The_Efficient_Market_Hypothesis

`A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions.’ Introduction In this essay I will be critically assesses the efficient market hypothesis (EMH) by examining empirical evidence that tests its validity. The main focus is on whether or not a set of information can be used to make abnormal profits to formulate buying and selling decisions predict. Information is given a broad definition in this context and includes all publicly available information. Some of the predictions and truths of the efficient market hypothesis are also examined in the process. The design of tests used in the evidence contributes significantly to their results. Consequently, mention is made of the procedures of tests prior to results being examined. Definition The efficient market hypothesis (EMH) refers to a capital market in which security prices fully reflect all available information. This implies that markets process information rationally. Relevant information is not ignored and systematic errors are not made. This in turn implies that prices reflect 'fundamentals', that is, economic fundamentals. Explaining EMH The Efficient Market Hypothesis (EMH) has been considered as one of the cornerstones of modern financial economics. The efficient-market hypothesis was developed by Professor Eugene Fama in financial literature in 1965 as one in which security prices fully reflect all available information. Efficient market hypothesis is the idea that information is quickly and efficiently incorporated into asset prices at any point in time, so that old information cannot be used to foretell future price movements thus making it difficult for investors to make abnormal returns. Consequently, three versions of EMH are being distinguished depends on the level of available information. The weak form EMH stipulates that current asset prices already reflect all publicly known past price and information. The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. It is named weak form because the security prices are the most publicly and easily accessible pieces of information. It implies that no one should be able to outperform the market using something that "everybody else knows". Yet, there are still numbers of financial researchers who are studying the past stock price series and trading volume data in attempt to generate profit. This technique is so called technical analysis that is asserted by EMH as useless for predicting future price changes. The semi strong form EMH states that all publicly available information is similarly already incorporated into asset prices. In another word, all publicly available information is fully reflected in a security's current market price. The public information stated not only past prices but also data reported in a company's financial statements, company's announcement, economic factors and others. It also implies that no one should be able to outperform the market using something that "everybody else knows". This indicates that a company's financial statements are of no help in forecasting future price movements and securing high investment returns. The strong form EMH stipulates that private information or insider information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security's current market price. Keeping in view that markets are efficient and that information and news spread quickly and is integrated into investment decision readily, we assume that no form of analysis would lead to a higher return than expected return of a portfolio of randomly selected stocks. The discussion of both usually used method of two types of analysis technical and fundamental analysis. The following will critically evaluate the differences between technical and fundamental analysis. Even though both technical and fundamental analyses are tools used to make investment decisions there is sharp differences in the two approaches Fundamental analysis involves making investment decisions based on the examination of the economy, an industry, and company variables that lead to an estimate of value for an investment, which is then compared to the prevailing market price of the investment. Technical analysis involves the examination of past market data, such as prices and the volume of trading, which leads to an estimate of future price trends and therefore an investment decision. Technical Analysis Technical analysis involves the examination of past market data, such as prices and the volume of trading, which leads to an estimate of future price trends and therefore an investment decision. Efficient Market Hypothesis in its weak form declares that all past information are included in the price (Samuels, 1999). It implies that no one should be able to outperform the market using something that everybody else knows. Yet, there are still numbers of financial researchers who are studying the past stock price series and trading volume data in attempt to generate profit. This technique is so called technical analysis that is asserted by EMH as useless for predicting future price changes. If the market is weak efficient there cannot be any opportunities to predict future price movements using past prices (Fama, 1991) Nevertheless, there are techniques to work out prices movements with patterns of past data such as technical analysis; and if these techniques provide opportunities to beat the market, it proves its inefficiency in weak form (Grabele, 2003). However, Higgins states technical analysis is of no use (Higgins, 1992). In addition, Russel and Torbey (2003) suggest that the inconsistent performance of technical analysts have inconsistent performance so technical analysis is indeed useless in beating the market. Technical analysis is in sharp contrast to efficient market hypothesis (EMH), which contends that past performance has no influence on future performance market values. This branch of financial analysis is model based and uses historical data to predict future prices of stocks and other securities. The people who carry out the technical branch of analysis are called technicians. A technician will use historical prices of securities and figures of volume to analyze the future outcome and make assumptions which would lead to decision making (Kirkpatrick & Dahlquist, 2006). When using technical analysis technicians use methods such as moving average, price graphing, head-shoulder, double top and various other archetypal patterns to predict the future. One of the most important assumptions is that market is not efficient and an analysis of past information can lead to decision making for profitable investment. The market does not always behave at it is supposed to and will crash because of more behavioral reasons that were explained in the discussion above. This factor is also supported by Malkiel, who says that technical forecasting tools such as pattern analysis are ultimately self-defeating (Malkiel, 1996). The weak or soft form of EMH predicts that technical analysis should not be able to predict prices using historical data but the prices must follow a random trend.). EMH in its weak form declares that all past information are included in the price (Samuels, 1999). If the market is weak efficient there cannot be any opportunities to predict future price movements using past prices (Fama, 1991) Nevertheless, there are techniques to work out prices movements with patterns of past data such as technical analysis; and if these techniques provide opportunities to beat the market, it proves its inefficiency in weak form (Grabele, 2003). However, Higgins states technical analysis is of no use (Higgins, 1992). In addition, Russel and Torbey (2003) suggest that the inconsistent performance of technical analysts have inconsistent performance so technical analysis is indeed useless in beating the market. The theory which supports weak or soft form of EMH is explained below: Random Walk behavior: The theory of random walk behavior is one key variable which supports the efficient market