Efficient Market Hypothesis

The primary principle upon which modern portfolio theory is based is the Efficient Market Hypothesis, which states that the movement of asset prices follows an unpredictable path. This hypothesis has three forms.

Weak Form

The weak form states that security prices reflect all information about price and trading behavior in the market. Therefore, an examination of a security’s or market’s past price history, volume of trading, short sales outstanding, and so forth, contains no information that enables predictions of future price movements to be made. In other words, charting and other forms of technical analysis do not work.

Semistrong Form

Under the semistrong form, the markets react quickly to new public information, whether it relates to the trading of securities (weak form) or “fundamental” information such as earnings, financial ratios, news announcements, and so forth. This means that examining the historical financial data pertaining to a company and its relationships with other variables provides no information that would enable an investor to make superior predictions about the future price movements of the security. Extrapolation of technical price trends or fundamental earnings, dividends, and financial ratio trends, will be of no use in gauging the future performance of a security.

Strong Form

The strong form assumes that all relevant information about a company, from both public and private sources, as well as the implications that can be drawn from this information is already imbedded in the price of a security. Only new information produces systematic price changes and the impact of this information on security prices is essentially instantaneous. Since new information enters the marketplace randomly, asset price movements are random.

Efficient Pricing Structure

The Efficient Market Theory states that marginal buyers and sellers set asset prices in the market. Yet these buyers and sellers are motivated by various factors – some are based on fundamental analysis, some are based on emotion, and others are based on personal circumstances. There is no fundamentally objective value in the market. Thus, prices are set by supply and demand. The market is not efficient in the sense that it prices securities “correctly.” It is efficient in that there is just as good a chance of earning more, as there is earning less, than the expected return on an investment and that returns are proportional to the risks taken.

Specifically, what an efficient capital market requires is that it is information efficient, meaning that all current prices of securities reflect all known information and that they adjust rapidly to the inflow of any new information. There are arguments that support the concept that the capital markets should be efficient.

• Large numbers of market participants are engaged in the process of attempting to maximize their profits by finding the best values and investing in them. Furthermore, these participants complete their analyses independent of each other.

• New information enters the market randomly.

• Security prices adjust rapidly to new information. Furthermore, this adjustment is unbiased – the market may not correctly gauge the effect of new information, but it is just as likely to overvalue as undervalue it. Therefore, on average, the market’s assessment of information is correct.

• The expected returns implicit in security prices should reflect the risks that are inherent in securities.

Tests of Market Efficiency

• Charts and Technical Trading Rules: No meaningful performance returns. (Confirms weak form.)

• Event Studies: Predictable performance trends surrounding a market event (stock split, public offering, merger, dividend increase, quarterly earnings reports, or takeover.) Suggests “leakage” of information, but pattern of trading quickly returns to normal.

• Dividend Yield Studies. Attempted to determine whether or not the stock market performed better when its dividend yield was abnormally high (indicating that stocks were relatively cheap), than when its dividend yield was abnormally low (indicating stocks were relatively expensive). The studies found that these measures were useful in timing the stock market, and refuting the semistrong EMH.

• Quarterly Earnings Surprise Anomaly. Studies found that when companies report much better or much worse earnings than expected, their stock prices advance or decline more than would be expected based upon their betas, refuting the EMH.

• January Anomaly. Small company stocks do particularly well in January with 50% of there abnormally positive returns occurring during the first few trading days of the month. This is usually due to tax loss selling in November and December causing stocks that were sold for tax loss reasons to rebound in January. This effect does not seem to be strong enough to overcome trading costs.

• Insider Trading. Tests for the strong form of EMH have examined the performance of four special groups: insiders, specialists, analysts, and money managers. Insiders and specialists who are privy to non-public information have been able to generate abnormal returns. However, analysts and money managers are not able to consistently beat the market.

The tests of the efficient market hypothesis suggest that the market might not be perfectly efficient, but it is highly efficient. While some anomalies exist, many of them are not exploitable because the cost of doing the research to implement them and the extra trading costs and taxes that they generate substantially reduce the ability to earn above-average returns.

EMH Exercise

Below are the top ten hedge funds as of last June. (See http://online.wsj.com/public/resources/documents/BA_HedgeFund50_071001.pdf ) Do these data argue for or against the EMH?