Stock Markets Efficiency in the Efficient Market Hypothesis - Essay Example

? THE STOCK MARKETS ARE EFFICIENCY ACCORDING TO THE EFFFICIENT MARKET HYPOTHESIS by Department Stock markets are critical players in the economic makeup of various social groupings, necessarily so due to their controlling factor of economic activities globally. Often varying skeptics have complained over their irrational exuberance, with enthusiasts often responding back by alluding to the Efficient Markets Theory. The theory holds that an unregulated market is better equipped towards assessing the prospects of economic opportunities, than any other variable. This is based on the ideal of ‘a balancing act’, where markets are regarded as knowing the best means forward. However, skeptics of the above, view markets as being necessarily inefficient due to the various forms of risks involved. The reasoning behind the aforementioned theory is that a free and competitive market arena does place various pricing indices to their true basic values. Lo (2007), provides that the Efficient Markets Hypothesis (EMH) does showcase the fact that market pricing indices do fully reflect all available data. This however does not eliminate critique, especially from behavioral economists and psychologists, who view it as being founded on assumptions which are counter-factual, especially with regard to human behavior/ rationality. A distinction is made between technical and fundamental analysis of stock pricing indices. The former, entails the utility of volume charts and geometric patterns in pricing, towards forecasting a given security’s future price fluctuation. The latter on its part, is concerned with the utility of both economic and accounting data, towards determining a given share’s fair valuation. Pegged on this assumption is the fact that as the existing market enhances overall efficiency, so does the price sequencing become completely unpredictable and random (Lo, 2007:17). As Shiller (2013) provides, though humanity continues being influenced by past global occurrences in the market arenas, this does not in any way remove the presence of existing market anomalies. The fact that the South American state of Colombia continues experiencing a real-estate bubble, which is ongoing, is representative of the volatility of the current market sector. With its real-estate pricing index rising by 69%, in terms of inflation-adjusted calculations, it provides a crucial insiders’ view of how market inefficiency continuously evolves. Rationality in individuals’ participation in various economic bubbles is educated by amongst others, the price increases as a result of the prevailing psychological contagion. It is this fundamental human aspect, which promotes a given mindset of justifiable price increases, thereby spurring fervent market activities. Due to the inherent nature of economic bubbles being socio-psychological phenomena, they are hence difficult to manage and control. Even with the presence of government regulation, there is only a reduction in overall occurrence and effects of the same, though this does not necessarily mean they will not recur (Shiller, 2013:45). To be noted is that public fear of the bubbles and their effects, does in some way, promote the aforementioned psychological contagion, which is critical in spurring market excitement and enhanced activities. These are vitally more pronounced as being episodes of speculative epidemics, where growth and attraction of investors is slow, with the assumed end not being easily tangible and/ verifiable. A fundamental of the economic market, would be its ideal of rationality, where even the best of individual behaviors is unable to engage in strategic implementation of less-risk, greater consistency economic activities (Shiller, 2013). Thus, with the constant failure of even the best in ever outsmarting the market provides a case example of the aforementioned notion of the market knowing best. However, this does not exactly hold true, due to the inherent nature of arbitrage, which is fundamentally risky. Such, refers to the bets against the mispricing of securities, with the reasoning being that the prices will ultimately converge to the true values. The prevailing nature of risks associated with market dynamism, portends to the fact that a free, competitively anchored market is not necessarily efficient (Shiller, 2013:23). As Schleifer (2000) inputs, this is rooted in the fact that while some risks present, are easily hedged, the majority cannot. Fundamentally, this is due to the risky nature of rational arbitrage, which is innately limited in its capacity to set prices to their true valuation indices. When an inefficient market arena becomes more inefficient, even the smartest of investors do loss a lot of money, as is exemplified by prevailing nature of Shell and Royal Dutch share price indexing. Best showcasing this would be the aftershocks of the Russian crisis, when Long Term Capital Management collapsed. Such inefficiency, with regard to the aforementioned pricing, proved an embarrassment, especially for the hypothesis founded on the Efficient Markets Theory aforementioned. This was due to the setting providing the best example of the theory, where both entities, though merged, had their shares tagged at given indices, therefore making it easier for their tracking and leveraging. While the same shares were to ideally sell at the same prices, within different market arenas, the lack of such consistency provides a clue as to the prevailing aspect of markets deviation (Schleifer, 2000:34). Such deviations, it is portended, can in a majority of cases, be persistent and large-scale, especially in case scenarios where there exists no forms of catalysts to counter the inefficiency present. Thus, as mispricing occurs, money is often lost, due to the prevailing nature of market forces not being strong enough to set standardized pricing indices. Even with the presence of various risks being hedged, this does not provide enough incentives for greater control of prevailing market arenas. Thus, due to the fact that arbitrage as a whole, is a risky affair, provides clear examples of the lack of overall market efficiency, thereby providing contexts in which mis-valued market shares can easily become even more greatly mis-valued. Due to the prevailing nature of inefficiency, it is only through active investment management that such irregularities may be managed effectively. This is through Contrarian strategies, which fundamentally are based on the bet against market shares’ general mispricing (Lo, 2007:45). Their long-term positive performance is even better than current systems of share price indexation. This is best exemplified by the prevailing nature of value stocks constantly outperforming growth stocks, over long durations of time in both European and American markets. However, due to the volatile aspect of markets, such strategies are intrinsically risky. This does not in any way portend to the fact that as a result of their risky and inefficient nature, government regulation is effective. Rather on the converse, there are many beneficial outcomes from the irrationality of markets, just as there are many negative outcomes. An example would be the internet boom, where financing from exuberant investors played a role in its wide-scale extension. Without the boom, millions of American citizens would not have been able to benefit from the market fluctuations. It is only through a paradigm shift that evolutionary ideals can be encompassed within the financial mainstream, especially as based on past experiences and historical occurrences. Risk preferences are as such, fundamentally influenced by the particular routes taken by the prevailing market price indices. These are influenced significantly, by the three core components vital for any form of market equilibrium i.e. preferences, probabilities and prices (Schleifer, 2000:34). In conclusion, speculative bubbles, which often result in untold forms of crises, do appear in various case scenarios. This is especially so, as influenced by various stories portraying a given jurisdiction’s economic growth and development, in addition to prevailing social contexts, crucial in enhancing economic output. This is usually followed by a strong narrative, influential enough, to spark a new round of contagion, with regard to investor thinking. Thus, speculative bubbles often are unpredictable, especially with regard to the bursts expected, nor in the nature of their re-emergence. Reference List Lo, Andrew W 2007, ‘Efficient Market Hypothesis.’ In Blume, L and Durlauf S. (2007). The New Palgrave: A Dictionary of Economics, (2nd Ed.). New York: Palgrave McMillan. Shiller, Robert J. 2013, July 17. Bubbles Forever. Project Syndicate: Economics + Business & Finance. Retrieved 2013, Dec. 10 from: http://www.project-syndicate.org/commentary/the-never-ending-struggle-with-speculative-bubbles-by-robert-j--shiller Schleifer, A 2000, Are Markets Efficient? – No, Arbitrage is Inherently Risky. Wall Street Journal. Read More