hypothesis and proves that market is efficient only if everyone has the all the information at the same time. The idea was first put forward by Burton Malkiel in his very famous investment guide ‘A Random Walk Down Wall Street’. This theory was first introduced by Maurice Kendall in 1953 and suggested that stock price fluctuations are independent of each other as people in a market have access to same information. According to Burton both technical analysis and fundamental analysis are unable to predict the future movement of shares. This phenomenon exists because if the movement of security price is predictable that would mean equal information is not available to investors and abnormal profits in this case would be made using that specific set of information. According to Burton an investor cannot outperform the market without taking additional risk. Therefore according to him the best strategy is a long term holding strategy, which would reap benefits of growth rather than speculation. Fundamental analysis The most famous and widely used analysis is fundamental analysis. Fundamental analysis involves making investment decisions based on the examination of the economy, an industry, and company variables that lead to an estimate of value for an investment, which is then compared to the prevailing market price of the investment. This form of analysis as the name suggests does not give a historical perspective but a resource based perspective. The word resource has been used here to describe the fundamental capability or the ability/ inability to generate future streams of income. Moreover fundamental analysis does not rely only on a market perspective of the security but would analyze the driver of the security to determine its price or for that matter predict its future price. The driver is a terminology used to describe the entity on which a security is dependent. The securities such as future are dependent on other securities such as shares and bonds. The shares and bonds floating in a market are in turn dependent on other entities such as companies, governments etc. Therefore in fundamental analysis the researcher or analyst would determine the potential in the entity that is a company to determine the price of security. This however is disproved by the efficient market hypothesis which predicts that information is readily available to all investors and profits can’t be made because everyone has the same set of information (Burton, 1987). So, if everyone knows about critical factors such as dividend announcements, stock splits, R&D ventures, financial results than the market will be efficient and no form of fundamental analysis would result in a gain. The semi strong form of EMH also states that no information is readily incorporated into the market decision and therefore no form of analysis fundamental or technical will be able to provide an excess return. A very famous study conducted by Wall Street which provides proof for this semi strong EMH is given below: Investment dartboard: This is a concept inspired by Burton’s books that suggested a random walk behavior for stocks. In 1988 Wall Street journal started a concept of Investment dartboard. This was a method of checking if the returns generated by random selection were lower or greater than big capital markets. According to this process a blind folded person throws darts to select different stocks and the return is than calculated (Burton, 1996). This contest has yielded some very interesting results. The stock market has been proved as efficient because out of a hundred turns the stocks picked by throwing darts won a staggering 39 times (Burton, 1996). Another research conducted through this experiment proved that the best stock analyst could not outperform the Dow Jones index. This means that any person investing passively in the Dow index would have yielded a return which would have been almost equal to the best analyst of the market. This proves that the market is efficient if everyone has the same set of information. If this information base is not shared by everyone in that case an abnormal profit can be made, which renders the use of fundamental analysis and technical analysis as questionable. Anomalies of EMH There are many empirical studies that attempt to contradict the efficient market hypothesis (Higgins, 1992). Researchers have documented some technical anomalies and stock market anomalies that may offer some hope for traders. According to Higgins (1992), the search for anomalies is effectively the search for systems or patterns that can be used to outperform passive strategies. The EMH became more controversial after the detection of these anomalies (Russel & Torbey, 2003). These phenomena have been rightly referred to as anomalies because they cannot be explained within the existing paradigm of EMH (Russel & Torbey, 2003). These anomalies have led researchers to question the EMH and to investigate alternate modes of theorizing market behavior. Some of the more popular anomalies are discussed below. The January Effect: Rozeff and Kinney (1976) documented the so-called “The January Effect” in which there is an evidence of higher mean returns in January as compared to other months. They used the NYSE stocks (1904-1974) and discovered that the average return for the month of January was 3.48 percent as compared to only .42 percent for the other months. The evidence is supported by Bhardwaj and Brooks (1992). The Day of Week Effect (weekend effect): The weekend effect (also known as the Monday effect, the day-of-the-week effect or the Monday seasonal) refers to the tendency of stocks to exhibit relatively large returns on Fridays compared to those on Mondays. This is a particularly puzzling anomaly because, as Monday returns span three days, if anything, one would expect returns on a Monday to be higher than returns for other days of the week due to the longer period and the greater risk. Conclusion The discussion above has proved that markets are efficient if all available information does not allow any one person to reap unfair profits. The assessment on technical analysis and fundamental analysis is therefore justified as research has proved that they do not allow reaping of excess profits over the market. The investment dartboard experiment has therefore proved that market will not give any investor excess profits no even if they use fundamental analysis. This also justifies the statement that abnormal profits can never be made in the market using information that is available to all investors. It can be also concluded that while technical analysis looks at stock price trends and refutes the Efficient Market hypothesis, fundamental analysis tends to analyze company information like cash flow, balance sheets etc. However, the common point is that both sets of tools are used to pick stocks. It must be highlighted that to ensure the right choice is made both sets of tools must be used at tandem to derive the best result. There are no conclusive results to suggest that fundamental analysis has generated better results than technical analysis and vice versa. Thus, it can be summarized that for day trading and other forms of short term trading technical analysis would be a better option while for longer term investment fundamental analysis tools would be more useful. Thus depending on the nature and time span of the investment either technical or fundamental analytical tools can be used to make the right investment decision. The first two levels of EMH therefore hold true for all investors even professional analysts which many years experience in their repute and expensive college degrees. References Higgins, R. (1992) The efficient market hypothesis and the random walk theory. Analysis for Financial Management. 3rd ed. New York: Irwin/McGraw-Hill. Eun, C. Resnick, B. (2004). International Financial Management. Singapore. McGraw-Hill Madura, J. (2007). International Financial Management. New York. 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