Efficient Market Hypothesis (EMH)

Efficient Market Hypothesis (EMH) asserts that financial markets are ’efficient’, meaning the prices of traded assets (Example stocks and bonds) reflect all known information. The prices of assets reflect the collective beliefs of all investors about future prospects. EMH implies that it is not possible to consistently outperform the market, appropriately adjusted for risk, by using any information that the market already knows, except through luck. Only new information affects price of assets.

Information or news in the EMH is defined as anything that may affect asset prices. Prices react to information. Flow of information is random. Therefore price changes are random. In the early 1900s, Louis Bachelier is credited with developing the idea that the stock prices are governed by a random walk. The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements.

Eugene Fama was the first to formally propose EMH. He stated that all relevant information is fully and immediately reflected in a security's market price. Fama made the argument that in an active market which has many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information.

He argued that in an efficient market, competition among the market participants leads to a situation where, at any point in time, actual prices of securities reflect the events that have happened and the events that the market expects to take place. (Fama defined an 'efficient' market as a market where large numbers of rational, profit-maximisers actively compete with each other and try to predict future market values of individual securities, and where important current information is almost freely available to all participants.)

The implication of EMH is that in an efficient market the actual price of a security will always be a good estimate of its intrinsic value. If this hypothesis is correct, no investor will be able to earn anything more than an equilibrium rate of return on investments (or it is not possible to “beat” the market).

Most people who buy and sell securities do so under the assumption that securities bought are worth more than the price paid, while securities sold are worth less than the selling price. However, if EMH is correct and security prices fully reflect all available information, it would not be worth an investor’s time and effort to find undervalued securities. Buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill. However, if EMH is not correct and prices do not fully reflect all available information, investors can find and use that information and perhaps make a killing in the market.

EMH has been the subject of intense debate among academics and financial professionals. Whether markets are efficient has been extensively researched and remains controversial. This unit deals with this concept in detail.

Concept of ‘Efficient Market’

The performance of a financial market depends on how efficiently capital is allocated by the market. Three related types of market efficiency are used to describe the performance of financial markets, which are allocation efficiency, operational efficiency, and informational efficiency.

Allocation efficiency: A financial system exhibits allocation efficiency if it allocates capital to its best (most productive) use. For example, stock market investors shun security offers from firms in declining industries, but welcome offerings from firms in more promising industries.

Operational efficiency: Operational efficiency refers to the impact of transaction costs and market frictions on the operation of a market.

Informational efficiency: Informational efficiency refers to whether prices reflect ‘true value’. In a market exhibiting informational efficiency, asset prices incorporate all relevant information fully and instantaneously. For example, when company A receives a takeover bid from company B that seems certain to succeed, the stock price of A increases immediately to reflect the per share bid premium.

Efficient market hypothesis (EMH) deals with informational efficiency.

Market efficiency refers to a condition in which current prices reflect all the publicly available information about a security. The basic idea underlying market efficiency is that competition will drive all information into the price quickly. In the financial market, the maximum price that investors are willing to pay for a financial asset is actually the present value of future cash inflows discounted at a rate to compensate for the uncertainty in the cash flow projections. Therefore the investors are actually trading information about future cash flows and their degree of certainty as a "commodity" in financial markets.

Efficient market emerges when new information is quickly incorporated into the price so that it reflects up-to-date information. Under these conditions, the current market price in any financial market could be the best unbiased estimate of the value of the investment.

In an efficient market therefore prices react to new information quickly and precisely. There is no free lunch in an efficient market. The only way you can get higher returns is by taking on more risk. But no information is available to construct strategies that can earn higher returns on a consistent basis.

The Value of an Efficient Market

It is important that financial markets are efficient for at least three reasons.

 To encourage share buying: Accurate pricing is required if individuals are to be encouraged to invest in companies. If shares are incorrectly priced, many savers will refuse to invest because of fear that when they sell their shares the price may not represent the fundamentals of the firm. This will seriously reduce the availability of funds to companies and retard economic growth. Investors need the assurance that they are paying a fair price for acquiring shares and that they will be able to sell their holdings at a fair price – that the market is efficient.

