The Strong Form of Efficient Market Hypothesis - Essay Example

The Strong Form of Efficient Market Hypothesis The concept of efficiency is very important and integral to the field of finance. The term efficiency primarily refers to a market where relevant and useful information remains within the confines of the price of financial assets. However, some economists use the term to refer to operational efficiency, particularly on the manner in which allocation of resources facilitate efficient market operation. Drawing from simple macroeconomics, a sufficiently competitive capital market means that investors may not achieve superior returns for their strategic investment. This evaluation may seem too obvious to day, but prior to the efficient market hypothesis in the 1900s, it was not so self-evident. In recent times however, the Efficient Market Hypothesis is subject to critical re-examination and trial in the paradigms of financial market research (Russel and Torbey, 2001:27). Primary evidence shows that the initial confidence of the concept of Efficient Market Hypothesis is misplaced. According to observations, Efficient Market Hypothesis based financial equilibrium models do not depict the actual trading operations in the world. Indeed, numerous inconsistent results and anomalies require refinement of the current paradigms. This paper presents a critical analysis on the validity of Efficient Market Hypothesis strong form based on existing evidence. Within the realms of finance, Efficient Market Hypothesis reiterates that there is efficient information in financial markets, that assets traded in the financial markets such as bonds, property, or stocks, reflect all the known and relevant information. In this regard therefore, there is no bias since the information present reflects the collective beliefs of involved investors concerning future expectations and prospects. The Effective Market Hypothesis states that in a financial market with effective information, it is impossible to outperform that market using known information, with the exception of lack (Palan, 2011:24). According to the hypothesis, news or information refers to anything capable of affecting the current market prices, and that such information is currently unknown presently and only appears in the future randomly. There are several assumptions pertaining to the Efficient Market Hypothesis. First, the agents must have rational expectations insofar as normal utility maximizing agents are concerned. Moreover, the average population is correct despite the possibility that all are wrong, and also that agents appropriately upgrade their expectations whenever new and relevant information appears. It is clear that agents must not necessary be rational, which is very different from their rational expectations. Rational agents tend to act cold in pursuit of their goals. Efficient Market Hypothesis accommodates the investors’ overreaction and under reaction of when they face new information. However, the reaction of the investors must be random and adhere to a normal distribution pattern such that the net market price effect is not reliable for exploitation to produce abnormal profits, with emphasis on transaction costs such as spreads and commissions. Therefore, an individual in the market (and indeed all individuals) may be wrong, but the market in its entirety is right. There are three common forms of Efficient Market Hypothesis: weak form, semi-strong form, and the strong form (Chandra, 2006:427). This paper emphasizes on the latter and its implication on the functionality of the market. In the strong form efficiency, the share prices reflect all the relevant information thus no person can benefit from excess returns. Additionally, legal barriers controlling private from publicity such as insider trading laws, makes the strong form efficiency impossible. Nonetheless, studies indicate that the stock market in the United States operates on inside information. To test accurately for the efficiency of the strong form hypothesis, a market must exist where the investors cannot benefit from consistent excess returns over a long trading period. The price of securities reflects all relevant information, including private information. Economists have been able to provide sufficient evidence that indeed insiders gain from trading on information not incorporated into the prices of securities, thus the strong form does not hold waters in the financial market with uneven playing fields (Chandra, 2006:429). The Efficient Market theory was the theoretical basis for majority of research in the financial markets during the 1970s and 1980s. The prices in the market seem to adhere to a random walk model, and predictable variations in returns on equity presumed statistically insignificant. Studies in the 1970s focused on prediction of future prices from past statistics, while those in the 1980s incorporated forecasting based on various variables such as price to earnings ratio, term structure variables, and dividend yields. Studies in the 1990s focused on inadequacies resulting from current asset pricing strategies and models. Efficient Market Hypothesis gave rise to a plethora of research and studies that focused on stock market reaction to public announcements such as stock splits, earnings, capital, divestitures, and takeovers. Judgment on the relevance of information was based on the association of market activity and particular events (Russel and Torbey, 2001:27). General results showed that the prices of securities adjusted to ne information, an inference consistent with the strong form efficiency. Nonetheless, there are no universal definitions of important terms such as economic value, abnormal returns, or the null hypothesis of market efficiency. The critical and cautious studies approach of the eighties and nineties followed the euphoric research of the seventies. Researchers raised critical questions such as Do the price movements directly result from announcement. Do announcements really have an impact of prices? Could there be some other factors affecting prices apart from announcements? Some economists such as Roll argued that individual stock price movement does not necessary relate to public announcements. Another analysis of the aggregate stock market shows that there is limited, if any, relation between the public announcement and aggregate market movement (Palan, 2011:31). Recent analysis of returns determinants in five countries by Baker and Haugen shows that among all factor related to macroeconomic variable sensitivity, none was an important determinant insofar expected stock returns were concerned. Such accumulating evidence shows that experts can predict stock prices with some degree of reliability. However, there are two competing explanations and opinions on the issue. Enthusiasts of the Efficient Market Hypothesis claim that such predictability is a product of different expected returns equilibriums generated from rational pricing in efficient financial markets, which are compensating for level of risk undertaken. On