Market Efficiency

Behavior of an Efficient Market

The efficient-market hypothesis (EMH) asserts that financial markets are informationally efficient and should, therefore, move unpredictably. In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient." As a result, given the information available when the investment is made, one cannot consistently achieve returns over average market returns on a risk-adjusted basis.

There are three major versions of the hypothesis: "weak," "semi-strong," and "strong." The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims that prices reflect all publicly available information and that prices instantly change to reflect new public information.

The strong-form EMH also claims that prices instantly reflect even hidden or "insider" information. Critics have blamed the belief in rational markets for much of the late 2000s financial crisis. In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future. Market efficiency is a simplification of the world, which may not always hold true. The market is practically efficient for most individuals' investment purposes.

Random-Walk Model

Historically, there was a very close link between EMH and the random-walk model and then the Martingale model. The random character of stock market prices was first modeled by Jules Regnault, a French broker, in 1863 and then by Louis Bachelier, a French mathematician, in his 1900 PhD thesis, "The Theory of Speculation."

His work was largely ignored until the 1950s; however, beginning in the 1930s, scattered, independent work corroborated his thesis. A few studies indicated that U.S. stock prices and related financial series followed a random walk model. Research by Alfred Cowles in the 1930s and 1940s suggested that professional investors were, in general, unable to outperform the market.

Random Walk Stock market cannot be predicted.

Weak, Semi-Strong, and Strong

The efficient market hypothesis emerged as a prominent theory in the mid-1960s. Paul Samuelson had begun to circulate Bachelier's work among economists. In 1964, Bachelier's dissertation, along with the empirical studies mentioned above, was published in an anthology edited by Paul Cootner.

In 1965, Eugene Fama published his dissertation arguing for the random walk hypothesis, and Samuelson published proof of a version of the efficient market hypothesis. In 1970, Fama published a review of both the theory and the evidence for the hypothesis. The paper extended and refined the theory and included the definitions for three forms of financial market efficiency: weak, semi-strong, and strong.

It has been argued that the stock market is "micro efficient" but not "macro inefficient." Samuelson, the main proponent of this view, asserted that the EMH is much better suited for individual stocks than it is for the aggregate stock market. Research-based on regression and scatter diagrams has strongly supported Samuelson's dictum.

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The Efficient Market Hypothesis

The EMH asserts that financial markets are informationally efficient with different implications in weak, semi-strong, and strong forms.

The efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient." Consequently, given the information available when the investment is made, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis.

There are three major versions of the hypothesis: weak, semi-strong, and strong.

• The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information.
  
  
• The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information.
  
  
• The strong-form EMH additionally claims that prices instantly reflect even hidden or "insider" information.

Weak-Form Efficiency

In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices.

This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This "soft" EMH does not require that prices remain at or near equilibrium; it only requires that market participants cannot systematically profit from market "inefficiencies."

However, while EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer. Moreover, there is a positive correlation between the degree of trending and the length of time period studied (but note that over long time periods, the trending is sinusoidal in appearance). Various explanations for such large and apparently non-random price movements have been promulgated.

Semi-Strong-Form Efficiency

In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.

To test for semi-strong-form efficiency, the adjustments to previously unknown news must be reasonable in size and instantaneous. Consistent upward or downward adjustments after the initial change must also be looked for. If there are any such adjustments, it would suggest that investors have interpreted the information in a biased fashion and, hence, inefficiently.

Strong-Form Efficiency

In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.

To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation of strong-form efficiency follows–with hundreds of thousands of fund managers worldwide, even a normal distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star" performers.

Implications and Limitations of the Efficient Market Hypothesis

The limitations of EMH include overconfidence, overreaction, representative bias, and information bias.

Investors and researchers have disputed the Efficient Market Hypothesis both empirically and theoretically. Behavioral economists attribute the imperfections in financial markets to cognitive biases such as overconfidence, overreaction, representative bias, information bias, and other predictable human errors in reasoning and information processing.

Psychologists such as Daniel Kahneman, Amos Tversky, Richard Thaler, and Paul Slovic have researched these. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at high prices, which allows those who reason correctly to profit from bargains in neglected value stocks and the excessive selling of growth stocks.

Empirical evidence has been mixed but has generally not supported strong forms of the Efficient Market Hypothesis. According to a 1995 publication by Dreman and Berry, low P/E stocks have greater returns. In an earlier paper, Dreman refuted Ray Ball's assertion that these higher returns could be attributed to higher beta. Ball's research had been accepted by Efficient Market theorists as explaining the anomaly in neat accordance with modern portfolio theory.

Speculative Economic Bubbles

Speculative economic bubbles are an obvious anomaly in that the market often appears to be driven by buyers operating on irrational exuberance, who take little notice of underlying value. These bubbles are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at bargain prices.

Rational investors have difficulty profiting by shorting irrational bubbles because, as John Maynard Keynes commented, "Markets can remain irrational far longer than you or I can remain solvent." Sudden market crashes, like the one that occurred on Black Monday in 1987, are mysterious from the perspective of efficient markets but allowed as a rare statistical event under the Weak Form of EMH. One could also argue that if the hypothesis is so weak, it should not be used in statistical models due to its lack of predictive behavior.

Transaction Costs

Further empirical work has highlighted the impact transaction costs have on market efficiency. Much evidence suggests that any anomalies about market inefficiencies result from a cost-benefit analysis made by those willing to incur the cost of acquiring the valuable information to trade on it. Additionally, liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns.

Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency since to do so requires the use of a measuring stick against which abnormal returns are compared – in other words, one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return. Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing the case.

Late 2000s Financial Crisis

The financial crisis of 2007–2012 has led to renewed scrutiny and criticism of the hypothesis. Market strategist Jeremy Grantham has stated flatly that the EMH is responsible for the current financial crisis, claiming that belief in the hypothesis caused financial leaders to have a "chronic underestimation of the dangers of asset bubbles breaking."

Noted financial journalist Roger Lowenstein blasted the theory, declaring, "The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the Efficient-Market Hypothesis." Former Federal Reserve chairman Paul Volcker said, "[it is] clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations and market efficiencies."

2008 Financial Crisis The strong form of EMH is diminished by the 2008 crisis

The financial crisis has led Richard Posner, a prominent judge, University of Chicago law professor, and innovator in Law and Economics, to back away from the hypothesis and express some belief in Keynesian economics. Posner accused some of his Chicago School colleagues of being "asleep at the switch," claiming that "the movement to deregulate the financial industry went too far by exaggerating the resilience – the self-healing powers – of laissez-faire capitalism."

Others, such as Fama himself, said that the hypothesis held up well during the crisis and that the markets were a casualty of the recession, not the cause of it. Despite this, Fama has conceded that "poorly informed investors could theoretically lead the market astray" and that stock prices could become "somewhat irrational."

Critics have suggested that financial institutions and corporations have been able to decrease the efficiency of financial markets by creating private information, reducing the accuracy of conventional disclosures, and developing new and complex products that are challenging for most market participants to evaluate and correctly price.