Understanding the Efficient-Market Hypothesis Analytical Essay

Fama asserts that in modern financial economics, efficient market hypothesis is perceived as a cornerstone theory. In fact, Fama (1970) in his financial literature defined the efficient market term as one where the security prices ideally reflects each of the accessible information (Fama & French, 1988, p.249).

That is, a souk is deemed efficient when the prevailing stock price responses to the unusual information are unprejudiced and instant. Thus, efficient market hypothesis also abbreviated EMH hinge on the notion that pertinent information is proficiently and swiftly incorporated in the securities prices so that at every time the previous information is not utilized in foretelling upcoming price actions.

Explanation for the financial market efficiency

The financial market is the market that allows for the credit and capital exchange. In most cases it tends to consist of both the capital and the money markets. Contrary, money markets are the short-range security arrears markets that have liquidable reserves and are alleged to be secure. Capital markets on the other hand permit the long-term trading of either securities or debts.

For a market to be efficient, it ought to endure situations in which the presently quoted prices ideally reflect openly accessible securities information. The underlying basic idea of market efficiency probably could be that competitions would quickly drive all the information into the stated prices (Ball, 1978, p.107).

Granger (1999, p.165), the highest price that savvy investors are eagerly willing to pay for any given financial asset within the financial market is essentially the present value of prospective cash payment. This price value ought to be discounted at a maximum rate so as to compensate for cash-flow projection uncertainties. Thus, in the financial markets, investors are actually trading on information rather than commodity.

The future cash flows coupled with accessible information helps in gauging the level of uncertainty. The price is thereafter expected to become the source of information. The current market price would hence reflect all accessible information (Aiolfi & Favero, 2002, p.392). So, in any given financial market, the current price under these conditions would be the finest unbiased investment value estimate.

The different EMH levels

Bachelier (1964) maintains that, since efficient market only persists where security prices evidently reflect available information, it is clear that all securities traded within the financial markets are correctly valued based on the accessible information.

Generally, this indicates that there are different levels of what makes up an efficient market reliant on the information that is considered available (Kahneman & Riepe, 1998, p.57). Various economic and financial analysts offer varying discussions on the different EMH versions as subsequently conferred.

The weak form EMH

Essentially, this EMH level insists that the prices of the present securities directly reflect the degree of information alongside the historical prices (Keim & Stambaugh, 1986, p.370). The information which is enclosed in the precedent security price sequence is completely replicated in the present market price of such a financial security.

The EMH level is dubbed weak form given that the security prices emanate to be the easiest and most publicly available pieces of information. This means that nobody will have the capacity to do better than the market via the use of something that everyone else seems to know (Brock et al, 1992, p.1738).

Despite this, there are several financial analysts who study the previous series of stock prices alongside the trading volume data with the intention of generating profits. The method is dubbed as technical analysis and EMH avers it as ineffectual in forecasting the upcoming variations in price.

Since security prices are assumed to reflect the information that historical prices contain, it is imperatively easier to show that stock prices tend to pursue the random walk. EMH literature loosely characterizes price series whereby all subsequent variations in prices denote random exit from past prices (Bossaert & Hillion, 1999, p.410).

The information flow appears to be unimpeded because information becomes immediately reflected in stock prices. Diebold and Mariano (1995, p.260) maintain that if prices change tomorrow, it will only reflect tomorrow’s news hence it will be independent of today’s price variations. Regardless of the technical analysis rejection, certain investors have profitably utilized the statistical arbitrage techniques.

But still, no marginalized traders generate large profits because after considering the information analysis transaction costs as well as the cost of trading securities, it becomes difficult to generate profit from such publicly accessible information like the previous series of stock prices (Black, 1986, p.535). The deviations from the efficient markets are averagely petite and seem very expensive to realize.

The semi-strong form of EMH

This level stipulates that all sorts of publicly accessible information already become integrated into the asset prices. In fact, the securities or shares current market price completely reflects such publicly accessible information. The declared unrestricted stock information does not simply belong to the precedent marketplace prices but similarly the stated firm’s pecuniary information.

These include financial statement data, dividends and earnings announcements, the company competitors’ financial situations, the announced merger plans and anticipated macroeconomic factors including unemployment and inflation.