 To give correct signals to company managers: Maximisation of shareholder wealth is the goal of managers of a company. Managers will be motivated to take the decisions that maximise the share price and hence the shareholder wealth, only when they know that their wealth maximising decisions are accurately signalled to the market and get incorporated in the share price. This is possible only when the market is efficient.

 To help allocate resources: If a badly run company in a declining industry has shares that are highly valued because the stock market is not pricing them correctly, it will be able to issue new capital by issuing shares. This will attract more of economy’s savings for its use. This would be bad for the economy as these funds would be better utilised elsewhere.

Random Walk Theory

EMH is associated with the idea of a “random walk”. Random walk is a term used to characterise a price series where all subsequent price changes represent random deviations from previous prices. The logic of the random walk idea is that if the flow of information is not hindered and if information is immediately incorporated and reflected in the stock prices, it follows that tomorrow’s security price will incorporate tomorrow’s news and security price changes tomorrow will be independent of the price changes today. Since news by definition is unpredictable and random, the resulting price changes must be random too.

The theory asserts that prices have no memory; therefore past and present prices cannot be used to predict future prices (as implied in technical analysis). Prices move at random, since new information is random, and adjust to new information as it becomes available. The adjustment to this new information is so fast that it is impossible to profit from it. Furthermore, news and events are also random and trying to predict these (fundamental analysis) is useless.

The theory implies that the prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the market prices will obtain a rate of return equal to that achieved by the experts. In his book “A Random Walk Down Wall Street”, Burton G Malkiel states that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that would perform as well as the portfolio that is selected by the experts. The advice to the investors is not to ask a chimpanzee to throw darts and select a portfolio for them, but to buy and hold a broad-based index fund.

 Random Walk and EMH

Statistical research has shown that stock prices seem to follow a random walk with no apparent predictable patterns that investors can exploit to their advantage. These findings are now taken to be evidence of market efficiency, i.e. market prices reflect all currently available information. Only new information will move stock prices, and this information is equally likely to be good or bad news. Therefore stock prices movements are random.

Random walk theory usually starts from the assumption that the major security exchanges are good examples of efficient markets where there are large numbers of rational profit-maximisers actively competing with one another, trying to predict future market values of individual securities. In an efficient market important current information is almost always freely available to all participants.

In an efficient market, actual prices of individual securities at any point in time reflect the information based both on past and future events. This is the result of competing actions of many intelligent market participants. In an efficient market the actual price of a security is a good estimate of its intrinsic value. In an uncertain world market, participants will disagree on the intrinsic value of the security, leading to discrepancies between actual prices and intrinsic values. But in an efficient market the actions of the many competing participants cause the actual price of a security to wander randomly about its intrinsic value.

If the differences between actual prices and intrinsic values are systematic rather than random in nature, as predicted by theory, then intelligent market participants should be able to predict the path by which the actual prices move towards their intrinsic values. However, when many intelligent traders attempt to take advantage of this knowledge, they would tend to neutralise such systematic behaviour in price series. Although uncertainty concerning intrinsic values will remain, actual prices of securities will wander randomly about their intrinsic values.

The intrinsic values change all the time as a result of new information coming in. The new information is about factors that may affect a company’s prospects, such as the success of a current R&D program, a change in management, a new tax imposed on the industry’s products in foreign countries etc. In an efficient market, on an average, competition between market players will cause the full effects of new information on intrinsic value to be reflected “instantaneously” in actual prices. This “instantaneous adjustment” property of an efficient market implies that successive price changes in individual securities will be independent. A market where successive price changes in individual securities are independent is, by definition, a random-walk market.

The random-walk hypothesis may not be an exact description of the behaviour of stock market prices. However, for practical purposes, the model may be accepted. Thus, although successive price changes may not be strictly independent, the actual amount of dependence may be so small as to be unimportant.

Forms of Market Efficiency

Informational efficiency is all about reflecting all available information in the price of a security. Two questions arise here are:

(1) What is all available information?

(2) What does reflection of available information mean?

Different answers to these questions give rise to different versions of market efficiency.

