Efficient Market Theory - Essay Example

? Efficient Market Theory Introduction “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”, and such market is called efficient market. Efficient Market Hypothesis postulates that stocks will always be traded at fair value, meaning all the factors both positive and negative are fully factored in the stock prices at all times. Any information, whether published or insider, will reflect in the prices instantly. This hypothesis presupposes that there is no question of under or overvaluation in the market and it is impossible to outperform the market by making abnormal profits in the stock exchanges. It is also pertinent to note that higher returns are associated with higher risks, and the factors affecting performance of a stock could vary from political risks, acquisitions and mergers, crisis of various sorts to fluctuations in other markets, and it may be difficult for the market forces to adjust to the impact of these factors instantly. Objectives This paper seeks to study and analyze the secondary sources with reference to the following questions relevant to efficient markets theory: 1. Is the Efficient Market theory true? 2. Is there any need for technical or fundamental analysis in efficient markets? Efficient Market Theory If beating the market is impossible, how come Warren Buffet is consistent in outperforming the market? There are so many mutual fund and portfolio managers giving consistent performance in the stock markets, which is not possible according to this theory. There is always scope for outperforming the markets thorough experience, expertise, intuition and discipline. The efficient market is an ideal situation which is hardly achieved in the real life. For example, Muhammad, N. M. N. and Rahman, N. M. N. A. (2010, p. 35) writes “EMH states that security prices fully reflect all available information and will immediately adjust to the arrival of new information (Adam, 2004). However, since market was closed on both Saturday and Sunday, it was argued that investors cannot do anything with the market even though they got some information during the weekend”. The equilibrium in the market is always disturbed by so many factors including psychological factors such as over confidence of the investors or over reaction to the market forces. Sharma, A. (2009, p. 37) states “Various studies have been conducted worldwide on stock market reaction to public announcements. Market’s reaction to such publicly available information is very swift. Inefficiency in the market exists when investors envisage such information before it is formally announced and earn abnormal returns”. Greed and fear are the motivating forces of the markets many a times, and rational approach to the investment or trading takes the backseat. Sudden crashes in the markets are nothing to do with fair value, and the market sentiments driven by so many factors rudely shakeup the very fundamental concept of this theory. Consequently, the question of under or overvaluation to the stock arises in the markets. Park, A. (2010, p. 365) states that one of the implications of the weak-form EMH is that prices are submartingale, or, more loosely, they are a random walk. Consequently, a so-called technical analysis, which is the extraction of information about the future movement of prices from past prices, should have no merit. In real life situations, perfect efficiency in the market place is unrealistic, and it also depends upon accuracy of the information, cost of the information, the efficiency of the information transmission and the risk-return reward in taking decisions based on the information. Livanas, J. (2006, p. 28) argues how can the market be efficient when investors seem to make decisions that perhaps are rational – but only within bounds? When the investors make decisions in an irrational manner, which is in line with the human behavior, it will be difficult to rely on a hypothesis based on the two conditions: The market uses all the information available and the market participants understand all the implications of this information which are at the heart of the hypothesis, as the market efficiency theory is founded on these principles. Market efficiency and the need for analysis The efficient market conditions provide information with regard to investment options, and everybody has access to reliable information. The results of a study by Mittal, S. K. and Jain, S. (2009, P. 27) “show that the anomalies do not exist in the Indian Stock Market and this market can be considered as informationally efficient. It means that it is not possible to earn abnormal returns constantly that are not commensurate with the risk”. Even under these circumstances, an investor needs to analyze the information on a scientific basis to find out the justification for the current prices for predicting the future performance by adopting different tools or techniques. Technical analysis and fundamental analysis are the two main types of analyses used with reference to stock market analysis. Whether the market is efficient or not in relation to a particular stock is revealed only on an analysis, which provides an opportunity to enter into the stock based on fundamental or technical factors related to the stock, industry and the overall market Fundamental Analysis As the name suggests, the analysis is with reference to the fundamental factors related to the company that influence price of the stock and considered as the cornerstone of the investment decisions. It is believed that the strengths and weaknesses in respect of a stock will ultimately reflect in the valuation of a stock irrespective of the technical aspects related to a stock which are governed by several factors including demand and supply phenomenon. It involves the quantitative analysis of the financial statements, particularly income statements, balance sheets and the cash flow statements of the companies taking into account the qualitative aspects underlying the functioning of the company. Also, comparison of a company’s performance with the competitors’ and the industry average and the market share of the company may reveal the strengths and weaknesses of the company. In respect of certain qualitative factors, computation of its impact on price level may not be possible. Nevertheless, the qualitative factors such as Management quality, labor relations, the level of competition, business model, technological advantages (or disadvantages), research and development, regulatory compliance, Corporate Social Responsibility (CSR) policies can’t be overlooked in an analysis. Analysis of trends based on the financial statements over a period of time gives an indication to the investor about the growth prospects of the company in future. The analysis with reference to the