under-adjust at any time you cannot derive abnormal profits from
adjustment errors.

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Fundamental analysts

The Fundamentalists believe the market to be 90% logical and 10% psychological. Their
major objective is to establish the proper value of a security. This intrinsic value is related
to the growth of the company, dividend payout, interest rates and risk. Depending on
whether the Intrinsic value is less or greater than the market value this will determine the
investor’s “buy and hold” or sell decision. The fundamentalists constantly look for under
priced stocks. Accordingly the market will in the short run adjust itself to equilibrium.
With regard to aggregate market analysis, the EMH implies that if you examine only past
economic events it is unlikely to help you out perform a buy-and-hold policy because the
market adjusts rapidly to known economic events. A fundamental analyst relying on only
historical data will not experience superior risk-adjusted returns. The market is close to
semi efficient.

The EMH does not contradict the value of aggregate market, industry or company
analysis but implies that you need to (i) understand the relevant variables that affect rates
of return and (ii) do a superior job of estimating movements in the valuation variables.
Some strong form tests have shown the likely existence of superior analysts. For
example, price adjustments that usually follow the publication of analysts’
recommendations point to the existence of superior analysts.

If you want to determine if an individual is a superior analyst or investor you should

examine the performance of numerous securities that this analyst or investor recommends
over time in relation to the performance of a set of randomly selected stocks of the same
risk class. The stock selections of a superior analyst or investor should consistently out
perform the randomly selected stocks.

We know the relevant variables that the fundamental analysts should analyse and all the
important techniques they use but actually estimating the relevant variables is as much as
an art and a product of hard work as it is a science. If the estimates could be done on the
basis of a mechanical formula one could program a computer to do it, and there would be
no need for analysts. Thus the superior analyst must understand what variables are
relevant to the valuation process and have the ability to do a superior job of estimating
these variables.

Efficient markets and portfolio management

As noted above, studies have indicated that professional money managers cannot beat a
buy-and-hold policy on a risk-adjusted basis. One explanation is there are no superior

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analysts and the cost of research forces the results of merely adequate analysis into the
inferior category.

Another explanation, which has some empirical support, is that money management firms
employ both superior and inferior analysts and the gains from the recommendations of
the few superior analysts are offset by the costs and poor results due to the
recommendations of the inferior analysts. This raises the question – should a portfolio be
managed actively or passively?

A portfolio manager with superior analysts can manage a portfolio actively looking for
undervalued securities and trading accordingly. Without superior analysts it only makes
sense and value to manage passively. Superior analysts need to concentrate on the second
tier of stocks. These stocks possess the liquidity required by institutional portfolio
managers, but because they do not receive the attention given the top-tier stocks, the
markets for these neglected stocks may be less efficient than the market for large well-
known stocks.

A portfolio manager without access to superior analysts needs a different procedure. First
the manager needs to measure the risk preferences of his/her clients, then build a
portfolio to match this risk level by investing a certain proportion of the portfolio in risky
assets and the rest in a risk-free asset. The manager must completely diversify the risky
asset portfolio on a global basis so it moves consistently with the world market.