There are three different types of market efficiency. Operational efficiency means that the market should operate at a minimum cost, speedily and readily. Allocational efficiency means that the market should allocate society’s limited resources to companies that will make the best use of them. Finally, informational efficiency means that the market should incorporate all available information into the share price of a company. This level of efficiency gives rise to the efficient market hypothesis. The efficient market hypothesis (EMH) implies that if new information is revealed about a company, it will be incorporated into the share price rapidly and rationally with regard to the direction and size of the movement. Therefore under the EMH, no investor should be able to make consistently abnormal profits. Abnormal profits are those where the level of return is greater than would ordinarily be expected for that level of risk. What is considered abnormal is therefore specific to each company/industry.
If the market is efficient, this will have significant implications for both companies and investors. For companies, the share price will reflect its true financial position, and therefore managers should be more focused on increasing NPV. Similarly, as information will have a direct effect on the share price, directors should seriously consider the information published by the company and the most likely effect it will have on the share price.
An efficient market would mean that investors could not earn consistently abnormal returns by studying published information as it would already be incorporated into the share price. Also no share would be considered a ‘bargain share’ as they would all reflect the current fair value, thus the NPV earned on buying a share would be £0.
The EMH identifies three levels of market efficiency: weak, semi-strong, and strong form efficient.
Weak Form Efficient
In a weak form efficient market, share prices are based on historic information including share price movements. The weak form implies that by definition, new information is not new unless it is unrelated to previous information. Therefore, future share price movements cannot be predicted from historic movements. Empirical evidence using serial correlation tests have found no patterns in share price movements, supporting the work done by Kendall (1953) who identified a ‘random walk’ principle i.e. movements are random and are only affected by new information which is unpredictable. The weak form suggests that the share price develops the characteristics of the random walk, implies that there is no advantage to analysing past price movements (technical analysis) as there is no correlation or patterns between movements.
Evidence against the weak form efficient market is established in the vast literature on the momentum effect identified by Jegadeesh and Titmar (1993). They found (through analysing historic share movements) that shares that have performed well in the last 3 -12 months tend to perform well in the next 3 – 12 months, allowing for opportunity to make abnormal returns.
Semi-Strong Form Efficient
In a semi-strong form efficient market, the share price will incorporate all publically available relevant information about a company as well as historic share price movements. This form of efficiency implies that it is pointless analysing published information (fundamental analysis) as it will already be incorporated into the share price. Most empirical evidence supports the semi-strong form and tests of reaction and information announcements consistently show that markets generally react quickly, hence it is not possible to make consistent abnormal returns.
However, some research identifies the possible existence of certain cyclical effects. For example, the weekend effect shows that investors appear to make abnormal returns on Fridays, and relative falls on Monday. Likewise, US researchers discovered a January effect, whereby abnormal returns were earned on the first few days of January each year. The problem with identifying these relationships is that if the market is efficient, the share price will reflect the information and thus the effects will be eliminated. Some researchers have also criticised the research into these effects, for example, Sullivan et al. (1999) claim to demonstrate that calendar effects are illusionary and the findings obtained in these studies are a result of data snooping (mining data until an apparent relationship appears).
The strong form efficient level of this model proposes that market share prices reflect the fair value of shares based on all information held both publicly and privately. Under this form, there is no type of information that may provide an investor with any sort of advantage, as the information should already be reflected in the share price. One of the main tests for the strong form is based on the ‘insider’ group of investors. Insider trading requires access to information that is unknown to the market and although illegal, insider trading is still a fairly common practice. Dealing on unknown information i.e. information that the market is unaware of, clearly demonstrates that markets are largely not strong form efficient.
Stock Market Crashes Invalidating the EMH
The primary explanation that the EMH aims to provide is that efficient markets value current shares at fair values based on all available information. However, those disputing the validity of the EMH often point to examples of renowned investors who repeatedly beat the market, for example Warren Buffet (possibly the most famous), and stock market crashes – most notably the 1987 stock market crash. In a single day, the value of shares fell by 20% (DJIA); a severe, unexpected and irregular deviation, far from the shares fair values at the time. According to the EMH, share prices should always be listed at their fair value, however stock market crashes seem to serve as compelling evidence against the idea of an efficient market.
It is interesting to consider the paradox that is argued to exist between market efficiency and the work undertaken by market analysts. One would assume that if markets are efficient, as stated in the opening paragraphs of this post, there would be no opportunities for investors to make consistent abnormal returns as all available information would already be incorporated into the share price. Under this premise, it would be suggested that market analysts are indeed wasting their time is analysing published information. However, the opposing argument is that analysts in fact act somewhat as market moderators by helping to make sure that relevant information is not missed, which would hence cause markets to become inefficient. Therefore, this paradox may be likened to the paradoxical cat in a box experiment proposed by Schrödinger, where the market may be considered to be both efficient and inefficient simultaneously.
In conclusion, there is much debate not only as to which level of the EMH seems to reflect the conditions of different markets, but also the validity of the EMH itself. It would seem that the only way to truly test market efficiency would be to remove any monitoring by market analysts, and to examine share price movements to see if they are as expected. In doing so this would help to provide evidence toward an efficient market. However, in the real world this is unlikely to happen, and it may therefore be concluded with some degree of certainty that this question will perhaps remain unanswered, and the role of market analysts is maintained for fear of a severely inefficient market.
Jegadeesh, N. and Titman, S. (1993), Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, The Journal Of Finance, 48(1), 65-91
Kendall, M. and Hill, A. (1953), The Analysis of Economic Time-Series-Part I: Prices. Journal Of The Royal Statistical Society, Series A (General), 116(1), 11-34
Sullivan, R., A. Timmermann and H. White (1999), Data-snooping, technical trading rules and the bootstrap, Journal of Finance, 54, 1647-1692
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