Available information: This is at three levels of strength. Basic information about the past prices refers to the weak version of EMH. Price information together with all published and publicly available data refers to the semi-strong version. Information about price, public data as well as private data refers to the strong version of EMH.

“Prices reflect all available information” means all financial transactions that are carried out at market prices, using the available information, are zero NPV activities.The weak form of EMH states that all past prices, volumes and other market statistics (generally referred to as technical data) cannot provide any information that would prove useful in predicting future stock price movements. The current prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return. It would mean that if the weak form of EMH is correct, then technical analysis cannot generate excess returns.

The semi-strong form suggests that stock prices fully reflect all publicly available information and all expectations about the future. “Old” information is to be discarded and not to be used to predict stock price fluctuations. The semi-strong form suggests that fundamental analysis is also fruitless knowing what a company generated in terms of earnings and revenues in the past will not help you determine stock price in the future. This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions.

Lastly, the strong form of EMH suggests that stock prices reflect all information, whether it be public (say in SEBI filings) or private (in the minds of the CEO and other insiders). So even with material non-public information, EMH asserts that stock prices cannot be predicted with any accuracy.

Empirical Tests of EMH

The debate about efficient markets has resulted in a plethora of empirical studies attempting to determine whether specific markets are in fact ‘efficient’ and if so to what degree. Academic studies have attempted to prove or disprove each of these forms of EMH, via testing of correlations (month-to-month and day-to-day returns), relative strengths, stock splits, earnings announcements, book value/market capitalisation correlation studies etc.

To test weak form efficiency, profitability of trading is tested to see whether past price or volume contains useful information. Auto correlation tests and filter rule tests are used to test weak form efficiency. An auto correlation test investigates whether the returns are statistically dependent on one another, i.e. can past stock return data predict future stock return data. A filter rule is a trading rule regarding the actions to be taken when shares rise or fall in value by x%. Filter rules should not work if markets show weak form of efficiency.

Semi-strong form efficiency denotes that any new information about the stock is incorporated into the price so quickly that the investor cannot act upon it and gain excess returns. The main line of research in this area is to watch the stock price just before and after a public announcement. These are called event studies. Event studies involving phenomena occurring at known points in time, such as a stock split or the announcement of corporate earnings, are frequently used in tests of the semi-strong form of market efficiency, to see whether public information is reflected immediately.

To test strong-form efficiency performance of professional managers or insiders is assessed to see whether they have superior information unknown to public investors. A tremendous amount of evidence supports the weak form of efficient market hypothesis. Technical trading rules are not consistently profitable. Serial correlation in daily stock returns is close to zero. The history of share prices cannot be used to predict the future in any abnormally profitable way. Early tests of the EMH focused on technical analysis. It is the technical analysts whose existence is threatened the most by EMH. The vast majority of studies of technical theories have found these strategies to be completely useless in predicting securities prices.

Recently though, there have been some studies which show that in certain circumstances some of the schemes technical analysts use might be of help in reaping excess returns, although the trading costs involved might eat up the higher returns.

Semi-strong form of EMH is generally supported by the data. Prices react to news quickly. Studies have looked, among other things, at the reaction of the stock market to the announcement of various events such as earnings, stock splits, capital expenditure, divestitures and takeovers. The usefulness or relevance of the information was judged based on the market activity associated with a particular event. In general, typical results from event studies have showed that security prices adjust to new information within a day of the event announcement, an inference that is consistent with the semi-strong form EMH.

Some evidence for and against the semi-strong form of market efficiency has been discovered in the following:

Information announcements: Can trading in shares, immediately following announcement of new information, (for example announcements on dividends or profit figures) produce abnormal returns? Evidence supports the semi-strong form of EMH, as excess returns, are nil. It is seen that most of the information in financial results or dividend announcements are reflected in share prices before the announcement is made.

Stock splits: When stock splits are made, no new money is raised by the company and existing shareholders receive more shares for the same value of stock. As the firm does not receive money and the fundamentals have not changed, prices should not react purely to a stock split. However, splits tend to occur when companies are doing well, and are seen as confirmation that the company anticipates continued growth in profits and dividends. Researches have shown that share prices rise steeply before the split, but not following it. So investors would not be able to profit by purchasing stock on the split date. This evidence is consistent with the semi-strong form of EMH.

