Do you believe in the efficient markets hypothesis (consider the semi-strong form of
market efficiency)?
Introduction
The Efficient Markets Hypothesis (EMH) is a popular theory that has been widely studied and debated
in the world of finance. According to the efficient-market theory, asset prices accurately reflect all
publicly available information in the realm of financial economics. As market prices will only respond
to new information, an obvious implication is that it is impossible to "beat the market" consistently on a
risk-adjusted basis unless we have more information such as insider information, however that is
illegal.
In this essay, we will explore the semi-strong form of the EMH and discuss the various research
studies that have been conducted on this topic.
Random Walk Theory
Efficient markets are important because they have implications for investment. Random walk is the
theory that stock prices follow a random pattern and do not move in a predictable pattern so investors
can take advantage. Random patterns occur because the market is efficient and when new
information appears the market adjusts quickly. To have an efficient market, you must have:
1. Many knowledgeable investors actively analysing and trading stocks
2. Information must be widely available to all investors
3. Events such as COVID happen randomly and unexpectedly
4. Investors have to react fast to new information.
Types of efficiency
There are two different types of efficiency: Operational efficiency which measures how well things
function in terms of how fast it is executed and accurate and informational efficiency is how quickly
and accurately the market reacts to new information i.e EMH revolves around this type of efficiency.
For example the market is extremely efficient if the security prices adjust quickly to new information.
Technical and Fundamental Analysis
Traders use technical analysis to find opportunities by analysing statistical trends, such as changes in
a stock's price and volume. The fundamental premise is that all known fundamentals are taken into
account by price, hence they are not particularly important. The intrinsic value of an asset is not
something that technical analysts try to calculate. Instead, they look for patterns and trends in stock
charts that indicate what will happen to a stock in the future.Thus EMH suggests that it is a waste of
time as past stock prices can not predict changes. The random-walk finding, which states that
historical stock price information cannot be used to predict changes, can be used to understand why
this is the simplest manner possible. As a result, technical analysis, which uses such data to generate
its forecasts, is unable to accurately estimate changes in stock values.
Stocks are analysed using fundamental analysis in an attempt to identify their intrinsic value.
Fundamental analysts research a wide range of topics, including the state of the global economy,
industry trends, as well as the management and financial health of specific businesses. Fundamental
analysts examine all of the following: earnings, costs, assets, and liabilities, economic news etc.A
fundamental analyst can forecast a stock's price's likely future direction by comparing a stock's price
to its intrinsic value.
Levels of EMH
Eugene Fama, a US economist, developed this theory for his Doctorate dissertation in the 1960s. The
MNPI's impact on market prices is assessed using the EMH, which has three different versions: weak,
semi-strong, and strong. Aiming to outperform the market, according to EMH, is subject to chance
rather than talent because markets are efficient and current prices reflect all available
information..The weak form, semi strong form and the strong form. The weak form is that market
prices reflect all historical information and you can not make profit by studying the past returns and
that technical analysis will never work. Semi strong is that the price of stock is quickly adjusted on
new information such as news articles. Therefore, fundamental analysis cannot be used to achieve
risk adjusted returns that are superior to the broader market over time. In accordance with proponents
of the strong form efficient market theory, the current price of an asset includes all information, both
public and private. In this way, investors cannot receive the possibility for excess gains even from
insider information. In this essay we are only interested in the semi strong form.
Semi strong form
According to semi-strong form efficiency, price adjustments to new equilibrium levels are reflections of
information that security prices have taken into account from publically accessible marketplaces.
Although it is regarded as the most realistic EMH hypothesis, it cannot explain the context for
significant nonpublic knowledge (MNPI). It comes to the conclusion that neither technical or
fundamental analysis can be used to generate superior gains and advises that only MNPI would be
advantageous to investors looking to generate returns on investments that are above average.
Example of semi strong form
Consider that the day before it is expected to release earnings, stock D is trading at $10. The evening
before its earnings conference, a news article alleges that D's business has suffered recently as a
result of unfavourable government regulation. The stock of D drops to $8 when trading resumes the
next day, demonstrating movement brought on by information that is already in the public domain.
However, the stock increased to $11 after the call as a consequence of the company reporting
successful earnings as a result of cost-cutting measures. The MNPI in this instance is information on
a cost-cutting measure that, had it been known to investors, would have allowed them to make
significant gains.
How efficient are the markets?
Market efficiency is the degree to which prices accurately represent all available information. The
efficient markets hypothesis (EMH) contends that because markets are efficient and everything is
already fairly and precisely priced, there is no potential for investing to generate excess gains. This
means that defeating the market is unlikely.
Inefficient Markets
When an asset's prices do not fairly reflect its true value, a market is said to be inefficient. This can
happen for a number of different reasons. Market inefficiencies can arise for a variety of causes,
including information asymmetries, a lack of buyers and sellers (low liquidity), high transaction costs
or delays, market psychology, and human emotion. Deadweight losses are frequently the result of
inefficiencies. In actuality, most markets do exhibit some degree of inefficiency, and in the worst
situation, an inefficient market might serve as an illustration of a market failure.
A market will grow more efficiently as more individuals participate, compete, and bring more and
varied forms of information to bear on the price. Arbitrageurs will also emerge when markets grow
more active and liquid, benefitting by addressing minor inefficiencies wherever they may appear and
swiftly restoring efficiency.