From this vital and publicly available information, Evans (1991) believes that the market cannot be outperformed using information that everyone else have at hand. Precisely, the company financial statements materialize to be of no essence in securing elevated investment returns and forecasting stock price movement expectations (Campbell & Robert, 1988, p.665).

Given the level of difficulty in finding smart investors groups who constantly outperform the financial and capital markets, this might appear to be likely. Indeed some savvy investors who are able to easily comprehend the vast financial information implications seem to have quite impressive records (Dimson & Marsh, 1999, p. 57).

Therefore, analyst literature claims that semi-strong EMH is relatively about to be true, yet not often true. Much evidence has been provided to indicate that savvy investors tend to outperform.

Perhaps, this reflects their access to superior market information instead of better information analysis which is available to everyone (Odean, 1999, p.1287). But because all publicly accessible stock information becomes reflected in the prices of securities, fundamental analysis persists to be of no significance.

The claimed outperformance of investors under weak form is not true. This is because to acquire the requisite fundamental skills, a lot of effort and time is sacrificed. Besides, gathering public information is also relatively difficult while the processing of this information is as well costly.

Gathering and processing sufficient information from major sources such as company produced publication, newspapers, wire reports, data bases and research journals to successfully analyze market securities renders the whole fundamental analysis process inefficient to be used to outperform the stock market (Rasches, 2001, p.1920).

The strong form EMH

Basically, the strong form efficient markets hypothesis alleges that the stipulated share prices integrate every kind of information that an investor might acquire. This apparently appears to be unlikely since those involved in insider trading could definitely make money somewhat consistently (Mills, 2002).

From study literature, either insider information or private information becomes promptly integrated in market prices hence might not be drawn on to generate unusual trading profits. All pertinent information that is either classified or unrestricted is entirely revealed in the contemporary market charges for securities.

Timmermann (1993, p.1138) argues that not even the insiders within the company management have the capacity to benefit from the insider information they are possessing. For example, the insiders do not stand a chance of taking advantage of the share information they hold to make profit.

The supporting rationale behind this claim is that the future development anticipation of the market occurs in an unbiased manner (Campbell, 1987, p.389). As a result, information is evaluated and incorporated in the market prices in rather an informative and objective way than the insiders.

The stocks prices random-walk replica is essentially an annexe of EMH founded on the understanding that arbitrage ensue to be unrealistic, gratis dines emerge to be commonly unavailable while the market is not habitually surpassed (Grossman & Stiglitz, 1980, p.397).

They eventually came into consensus that the future prices of stock could fairly be predictable founded on the previous patterns of stock prices and certain elementary valuation metrics. More controversial claims were equally made by economists that such conventional patterns enabled savvy financiers to make risk adjusted return rates.

Analysts views on causes of change in share price

EMH is commonly known as Random Walk Theory implying that EMH is the assertion that the present stock prices totally reflect the accessible information on the firm’s value (Odean, 1999, p.1280). Thus, it is impossible to generate excess profits over what the market could earn using accessible information.

EMH deals with the exciting and fundamental finance issue appertaining to why security markets experience price changes and the rationale assumed by those price changes.

This theory has imperative implications for both financial managers and investors alike. Fama (1970) claimed that averagely, in the efficient markets, the prevailing rivalry will definitely cause the complete impact of novel information on the inherent worth to be instantly reflected in the real prices.

Investors yearn to spot securities which are underrated and are anticipated to have their values increase in the future (Fluck et al., 1997, p.179). Investors specifically investment managers tend to suppose that they could choose securities which will surpass the market. Various valuation and forecasting techniques are used by such investors to assist in making their investment decisions with the objective of generating substantial profits.

The EMH analysis however affirms that neither of such techniques is deemed effective since the acquired advantage does not surpass the research and transaction cost incurred. No any single individual could as anticipated outperform the markets.

According to Jensen (1968, p.400), profiting from the prediction of price movements materialize to be very unlikely and difficult. Hence, the key engine behind changes in stock prices is only the influx of new market information.

An efficient market exists provided the price adjustments are on average and quick devoid of new information biasness. The securities current prices reflect all accessible information any moment and there are no reasons for investors to think that stock prices are either too low or too high (French, 1980, p.59).

