Stock market and Efficient Markets Hypothesis (MME)

This means that the prices of securities follow a “random walk” and are not easy to predict. Any information that could be used to predict security prices would already be reflected in the prices of those securities. Price changes should be random and unpredictable. Prices of securities can only change as a result of new information coming into the market. If the market Is not efficient. The market price may deviate from the true value. Thus, some investors may be able to make higher returns than others because of their ability to spot “under-valued and over-valued” securities.

They can do this by studying the firms that have Issued the securities, or digging up any other relevant information that may affect the value of the security. This has come to be known as the Efficient Markets Hypothesis (MME). The MME has three forms: the strong form, the semi-strong form, and the weak form. In market-based economies, market prices help determine which companies (and which projects) obtain capital. If these prices do not efficiently incorporate information about a company’s prospects, then it is possible that funds will be misdirected.

By contrast, prices that are Informative help direct scarce resources and funds available for investment to their highest-valued uses. Informative prices thus promote economic growth. The efficiency of a country’s UAPITA markets (In which businesses raise financing) Is an Important characteristic of a well-functioning financial system. Investment managers and analysts, as noted, are interested in market efficiency opportunities (market inefficiencies) exist. Consistent, superior, risk-adjusted returns (net of all expenses) are not achievable in an efficient market.

Related: The Stock Market Is Worried About Inflation. Should It Be?

In a highly efficient market, a passive investment strategy (I. E. , buying and holding a broad market portfolio) that does not seek superior risk-adjusted returns is preferred to an active investment strategy because of lower costs (for example, transaction and information-seeking costs). By contrast, in a very inefficient market, opportunities may exist for an active investment strategy to achieve superior risk-adjusted returns (net of all expenses in executing the strategy) as compared with a passive investment strategy.

In inefficient markets, an active investment strategy may outperform a passive investment strategy on a risk-adjusted basis. Understanding the characteristics of an efficient market and being able to evaluate the efficiency of a particular market are important topics for investment analysts and portfolio managers. An efficient market is a market in which asset prices reflect information quickly. But what is the time frame of “quickly’? Trades are the mechanism by which information can be incorporated into asset transaction prices.

The time needed to execute trades to exploit an inefficiency may provide a baseline for Judging speed of adjustment. The time frame for an asset’s price to incorporate information must be at least as long as the shortest time a trader needs to execute a transaction in the asset. In certain markets, such as foreign exchange and developed equity markets, market efficiency relative to certain types of information has been studied using time frames s short as one minute or less. If the time frame of price adjustment allows many traders to earn profits with little risk, then the market is relatively inefficient.

These considerations lead to the observation that market efficiency can be viewed as falling on a continuum. Finally, an important point is that in an efficient market, prices should be expected to react only to the elements of information releases that are not anticipated fully by investors-?that is, to the “unexpected” or “surprise” element of such releases. Investors process the unexpected information and revise expectations for example, about an asset’s future cash flows, risk, or required rate of return) accordingly.

The revised expectations enter or get incorporated in the asset price through trades in the asset. Market participants who process the news and believe that at the current market price an asset does not offer sufficient compensation for its perceived risk will tend to sell it or even sell it short. Market participants with opposite views should be buyers. In this way the market establishes the price that balances the various opinions after expectations are revised. Factors Impeding a Market’s Efficiency Market Participants

One of the most critical factors that determine market efficiency is the number of participants in the markets. A large number of investors (individual and institutional) follow the major financial markets closely on a daily basis, and if MIS-pricing exist in these markets, as illustrated by the example, investors will act so that these MIS- pricing disappear quickly. Besides the number of investors, the number of financial analysts who follow or analyze a security or asset should be positively related to market efficiency.

The number of market participants and resulting trading activity Information availability (e. . , an active financial news media) and financial disclosure should promote market efficiency. Information regarding trading activity and traded companies in such markets as the New York Stock Exchange, the London Stock Exchange, and the Tokyo Stock Exchange is readily available. Many investors and analysts participate in these markets, and analyst coverage of listed companies is typically substantial.