Anomalies
There are certain anomalies that affect stock prices. An example being the calendar effect, stock
returns may be closely tied to the time of year or time of week, e.g weekend effect or january effect
idea in which people sell the losing stock in december in order to take the tax loss in their tax return
and then buy these companies back in january and stock prices shoot up. Another market anomalies
may be small firm effects i.e the size of a firm impacts stock return, small firms may offer higher
returns even after adjusting risks.
If the
For EMH
The only strategy that has been proved to outperform the market involves exploiting insider
information, but this is prohibited in many, but not all, nations. Raj is one case where this is evident.
By making investments in companies about which he allegedly had inside information in the middle of
the 2000s, Mr. Rajaratnam amassed millions of dollars for both himself and his investors. His
approach demonstrates how you can make money off of knowledge that the market lacks. But he was
imprisoned for insider trading because of that method.
Future fluctuations in stock prices should be unpredictable, according to the Efficient Market
Hypothesis (EMH). As a result, investors will buy a stock if it is expected to increase until it reaches an
equilibrium level. Similar to this, if a stock's price is expected to decline, buyers will dump it until it
likewise achieves an equilibrium level. Price changes would be close to zero if stock prices were
predictable, which would result in the aforementioned behaviour. But, historically, this has not been
the case. Since future changes cannot be foreseen, stock price behaviour exhibits a random-walk
pattern.
Against EMH
Market Overreaction: According to recent research, stock prices may overreact to news
announcements, and pricing errors are very slowly remedied. The stock price may overshoot when
firms report a significant shift in earnings, such as a huge decrease, and after an initial large decline, it
may rebound back to more normal levels over the course of many weeks. This goes against the EMH
because an investor could, on average, earn abnormally large returns by purchasing a stock right
away following a disappointing earnings report and then selling it a few weeks later when it had
recovered to normal levels.
Stock prices don't always adjust as soon as new information is released. Despite being generally
accurate, recent research indicates that stock prices do not immediately respond to profit
announcements, contradicting the efficient market concept. In contrast, stock prices typically continue
to increase for a while following the release of surprise large earnings and to decline following the
disclosure of surprisingly low profits.
Implications for investors
Some stocks may be underpriced or overpriced; this is known as hot tips.According to the EMH, you
should be wary of hot tips because, if the stock market is efficient, it has already set the price of the
hot tip stock so that its projected return would be equal to the equilibrium return. As a result, the hot
tip is not very useful and won't let you get an unusually big return.The unexplored profit opportunity it
offers will be swiftly destroyed as soon as the information becomes public. You should anticipate just
realising the equilibrium return since the stock's price will have already reflected the information.
The investor should instead adopt a "buy and hold" approach, in which they buy equities and keep
them for a long time. Average returns will remain the same, but the investor's net earnings will
increase as fewer brokerage commissions are required to be paid.
Event Studies
The validity of the semi-strong variant of the EMH is frequently examined through the use of event
studies. These studies examine the security price's response to a certain occurrence. For instance, if
a company reports unexpectedly higher earnings, the stock price should rise; conversely, if a
company reports lower earnings, the stock price should plummet. The stock price should react to the
announcement instantly and fully if the market is functioning properly.
To test the semi-strong variant of the EMH, several event investigations have been carried out. The
market reacts to earnings announcements, and stock prices adapt to reflect the new information
within a few days following the announcement, according to a study by Ball and Brown
(1968).However, some research indicates that the market may not always respond to announcements
effectively. The market does not completely adjust to dividend announcements, according to a study
by Fama, Fisher, Jensen, and Roll from 1969.
Research Studies
There has been research done to evaluate the reliability of the semi-strong variant of the EMH. For
instance, Jegadeesh and Titman (1993) discovered that the market outperformed portfolios based on
prior performance, indicating that the market is effective at digesting and reflecting historical
knowledge.
A different investigation by Fama and French (1992) discovered a connection between stock returns
and accounting profitability. This conclusion implies that accounting information is processed and
reflected by the market in an effective manner.
The semi-strong variant of the EMH has also been the subject of more recent research. The market,
for instance, is effective in processing and reflecting information connected to earnings releases,
according to a study by Fama and French (2015). The study examined how the security price
responded to earnings releases and discovered that the market responded effectively.
Conclusion
In conclusion, the semi-strong form of the EMH shows that neither technical or fundamental analysis
can be employed to provide higher gains. It suggests that investors wishing to get above-average
returns on their investments should only consider MNPI. Recent studies, however, show that the EMH
is false and that stock prices might overreact to news announcements and that stock prices don't
always adjust as quickly as new information is made public. The EMH is still generally recognised and
has significant ramifications for investors despite these discrepancies.
References
1. (Downey, 2021)Downey, L. (2021). Efficient market hypothesis (EMH) definition.
[online] Investopedia. Available at:
https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
2. (Baldridge, 2022)Baldridge, R. (2022). What Is the Efficient Market Hypothesis?
[online] Forbes Advisor. Available at:
https://www.forbes.com/advisor/investing/efficient-market-hypothesis/.
3. (Chen, 2019)Chen, J. (2019). Semi-Strong Form Efficiency Definition. [online]
Investopedia. Available at:
https://www.investopedia.com/terms/s/semistrongform.asp.
4. www.youtube.com. (n.d.). Efficient Markets. [online] Available at:
https://www.youtube.com/watch?v=L6zk0E6YApw [Accessed 6 Mar. 2023].
5. PowerPoint Slides 1-3