Manipulation of earnings: Release of financials is an important source of information about a company. Most companies present a truthful account of their business, but some do creative accounting (which obeys the letter of the law and accounting rules but involves the manipulation of the accounts to show the most favourable figures). Market efficiency tests have shown that investors certainly ingest accounting information in their decision, but doubts have been raised about market efficiency to large-scale creative accounting.

Evidence does not support strong form EMH. Insiders can make a profit on their knowledge, and people go to jail, get fined, or get suspended from trading for doing so. One does not even have to look at the studies done in this area. All the news stories of people making excess returns by participating in insider trading, (e.g. Ken Lay and Jeff Skilling, former Enron executives who allegedly participated in insider trading), contradict the strong form of the EMH. It is well-known that people can and do make abnormal gains using information that is not in the public domain. In this respect stock markets are not strong form efficient. Those who do not have the private information feel cheated by insider trading. To avoid a loss of confidence in the market, most stock exchanges attempt to curb insider trading and it is a criminal offence in most exchanges.

There is also negative evidence for EMH as given below:

1. Stock market crash of 1987: There was no apparent exogenous news that could cause the crash which resulted in an enormous and discontinuous price drop. On October 19, 1987, the Dow Jones Industrial Average fell by 22 percent. The effect was felt worldwide and there was no immediate bouncing back from the crash. There was heavy institutional selling (one institution sold $1.7 billion). The suspects for the crash were index arbitrage and portfolio insurance whose collective mass selling caused the market to fall.

2. Smooth dividends but volatile prices (research conducted by Shiller): The volatility of share prices relative to variables that affect share prices can be studied to test market efficiency. Shiller’s study of share price volatility revealed significant volatility in the stock market. Shiller inferred that the fluctuations in actual prices which were greater than those implied by changes in the fundamental variables were the result of fads or waves of optimistic or pessimistic market psychology.

 Misconceptions about EMH

There are three classic misconceptions:

Any share portfolio will perform as well as or better than a special trading rule designed to outperform the market: Market efficiency does not mean that it does not make a difference how you invest. The risk-return trade-off applies at all times, and it is important that the portfolio is broad-based and diversified. EMH only cautions you not to expect to consistently "beat the market" on a risk-adjusted basis, using costless trading strategies.

There should be fewer price fluctuations: Again, EMH does not mean stability of stock prices. In fact constant fluctuation of market prices is really an indication that markets are efficient. New information impacting security prices arrives constantly and causes continuous adjustment of prices.

EMH presumes that all investors have to be informed, skilled, and able to constantly analyse the flow of new information. Still, the majority of common investors are not trained financial experts. Therefore market efficiency cannot be achieved: This too is wrong. Not all investors have to be informed. In fact, market efficiency can be achieved even if only a relatively small core of informed and skilled investors trade in the market. It only needs a few trades by informed investors using all the publicly available information to drive the share price to its semi-strong-form efficient price.

EMH, Technical Analysis and Fundamental Analysis

Technical analysis is a general term for a number of investing techniques that attempt to forecast securities prices by studying past prices and related statistics. Fundamental analysis focuses on the determinants of the underlying value of the stock or security, such as a firm's profitability and growth prospects. As both types of analysis are based on public information, neither should generate excess profits if markets are operating efficiently.

Weak-form EMH states that the current prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information. This implies that past rates of return and other market data should have no relationship with future rates of return.

Technical analysis searches for profitable trading strategies based on recurring patterns in stock prices. Many people do price charting to predict share prices. However, examining recent trends in price and other market data in order to predict prices would be a waste of time if the market is weak-form efficient. Investors cannot devise an investment strategy to yield abnormal profits on the basis of an analysis of past price patterns.

Under the weak form of EMH, technical analysis is useless. Technical analysis relies on sluggish response of stock prices to fundamental supply and demand factors. This possibility is diametrically opposed to the notion of an efficient market. Stock prices follow random walks, and past returns are entirely useless for predicting future returns.