As a result, these markets are quite efficient. In contrast, trading activity and material information availability may be lacking in smaller securities markets, such as those operating in some emerging markets. A key element of this fairness is that all investors have access to the information necessary to value securities that trade in the market. Rules and regulations that promote fairness and efficiency in a market include those pertaining to the disclosure of information and illegal insider trading. For example, U. S. Securities and Exchange Commission’s (SEC’s) Regulation FAD (Fair Disclosure) requires that if security issuers provide nonpublic information to some market professionals or investors, they must also disclose this information to the public. This requirement helps provide equal and fair opportunities, which is important in encouraging participation in the market. A related issue deals with illegal insider trading. Limits to Trading Arbitrage is a set of transactions that produces reckless profits. Arbitrageurs are traders who engage in such trades to benefit from pricing discrepancies (inefficiencies) in markets.

Such trading activity contributes to market efficiency. For example, if an asset is traded in two markets but at different prices, the actions of buying the asset in the market in which it is underpinned and selling the asset in the market in which it is overpriced will eventually bring these two prices together. The presence of these arbitrageurs helps pricing discrepancies disappear quickly. Obviously, market efficiency is impeded by any limitation on arbitrage resulting from operating inefficiencies, such as difficulties in executing trades in a timely manner, prohibitively high trading costs, and a lack of transparency in market prices.

Some market experts argue that restrictions on short selling limit arbitrage trading, which impedes market efficiency. Short selling is the transaction whereby an investor sells shares that he or she does not own by borrowing them from a broker and agreeing to place them at a future date. Short selling allows investors to sell securities they believe to be overvalued, much in the same way they can buy those they believe to be undervalued. In theory, such activities promote more efficient pricing.

Regulators and others, however, have argued that short selling may exaggerate downward market movements, leading to crashes in affected securities. In contrast, some researchers report evidence indicating that when investors are unable to borrow securities, that is to short the security, or when costs to borrow shares are high, market prices may deviate from intrinsic values. Weak-form market efficiency This asserts that security prices already reflect all information that can be derived by examining data on the security, for example, past price movements and trading volumes.

This means that any attempt to analyze this data will not yield results for the investor as it is already publicly available and incorporated in the share prices. Such a signal is available to all and is thus not valuable to a single investor. “Charts” and other technical analyses that rely on past prices alone are fruitless. Can technical analysts profit from trading on past trends? Overall, the evidence indicates hat investors cannot consistently earn abnormal profits using past prices or other technical analysis strategies in developed markets.

Some evidence suggests, however, that there are opportunities to profit on technical analysis in countries with developing markets, including China, Hungary, Bangladesh, and Turkey. Semi-strong form. This asserts that the current price of the security reflects, not only the information contained in past prices, but all public information. Such public information includes “fundamental data” on the firm, such as financial statements, product lines, management, and earnings forecasts.

This means that “fundamental analysis” is also fruitless for the investor who wants to “beat” the market by analyzing the fundamentals of the firm that has issued the security in question. Researchers have examined many different company-specific information events, including stock splits, dividend changes, and merger announcements, as well as economy-wide events, such as regulation changes and tax rate changes. The results of most research are consistent with the view that developed securities markets might be semi-strong efficient.

But some evidence suggests that the markets in developing countries may not be semi-strong efficient. . 3. 3. Strong-form. This asserts that security prices reflect all information relevant to the firm, including information available only to insiders such as managers. Thus, no investor will be able to consistently find under-valued securities. A strong-form efficient market also means that prices reflect all private information, which means that prices reflect everything that the management of a company knows about the financial condition of the company that has not been publicly released.

However, this is not likely because of the strong prohibitions against insider trading that are found in most countries. If market is strong-form efficient, those with insider information cannot earn abnormal returns. Researchers test whether a market is strong-form efficient by testing whether investors can earn abnormal profits by trading on nonpublic information. The results of these tests are consistent with the view that securities markets are not strong-form efficient; many studies have found that abnormal profits can be earned when nonpublic information is used.

Discussion question Does strong-form efficiency also imply weak-form efficiency? Let us summarize the MME using figure 8. 1 . Below, which shows the three sets of information:

Figure 8. 1 : Information sets for the OHM history of price movements and trading volumes. The semi-strong set includes the weak-form, plus all publicly available information. The strong-form set includes the weak-form, the semi-strong form, plus insiders’ information. The direction of valid implication is that a market that is efficient in the strong sense is also efficient in both the semi-strong and weak-form.

The reverse is not valid, that is security prices may reflect all past data ( weak-form efficiency ), but may not reflect relevant fundamental data ( semi-strong efficiency ).

