The Efficient Markets Hypothesis

Corporate and market finance in Europe

19/07/2012

Efficient Capital Market

EMH holds that stock prices fully reflect all available information at any time and respond to it as soon as it becomes available.

Perfectly competitive securities market:

New information arrives at market independently and randomly. Both buyers and sellers adjust rapidly to new info. Current security prices reflect all relevant risk/return info.
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Random Walk Theory

Random Walk Theory: concept that stock price movements do not follow any pattern or trend Fair Game: even bet; 50-50 chance Random walk as approximate implication of unpredictability of returns Random Walk With Drift: slight upward bias to inherently unpredictable daily stock prices
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Evidence supporting notion of random walk

Public vs. Private Information

Stock Market Information: stock price and trading volume figures Public Information: freely shared information Non-public Information: proprietary data Insider Information: proprietary information within a firm
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Three Forms of EMH

Weak Form Effeciency

Security prices reflect all information found in past prices and volume.

Semi-Strong Form Effeciency

Security prices reflect all publicly available information.

Strong Form Effeciency

Security prices reflect all information public and private.
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Three Forms of EMH

Weak Form Effeciency

Security prices reflect all information found in past prices and volume. Future prices cannot be predicted by analyzing prices from the past >> Technical analysis is of no value . Stock prices only respond to new information (which arrives randomly) >> stock prices follow a random walk. Excess returns cannot be earned in the long run.

Semi-Strong Form Effeciency

Security

Prices reflect all publicly available information. Publicly available information includes:
Historical price and volume information Published accounting statements Information found in annual reports.

Rapid and unbiased adjustment of share prices to publicly available new information
No excess returns can be earned by trading on that information. 9

Strong Form Effeciency

Security Prices reflect all information public and private. Strong form efficiency incorporates weak and semi-strong form efficiency. Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the securitys price. Even the knowledge of material, nonpublic information cannot be used to earn superior results.

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Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price Efficient market response to bad news Delayed response to bad news

-30 -20 -10 Overreaction to bad news with reversion

+10

+20

+30

Days before (-) and after (+) announcement

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EMH Anomalies

The Size Effect (Small Firm Effect) The Incredible January Effect The Weekend Effect (or Monday Effect) Other Seasonal Effects P/E Ratio Effect

These

anomalies cannot be explained within the existing paradigm of EMH Information alone is not moving the prices Possible explanations for anomalies that are consistent with securities market efficiency
Risk Transactions costs
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Criticism: Psychological factors & Behavioral finance

Imperfections in financial markets due to:

Believing-is-Seeing Problem Gambling behavior Overconfidence Overreaction Various other predictable human errors in reasoning and information processing

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Conclusion

Weak form is supported, so technical analysis cannot consistently outperform the market. Semi-strong form is mostly supported , so fundamental analysis cannot consistently outperform the market.

Strong form is generally not supported. If you have secret (insider) information, you CAN use it to earn excess returns on a consistent basis. Ultimately, most believe that the market is very efficient, though not perfectly efficient. It is unlikely that any system of analysis could consistently and significantly beat the market (adjusted for costs and risk) over the long run.
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