In fact, securities prices aptly change before the investors have enough time to trade on newly accessible information to make profit. Intense competition amongst investors to make profit using new information relies on the capacity to identify undervalued and overvalued stocks.

This would allow them to purchase stocks below the true values and sell them above their worth (Hawawini & Donald, 1995, p.509). People nevertheless spend considerable amount of resources and time to identify any mispriced stocks.

Competition to take advantage reduces the chances to get and exploit securities pricing. Making significant profits only occurs mostly by chance because there are no rooms for fooling investors. Efficient market investments persist to be fairly priced since on average the investors obtain just what they paid for (Malkiel, 1973).

Securities fair pricing does not necessarily imply that similar performance is obvious or the falling and rising in stock prices is probably alike for all securities. The security return expectation is basically a function of the related risks. For example, the security price reveals the net present value of the anticipated future cash flow.

This nonetheless incorporates various factors including risk of insolvency, volatility and liquidity (Nicholson, 1960, p.44). Whereas stock prices are sensibly based, variations in prices are anticipated to be unpredictable and random given that the ensuing new information is unpredictable by the virtue of its very nature. Stock prices are assumed to pursue a random walk.

EMH repercussions for the finest venture schemes

The EMH level claims that a flea market cannot be surpassed by anyone either by selecting viable security or proper market timing (Evans, 1991, p.927). It carries depressing implications for various investment decision strategies. The triumphant fundamental analysts including Warren Buffet claim that the effect of EMH could be examined from two unlike perceptions.

Investors viewpoint

The technical analysis approach: As explicated in first EMH level, the analysis utilizes the historical outlines of trading quantities along with prices as the foundation to envisage potential prices.

The facts tendered by random walk hints that stock prices emit to be significantly influenced by souk news (Ariel, 1990, p.1619) Thus, favourable news would definitely push share prices up and visa vie. The EMH alleges that it is proper proviso the technical analysis worth is enquired as an approach to opt for security speculation.

Fundamentals analysis (FA): This entails utilizing market information to establish the securities’ intrinsic values so as to classify securities which are undervalued (Nicholson, 1960, p.48). Semi-strong form EMH nevertheless asserts that fundamental analysis may not be drawn on to beat the stock market.

Within EMH, equity appraisal and exploration occurs to be an awfully pricey undertaking which warranties no profits. Obtaining undervalued stock is as a result perceived to be random (Granger, 1999, p.168). The accruing profits from equity research and information gathering would in most cases cover the incurred cost outlays of carrying out research.

For instance, based on the above discussed semi-strong form efficient market hypothesis, it is apparent that fundamental analysis entails analyzing business financial health and statements, competitive advantage, management as well as market competitors (Lakonishok et al. 1994, p.1544). Such an analysis is conducted on the present and historical data with an intention of making decisive financial forecasts.

FA objectively aims at conducting stock valuation and predicting the possible price evolution. It makes projections on share performances while evaluating its management, make internal business decisions and calculate the expected credit risks. This model maintains that stock markets might misprice the securities in the short-run yet the right price will finally be attained (Malkiel, 1973, p.76).

However, investors may make profits via trading such mispriced securities and wait for the stock market to identify mistake in order to re-price the securities. Given that all publicly accessible stock information becomes reflected in the prices of securities, FA is perceived not to be worthwhile under semi-strong form efficient market hypothesis.

Evans (1991) states that, using investors’ perspective it is advisable that to have the best investment strategies, an investor must pursue passive investment strategies that do not make an attempt to outperform the stock market (p.928). Investors ought not to randomly choose securities anchored on their tax positions or risk aversions (Lo et al., 2000, p.1720).

This does not necessarily imply that portfolio management is inexistence. The strategy should be to randomly diversify across securities which carry very petite or no cost of information acquisition and negligible cost in the execution to optimize profits.

The investment strategist and portfolio managers should not add value but they should select portfolios which are geared towards the investors risk and time horizon profiles (Dimson & Marsh, 1999, p.57).