8. 4. Implications of market efficiency. In an efficient market no group of investors should be able to consistently beat the market using a common investment strategy.

Thus, : 1 . Equity research and valuation would be costly and of no benefit,

2. Investors should follow a “passive investment strategy”. This is the selection of securities by indexing to the market, with little information costs.

An efficient market does not imply that:

1 . Security prices cannot deviate from true value. The only requirement is that the deviations be random and unpredictable.

2. No investor can “beat” the market at any time. Actually, there is a 50-50 chance of beating the market at any one time. Given these implications, you will appreciate why we still have room for portfolio managers, who are constantly managing the portfolios of firms and individuals. In this regard, let us look more closely at technical analysis. Technical analysis.

This is the search for recurrent and predictable patterns in security prices. Technical analysts are therefore not surprisingly known as “chartists” because they study records and chart the movement of security prices on a daily basis, hoping to find patterns that they can exploit to make a profit. Investors using technical analysis attempt to profit by looking at patterns of prices and trading volume. Although some price patterns persist, exploiting these patterns may be too costly and, hence, would exists. With so many investors examining prices, this pattern will be detected.

If profitable, exploiting this pattern will eventually affect prices such that this pattern will no longer exist; it will be arbitraged away. In other words, by detecting and exploiting patterns in prices, technical analysts assist markets in maintaining weak- form efficiency. Does this mean that technical analysts cannot earn abnormal profits? Not necessarily, because there may be a possibility of earning abnormal profits from a pricing inefficiency. But would it be possible to earn abnormal returns on a consistent basis from exploiting such a pat- tern?

No, because the actions of market participants will arbitrage this opportunity quickly, and the inefficiency will no longer exist. Fundamental Analysis Fundamental analysis is the examination of publicly available information and the formulation of forecasts to estimate the intrinsic value of assets. Fundamental analysis involves the estimation of an asset’s value using company data, such as earnings and sales forecasts, and risk estimates as well as industry and economic data, such as economic growth, inflation, and interest rates.

Buy and sell decisions depend on whether the current market price is less than or greater than the estimated intrinsic value. The semi-strong form of market efficiency says that all available public information is reflected in current prices. So, what good is fundamental analysis? Fundamental analysis is necessary in a well-functioning market because this analysis helps the market participants understand the value implications of information. In other words, fundamental analysis facilitates a semi- strong efficient market by disseminating value- relevant information.

And, although fundamental analysis requires costly information, this analysis can be profitable in terms of generating abnormal returns if the analyst creates a comparative advantage with respect to this information. Event Studies A common empirical test of investors’ reaction to information releases is the event study. Suppose a researcher wants to test whether investors react to the announce- meet that the company is paying a special dividend. The researcher identifies a ample period and then those companies that paid a special dividend in the period and the date of the announcement.

Then, for each company’s stock, the researcher calculates the expected return on the share for the event date. This expected return may be based on many different models, including the capital asset pricing model, a simple market model, or a market index return. The researcher calculates the excess return as the difference between the actual return and the expected return. Once the researcher has calculated the event’s excess return for each share, statistical sets are conducted to see whether the abnormal returns are statistically different from zero

The Event Study Process

1. Identify the period of study.

2. Identify the stocks associated with the event within the study period.

3. Estimate the expected return for each company for the announcement date.

4. Calculate the excess return for each company in the sample as the actual return on the announcement date, less the expected return.

5. Perform statistical analyses on the a semi-strong efficient market, share prices react quickly and accurately to public information.

Therefore, if the information is good news, such as better-than-expected earnings, one would expect the company’s shares to increase immediately at the time of the announcement; if it is bad news, one would expect a swift, negative reaction.

If actual returns exceed what is expected in absence of the announcement and these returns are confined to the announcement period, then they are consistent with the idea that market prices react quickly to new information. In other words, the finding of excess returns at the time of the announcement does not necessarily indicate market inefficiency.

In contrast, the finding of consistent excess returns following the announcement would suggest a trading opportunity. Trading on the basis of the announcement that is, once the announcement is made would not, on average, yield abnormal returns.

Active versus Passive Portfolio Management.

As we have seen, the MME implies that technical analysis has no merit. The proponents of the MME recommend a passive investment strategy. In this strategy, the investors establish a well-diversified portfolio without any attempt to identify over-valued or under-valued securities.