Empirical studies of technical analysis do not generally support the hypothesis that these can generate trading profits. Only very short-term filters seem to offer any hope for profits, yet these are extremely expensive in terms of trading costs. These costs exceed potential profits even in the case of floor traders. The majority of researchers that have tested technical trading systems (and the weak-form EMH) have found that prices adjust rapidly to stock market information and that technical analysis is unlikely to provide any advantage to investors who use them.

However, others argue that all this does not negate technical analysis.

Semi-strong form EMH states that the current security prices reflect all public information, including market and non-market information implies that decisions made on new information after it becomes public should not lead to above-average risk-adjusted profits from those transactions.

Implications of semi-strong form EMH: The semi-strong form tests focus on the question of whether it is worthwhile to acquire and analyse publicly available information. If semi-strong efficiency is true, it undermines the work of fundamental analysts whose trading rules cannot be applied to produce abnormal returns because all publicly available information is already reflected in the share price. An analysis of balance sheets, income statements, product line, announcements of dividend changes or stock splits, or any other public information about a company will not yield abnormal profits if the market is semi-strong form efficient.

Several anomalies (discussed in this unit) regarding semi-strong form of EMH have been uncovered. These include the P/E effect, the small-firm effect, the neglected-firm effect, and the market-to-book effect. The anomalies seem to contradict the semi-strong version of EMH.

Strong-form EMH states that stock prices fully reflect all information from public and private sources. This would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case). Implication of strong-form EMH is that not even “insiders” would be able to “beat the market” on a consistent basis.

 Implications of EMH for Security Analysis and Portfolio Management

 Implications for active and passive investment

Proponents of EMH often advocate passive as opposed to active investment strategies. Active management is the art of stock-picking and market-timing.The policy of passive investors is to buy and hold a broad-based market index. Passive investors spend neither on market research, on frequent purchase nor on sale of shares.

The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for skilful managers to outperform the market. However, it is important to realise that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether or not the markets are efficient. This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, when costs are added, even marginally successful active managers may underperform the market. By and large, performance record of professionally managed funds does not support the claim that active managers can consistently beat the market. The empirical evidence is that investing in passively managed funds such as index fund has outperformed actively managed funds for the last several decades.

If markets are efficient, what is the role for investment professionals? Those who accept EMH generally reason that the primary role of a portfolio manager consists of analysing and investing appropriately based on an investor's tax considerations and risk profile. Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion, and employment. The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.

Implications for investors and companies

EMH has a number of implications for both investors and companies.

For investors: Much of the existing evidence indicates that the stock market is highly efficient, and therefore, investors have little to gain from active management strategies. Attempts to beat the market are not only useless but can reduce returns due to the costs incurred in active management (management fees, transaction costs, taxes, etc.). Investors should therefore follow a passive investment strategy, which makes no attempt to beat the market.

This does not mean that there is no role for portfolio management. Returns can be optimised through diversification and asset allocation, and by minimisation of investment costs and taxes. In addition, the portfolio should be geared to the time horizon and risk profile of the investor.

Public information cannot be used to earn abnormal returns. Therefore, the implication is that fundamental analysis is a waste of time and money and as long as market efficiency is maintained, the average investor should buy and hold a suitably diversified portfolio.

Investors, however, will have to make efforts to obtain timely information. Semi-strong form of market efficiency depends on the quality and quantity of publicly available information. Therefore, companies should be encouraged by investor pressure, accounting bodies, government rulings and stock market regulation to provide as much information as feasible, subject to the need for secrecy.

The perception of a fair and efficient market can be improved by more constraints and deterrents placed on insider trading.

For companies: EMH also has implications for companies.

 Companies should focus on substance, not on window-dressing accounting data: Some managers believe that they can fool shareholders through creative accounting but investors are able to see through the manipulation and interpret the real position, and consequently security prices do not rise.

 The timing of security issues does not have to be fine-tuned: A company need not delay a share issue thinking that its shares are currently under-priced because the market is low and hoping that the market will rise to a more ‘normal level’ later. This thinking defies the logic of the EMH – if the market is efficient the shares are already correctly priced and it is just as likely that the next move in prices will be down as up.