The Efficient Market Hypothesis

What do we mean by an Efficient Market?

In an efficient capital market, security (for example shares) prices rationally reflect available information If new information is revealed about a firm, it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement No trader will be presented with an opportunity for making a return on a share greater than a fair return for the riskiness associated with that share, except by chance Stock market efficiency does not mean that investors have perfect powers of prediction The current share price level is an unbiased estimate of its true economic value based on the information revealed  

Efficiency in practice?  The conditions required for an Efficient Market

Large number of rational, profit-maximizing investors Actively participate in the market Individuals cannot affect market prices Information is costless, widely available, generated in a random fashion Investors react quickly and fully to new information Errors that are made in pricing shares are unbiased;   price deviations from true value are random There is an equal chance of our being too pessimistic at £3 as being too optimistic Prices are set by the forces of supply and demand

What efficiency does not mean

Prices do not depart from true economic value You will not come across an investor beating the market in any single time period No investor following a particular investment strategy will beat the market in the long term

Example: New information (an electric car announcement by BMW) and alternative stock market reactions – efficient and inefficient

The Positive Aspects of Market Efficiency

To encourage share buying To give correct signals to company managers

–        Managers need to be assured that the implication of a decision is accurately signaled to shareholders and to management through the share price

–        The rate of return investors demand on securities

–        Information communicated to the market

To help allocate resources

The Random Walk Hypothesis – a consequence of an efficient market

The consequences of an efficient market include:

Quick price adjustment in response to the arrival of random information makes the reward for analysis low Prices reflect all available information Price changes are independent of one another and move in a random fashion

–        New information is independent of past

–        The movement of share price is unpredictable, and the pattern of movements will resemble a random walk (Kendall, 1953)

Note that the changes in the share price do not occur for arbitrary reasons – the randomness is concerned with the unpredictability of the next piece of new information.

 the Three Forms of Market Efficiency

Weak-form efficiency. Share prices fully reflect all information contained in past price movements

Testing for Weak Form Efficiency

There will be no mechanical trading rules based on   past movements which will generate profits in excess of the average market return (except by chance) The evidence and the weight of academic opinion is that the weak form of the EMH is generally to be accepted Benjamin Graham: “One principle that applies to nearly all   these so-called ‘technical approaches’ is that one should buy because a stock or the market has gone up and should sell because it has declined… the exact opposite of sound business sense everywhere else… we have not known a single person who has consistently or lastingly made money by thus ‘following the market”’ However, there is some evidence of patterns.

Return Reversal

De Bondt and Thaler (1985) Shares that had given the worst returns over a three-year period outperformed the market by an average of 19.6 percent in the next 36 months Chopra et al. (1992) Extreme prior losers outperform extreme prior winners by 5–10 per cent per year during the subsequent five years Arnold and Baker (2005) Loser shares outperformed winner shares by 14 percent per year

Cumulative market-adjusted returns for UK share portfolios constructed on the basis of prior five-year returns

Price momentum

Jegadeesh and Titman (1993): a strategy that selects shares on their past six-month returns and holds them for six months, realises a compounded return above the market of 12.01 per cent per year on average

Possible explanations:

–        Investors underreacting to new information

–        Investors overreacting during the test period

Semi-strong form efficiency. Share prices fully reflect all the relevant publicly available information

Testing the for semi-strong efficiency

Is worthwhile expensively acquiring and analysing   publicly available information? Fundamental analysts try to estimate a share’s true value based on future business returns Majority of the early evidence (1960s and 1970s) supported the hypothesis Some academic studies which appear to suggest that the market is less than perfectly efficient

Some patterns that undermine semi-strong efficiency:


Investors are slow to react to the release of information in some circumstances ‘Post-earnings-announcement drift’ Bernard and Thomas (1989): cumulative abnormal    returns (CARs) continue to drift up for firms that report unexpectedly good earnings and drift down for firms that report unexpectedly bad figures for up to 60 days after the announcement. The abnormal return in a period is the return of a portfolio after adjusting for both the market return in that period and risk

The cumulative abnormal returns (CAR) of shares in the 60 days before and the 60 days after an earnings announcement

Other areas of research into under-reaction

Ikenberry et al. (1995) share prices rise on the announcement that the company will repurchase its own shares Michaely et al. (1995) found evidence of share price drift following dividend initiations and omissions Ikenberry et al. (1996) found share price drift after share split announcements Jegadeesh and Titman (1993) found that trading strategies in which the investor buys shares that have risen in recent months produce significant abnormal returns Chan et al. (1996) confirm an under-reaction to past price movements (a ‘momentum effect’) and also identify a drift after earnings surprises

Event studies

Empirical analysis of stock price behavior surrounding a particular event  

Strong-form efficiency. All relevant information, including that which is privately held, is reflected in the share price

Test performance of groups which have access to nonpublic information

–        Corporate insiders have valuable private information

–        Evidence that many have consistently earned abnormal returns on their stock transactions

Insider transactions must be publicly reported

There is no evidence to support the existence of strong form efficiency in the UK equity markets.

Conclusions about Market Efficiency

Support for market efficiency is persuasive

–        Much research using different methods

–        Also many anomalies that cannot be explained satisfactorily

Markets very efficient but not totally

–        To outperform the market, fundamental analysis beyond the norm must be done