the other hand, critics of the Efficient Market Hypothesis counter argue that such predictability reflects the social movements, nose trading, psychological factors, and fads and fashion of irrational investors in speculative markets (Huberman and Regev, 2001:387). The query about the predictability of returns actually represents expected returns variations or results from deviations of irrational speculation from theoretical principles provided the foundation for intellectual enquiries over the past few decades. The reports from previous financial market research provide evidence against Efficient Market Hypothesis, especially after various anomalies became apparent in the capital market, such as the January effect, the Monday effect, seasonal effects, small firm effects, price-to-earnings ratio, and distressed securities market among others. On the January effect, Kinney and group provided evidence that January had higher mean returns than all other months. The economists used New York Stock Exchange for the period 1904 to 1974, finding that the average return rate for January was 3.48 percent compared to 0.42 percent for the other months (Rabin and Thaler, 2001:226). Other researchers follow pursuit reporting similar findings in other countries and other forms of securities such as bonds. Moreover, the researchers found that since 1986, the January effect has been growing stronger. According to an analysis by French, stocks daily returns for Mondays tends to be negative but become positive in the other weekdays. French notes that these negative effects are results of the weekend effect but not the general closed-market effect. Therefore, a trading strategy would be to buy stocks on Monday and sell on Friday, a profitable case. There are numerous documentations regarding the turn of the month and holiday effects across many countries. According to some researcher, the stocks returns in many countries are higher as the month turns, which is between first two and the last days of a month. Other researchers show that on average, the returns are higher a day prior to the turn of a holiday than any other days (Rabin and Thaler, 2001:220). This seasonal effect is among the most consistent and oldest seasonal regularities in financial markets. Apart from the anomalies in the capital market, the criticism of Efficient Market Hypothesis has been the result of volatility tests, noise trading, and fads. Volatility tests primarily test the rationality of market behaviour by examining the relationship between share price volatility and the volatility of fundamental variables that may affect the prices of shares. Leroy and Porter were among the first economists to apply the tests in bond markets, and others followed in stock markets. Their results showed that there were significant volatilities in both the bond and stock markets. The researches inferred the actual price fluctuations greater than the implications by fundamental variables changes that affect prices as waves or fads of pessimistic or optimistic market psychology (Russel and Torbey, 2001:27). Yet another economist did a test for the relationship between economic activity and stock return volatility, reporting that the returns of financial assets increased during recessions. This suggests that during recessions, operating advantages increase. Further, the researcher found that during periods of that a firm’s existing capital is less than the proportion of new debt issues to equity issues, there was an increase in volatility. Nonetheless, none of the factors presents an explanation on the time-varying volatility eminent in stock markets. Summers and group argued that there are two common types of market investors: rational speculators who base their trade on information, and noise traders who base their trade on imperfect information. Noise traders primarily act on imperfect information, thus they make affect the prices by offsetting the equilibrium values. On the other hand, rational speculators (arbitrageurs) play important roles in stabilizing prices (Palan, 2011:45). As they dilute such price shifts however, they do not get rid of them completely. In this regard therefore, two risks limit arbitrage: unpredictability of resale prices in the future, and fundamental risks. The limits to arbitrage therefore mean that the prices of securities do not respond to information only but also to sentiments and expectations not justifiable by information. Another important observation is that the trading strategies of investors, such as trend chasing, provides sufficient evidence that their decision-making focuses on noise instead of rational information evaluation. This presumption receives further support from financial analysts who put enormous effort in predicting changes in sentiments of others investors as well as changes in fundamentals (Huberman and Regev, 2001:390). From a rational point of view, these predictions make no sense if indeed the prices respond to fundamental news rather than the demands of investors. Critics of the Efficient Market Hypothesis at times cite inexplicable market movements based on conventional stock-price determination theories. This class of theories is the alternative theory, or behavioural finance. The studies on Efficient Market Hypothesis undoubtedly make significant contributions on how the society understands the securities market. However, reports from researches and studies show that majority of the experts are discontent with the theory. Recent surveys show that criticism for Efficient Market Theory is gaining momentum with time. Without a doubt, markets respond to new information, but other variables also affect the valuation of securities. Recently, critics were able to provide a small list of investors who outperformed the market over long duration, such that it is inappropriate to attribute such success to luck, including Warren Buffet, Peter Lynch, and Bill Miller. From such observations and evidence, it is therefore correct to conclude that the strong form of Efficient Market Hypothesis is not valid (Bierman, 2010:276). This assumption receives further support from anomalies in the security markets, as well as concepts such as results of volatility tests, noise trading, and fads. Bibliography Bierman, H., 2010. An Introduction to Accounting and Managerial Finance: A Merger of Equals. Hackensack, New Jersey: World Scientific Publishing. Chandra, P., 2006. Financial Management. New Delhi: Tata McGraw-Hill Education. Huberman, G. and T. Regev, 2001. Contagious speculation and a cure for cancer: A nonevent that made stock prices soar, Journal of Finance 56, 387 396. Palan, S., 2011. The Efficient Market Hypothesis and its Validity in Today’s Market. Munich: Grin Verlag Publishing. Rabin, M. and R.H. Thaler, 2001. Anomalies: Risk Aversion," Journal of Economic Perspectives 15, 219-232. Russel, P. and Torbey, V., 2001. The Effective Market Hypothesis: A Survey. Available from: http://www.er.ethz.ch/teaching/EFFICIENT_MARKET_HYPOTHESIS_Russel-Torbey.pdf [Accessed March 27, 2012] Read More