financial statements is important with regard to the following: Balance sheet The capital structure of the company is very important and over leveraging could pose a serious problem at the times of recession. Efficiency in the utilization of the assets is very crucial for growth and current ratio in line with the industry norms reflects the financial stability of the company in relation to its current operations. Profit and loss account Increase in sales and operating margins, which reflect the profit fundamentals, may augur well for the growth of the company. Cash flow statement Increase in cash reserves and free cash flow signifies the ability of the company to repay the debts, possible distribution of profits, embark on buyback program or pursue growth and expansion plans with internal accrual. Apart from the analysis based on the financial statements, the Directors report, Auditors report and the notes to the financial statements may include crucial information such as the comments on performance, plans for future, opportunities and threats to the business in future, the opinion or reservations of the auditors in respect of the financial statements, change in accounting methods and other disclosures by way of footnotes. Fundamental analysis techniques The application of the techniques may vary for growth stocks, value stocks or income stocks. One can apply several tools for the fundamental analysis of the financial statements, which also vary according to type of business or industry, and the following are commonly used by the analysts. Growth rates: Earnings per share (EPS), Price Earnings ratio (P/E) Financial strength: Debt Equity Ratio, Quick Ratio Profitability: Operating Profit Margin, Net Profit Margin Efficiency: Assets turnover, Receivables turnover, Inventory turnover Management effectiveness: Return on assets, Return on Investment, Return on equity Dividends: Dividend payout ratio, Dividend yield It has been accepted by many professionals that the long term investment based on fundamental analysis give superior returns over a period of time. For example, based on a study conducted, Stanley, D. J. and Samuelson, B. A. (2009, p. 191) state that the results of the study are in line with others clearly indicating the superior performance of low price multiple investing for wealth maximization. Technical Analysis Technical analysis is concerned with the price movements, and it is believed that all the factors relating to the value of the stock is inevitably factored into the price and the extrapolation of the movement into future is attempted by the analysts, also known as chartists. ‘Trend is my friend’ is the approach, and the study is grounded on market sentiments and nothing to do with fundamentals. Also, it is believed that the trends follow certain patterns or cycles. There are limitations to this analysis, but useful in predicting the movements of bullion, currency, commodities or other instruments based on historical trading data. The charts may be line, bar or Japanese candlestick type. Unlike Bar chart, Candlestick chart gives direction. Candlestick Chart Note: Black candle indicates that the closing price (right bottom of candle) is lower than opening, white vice-versa (right top of the candle) and the upper and the lower tails represent high and low respectively. Trend lines representing the trends are drawn, and are useful in predicting the resistances in the upward price movement and supports available in the downtrend. Trend lines are also useful in identifying the breakout or trend reversals. Fresh buying emerges at the support level; similarly selling at resistance level and the trend lines are treated as psychological barriers in the price movements. Once these barriers are breached on either direction, the stocks will have a tendency to moves in the same direction (continuation pattern) beyond these levels, and the earlier level of resistance for the uptrend becomes the support level on reversal of the uptrend. Uptrend with good volumes indicates that there is potential for the stock to go higher. Trend reversals supported by good volume compared to the average volume during the period confirms the reversal. Deterioration in volume signifies weakness in the trend, up or down as the case may be. There are several indicators such as Rate of Change (ROC), Relative Strength Index (RSI) Stochastic Oscillator and Moving Average Convergence Divergence (MACD) giving signals for taking buy or sell decisions. Sometimes several indicators may give contradictory signals. Therefore, experience and skill in the interpretation of the indicators on the part of the chartist is important for its effective use in predicting the trends. Conclusion Risk is always associated with investment. According to Das, A. (2010, p. 17) “In the strict form, an efficient market is an idealized system. In actual markets, residual inefficiencies are always present. Investors over react, under react and make irrational decisions based on imperfect data” Though various information related to a stock are factored in the market price, the perfect and efficient market conditions are difficult to achieve in practice. Analysis of the information available is prerequisite in buying and selling in relation to trading or investment in stocks to minimize risk. The information could be efficiently analyzed through fundamental or technical analysis or both by adopting different techniques as may be required. References Das, A. (2010) MARTINGALES, EFFICIENT MARKET HYPOTHESIS AND KOLMOGOROV’S COMPLEXITY THEORY: A NOTE, Allied Academies International Conference, Academy of Accounting and Financial Studies: Proceedings. Volume 15, Issue 1, pp. 15-20. Livanas, J. (2006) How can the market be efficient if investors are not rational? Finsia - Financial Services Institute of Australasia, Issue 2, pp. 24-28. Mittal, S. K. and Jain, S. (2009) STOCK MARKET BEHAVIOUR: EVIDENCES FROM INDIAN MARKET, Management Development Institute, Volume 13, Issue 3, pp. 19-29. Muhammad, N. M. N. and Rahman, N. M. N. A. (2010) Efficient Market Hypothesis and Market Anomaly: Evidence from Day-of-the Week Effect of Malaysian Exchange, International Journal of Economics and Finance, Volume 2, Issue, 2, May 2010, pp. 35-42. Park, A. (2010) Experiential Learning of the Efficient Market Hypothesis: Two Trading Games, Journal of Economic Education, Volume 41, Issue 4, pp.35-369. Sharma, A. (2009) Impact of Public Announcement of Open Offer on Shareholders Return: An Empirical Test for Efficient Market Hypothesis, IUP Journal of Applied Finance, Volume 15, Issue 11, pp. 37-51. Stanley, D. J. and Samuelson, B. A. (2009) The Efficient Market Hypothesis, Price Multiples, and the Australian Stock Markets, Journal of Global Business Issues; Spring 2009; Volume 3, Issue 1, pp. 183-192. Read More