The perception of financial directors

Monetary directors must know that share markets might under respond or over respond to the corporation’s stock value information broadcast. The accounts of past share or stock prices might be utilized to gauge the corporation performance while the liability is assumed by the administration. Managers are expected to avoid allocating new shares provided shares become underpriced.

Such a perception is alleged to worsen the prevailing situation. Market theory under customary circumstances offers constructive insights regarding price behaviours (Hawawini & Donald, 1995, p.507). Then, financiers ought to anticipate ordinary proceeds rate while the corporation must wait to receive justified security charge for the allotted shares.

Information that share price incorporates at different EMH levels

Weak form of EMH illustration

Basically, random walk hypothesis denotes that succeeding price movement must be autonomous (Black, 1986, p.530). Studies tried to examine this hypothesis via observing the correlation existing amid current securities returns and returns on similar securities over preceding period. Lest there is a sequential positive correlation, then profits above average returns will probably be followed by above average returns.

Conversely, serial negative correlations stipulate that above average profits will be followed averagely by below average return. Zero correlation is expected when random walk theory is true.

Fama (1970) conducted a study using a sample of thirty Dow Jones Industrial stocks that is in harmony with this theory (p.393). The scholar found that even though the sequential correlation coefficients for the stocks were statistically significant, the returns were minimal to cover the incurred trading transactions costs.

Besides, literature studies have been conducted to test the weak form EMH through exploring the technical analysis gains. Despite the fact that most early researches deem technical analysis as ineffective, Ariel (1990) recent research evidence proves to be contrary (p.1618).

The scholars found that fairly uncomplicated technical trading rules might have been unbeaten in the prediction of Dow Jones Industrial Average changes. Subsequent studies however found that benefits from these strategies seem insufficient in covering transaction costs. The conclusions are in agreement with the weak form EMH (Ball, 1978, p.104).

Illustration for semi-strong form of EMH

Being the most controversial, this level has attracted numerous attentions. When a semi strong form efficient market exists, all accessible public information will be revealed by the stock prices (Odean, 1999, p.1290). This clearly indicates that investors are not able to consistently benefit via trading on such publicly accessible information.

For instance, many people propose that mutual funds directors are always skilled investors with the ability to constantly outperform the market.

Empirical evidence unfortunately tends not to support this assertion. A study conducted by Jensen (1968, p.392) ascertained that over the fiscal 1955-1964 period, mutual funds realized an annual risk regulated performance of around 0%. Mutual funds managers demonstrated that they do not have exceptional stock selection competence.

Moreover, the return dropped to -0.91% annually subsequent to allowing for expenses and commissions. Fluck et al., (1997, p.178) more recently compared the generally managed portfolio funds performance with the S&P 500 index performance. It emanated that during the fiscal 1984 to 1994, again equivalent to 281.65% was realized by S&P 500 whereas equity funds averagely appreciated merely by about 214.80%.

Since studies have revealed that averagely mutual funds do not exceed the market index returns, the conclusion could be that the performance of securities over a given time period could not be used to predict their future performance.

Illustration for the strong form of EMH

Evidence for this form of EMH typically focuses on insider trading profitability. Thus, provided the strong-form EMH materializes to be right, insiders ought not to have the capacity to generate returns via trading on the available private information. For instance, considerable evidence was found by French (1980) indicating that insider trading is apparently very profitable (57).

Moreover, DeBondt, and Richard (1995), in their study ascertained that after deducting the assumed 2% transaction costs the annual insider profits are 3% (797). This implies that there was no uniformity with strong form of EMH.

Conclusion

Nearly all investors yearn to realize optimal returns. Books have been published by investment professionals on various ways to outperform the stock markets. For the investment gurus unfortunately, the claimed investment strategies fall short of performing as anticipated. In fact, the strong rivalry amongst investors creates efficient markets where prices rapidly adjust to the accessible new information.

Investors on average just receive returns which reimburse time value of the utilized funds alongside the encountered risks. Active securities management after taking transaction costs and risks into account seem to be a mislaying proposition.

Even though no theory appears to be ideal, most empirical evidences support EMH. Regardless of the assertion by opposing scholars based on the overreaction and under reaction within the security markets, it is imperative to realize that most researches are contentious and have not generally proved worth as time expires. Therefore, EMH incessantly seems the best price movement description within securities market.

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