Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) was first referenced in an academic paper produced by Eugene Fama in 1965. In this work, Fama put forward the idea that in an open and efficient market, security prices are always reflective of all the information available including corporate details for equities, and the state of the economy for currencies and fixed income. For this reason, market prices are always the “correct” price for any given security.

Taking this idea one step further, Fama reasoned that because securities in an efficient market with competitive buyers and sellers always settle at an appropriate level of intrinsic value – that is, the price supported by all the relevant information that could affect the price – there can be no such thing as an over- or under-valued security. Attempts to buy and sell securities in a bid to “out-perform” the market are nothing more than a game of chance with skill having nothing to do with one’s success. Fama refers to this as the Random Walk Theory and expanded on it in a paper published at the Graduate School of Business, University of Chicago in 1970:

For many years, economists, statisticians, and teachers of finance have been interested in developing and testing models of stock price behavior. One important model that has evolved from this research is the theory of random walks. This theory casts serious doubt on many other methods for describing and predicting stock prices behavior-methods that have considerable popularity outside the academic world. For example, we shall see later that if the random-walk theory is an accurate description of reality, then the various “technical” or “chartist” procedures for predicting stock prices are completely without value.^[1]

The Random Walk Theory

The theory of the random walk is based on first accepting that the primary security exchanges as well as the currency and fixed income secondary markets meet the definition of an efficient market. In Fama’s words:

An “efficient” market is defined as a market where there are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.^[2]

Thus, in an efficient market as described by Fama, it is the competition between knowledgeable market participants with full access to current information that ensures market prices represent the true value of the security. Fama acknowledges that intrinsic value can change with new information, and the market, upon absorbing the new information, will adjust the price accordingly:

The new information may involve such things as the success of a current research and development project, a change in management, a tariff imposed on the industry’s product by a foreign country, an increase in industrial production, or any other actual or anticipated change in a factor which is likely to affect the company’s prospects. In an efficient market, on the average, competition will cause the full effects of new information on intrinsic value to be reflected “instantaneously” in actual prices.^[3]

In other words, prices can “wander” as news affecting the security becomes available. This is an important concept and forms the basis of the random walk theory – the premise is that historical prices and trends cannot accurately predict these random changes and this is clearly a shot across the bow of those that engage in the technical analysis of security prices.

Efficient Market Hypothesis – Three Forms

As part his theory, Fama defines three forms that the Efficient Market Hypothesis can take:^[4]

1. Weak Form

States that security prices reflect all historical prices and trade volume information – and any effect this may have on prices – is already factored into the price and has no further effect on future values. Therefore, technical analysis that charts historical performance and looks for trends is of no value in determining future prices.

2. Semi-Strong Form

Contends that all publically available information is readily available to market participants and any effect that this information could have on the security automatically and continuously updates the price. This means that there are no under- or over-valued securities in an efficient market, thus rendering fundamental analysis worthless as a means of identifying buy or sell opportunities.

3. Strong Form

The Strong form goes beyond the Semi-Strong form and states that in addition to all public information, all private information is also fully reflected in the market price so even insider information is useless.

Criticism of the Efficient Market Hypothesis / Random Walk Theory

Most economic theories – certainly those attempting to predict future market values – are open to criticism and the Efficient Market Hypothesis is no exception. The first aspect of the Efficient Markey Hypothesis and Random Walk theories that attracts attention is Fama’s idea of the market being an efficient mechanism that ensures an appropriate intrinsic value is placed on securities within the market.

Many notable economists agree with Fama’s arguments to a point, but feel there are obvious problems with considering open markets as a perfect pricing vehicle. One need only look at the dot com experience of the late 90s and early 2000 or the more recent housing bubble in the U.S. as examples where market prices greatly out-weighed the actual value. This can be partly explained by market psychology and the “herd mentality” where investors scrambled to get in on the next “sure thing”.

This run up in prices is explained by economist Burton G. Malkiel of Princeton University who feels that “while the stock market in the short run may be a voting mechanism, in the long run it is a weighing mechanism. True value will out in the end. And before the fact, there is no way in which investors can reliably exploit any anomalies or patterns that might exist”.^[5]

Malkiel is making a very important distinction here regarding the nature of the markets. In some cases, security values can be inflated and pushed higher because of the “herd mentality” resulting in an unwarranted run up of the price – this is what Malkiel refers to as the markets being a “voting mechanism” in the short term.

However, these prices cannot be supported over the long term and prices will eventually fall back to a more realistic level. This also means that investors could outperform the market by selling out before the price correction, and this runs counter to the Efficient Market Hypothesis. To accept Fama’s theories means to also accept that it is impossible to outperform the market through any kind of investment strategy – if the market price is always “correct”, then there are no over- or under-valued securities with which to realize additional gains.

If this were the case, then any form of active trading strategy will actually return less than the market once you deduct trading fees from any trade profits. Given this, why not simply abandon any form of active portfolio management in favor of a completely passive approach?

The “Semi-Efficient” Market Hypothesis

While various commentators feel there is some merit in Fama’s ideas on market efficiency, the existence of many high-profile anomalies including the U.S. housing bubble noted earlier does seriously question the idea that a completely efficient market can ever exist. Some economists suggest that the best way to describe markets is that there are varying degrees of efficiency with some markets – and even segments within a market – being more efficient than others.

In their study of the Efficient Market Hypothesis, David L. Dowe and Kevin B. Korb from the Department of Computer Science at Monash University in Australia turn to the question of openness regarding financial markets and the ability of all market participants to engage on the same level:

The basic problem ... is that security analysts are very good at interpreting whatever new information does become available and acting on it quickly. The analysts then get the advantage from the new information leaving the insignificant crumbs for the rest of us.^[6]

The findings of Dowe and Korb suggest that a level playing field does not really exist for all investors. Professional traders naturally have a more immediate access to information to most non-professional and this may be the main determining factor that enables some investors to consistently beat the market benchmark returns. There is no guarantee for any trade and luck and good timing certainly can have an effect, but it has been shown consistently that the better informed one is, the greater the likelihood of a successful trading strategy.

References

1. ↑ Random Walks in Stock Market Prices - Eugene F. Fama, 1965
2. ↑ Random Walks in Stock Market Prices - Eugene F. Fama, 1965
3. ↑ Random Walks in Stock Market Prices - Eugene F. Fama, 1965
4. ↑ Random Walks in Stock Market Prices - Eugene F. Fama, 1965
5. ↑ The Efficient Market Hypothesis and its Critics - Burton G. Malkiel, 2003
6. ↑ Conceptual Difficulties with the Efficient Market Hypothesis: Towards a Naturalized Economics - David L. Dowe and Kevin B. Korb, Department of Computer Science, Monash University, 1965

Related Links

Technical Analysis vs. Fundamental Analysis

Leading Indicators