EFFICIENT MARKET HYPOTHESIS (EMH) 1.

0 Introduction Market efficiency is a description of how prices in competitive markets respond to new information. An efficient capital market is one whereby at any given time security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all the available information about the security. Its a market where there are large numbers of rational, profit maximising investors actively competing, trying to predict future market values of individual securities, and where important current information is readily and freely available to all participants. From the above introduction, its clear that the major premise of capital markets is that: there are large numbers of profit-maximising participants analysing and valuing securities, each independently of the others, new information regarding securities comes to the market in a random fashion each generally independent of the others, and

Investors adjust security prices rapidly to reflect the effect of new information.

In an efficient market competition among the many intelligent participants leads to a situation where, at any one time actual prices of individual securities already reflect the effects of information based on both events that have already happened and on events as of now the market expects to take place in the future. This means that in an efficient market at any point in time the actual price of a security will be a good indicator of its intrinsic value therefore there is a fair game with respect to the information set. Investors can be confident that asset prices fully reflect all available information and are consistent with the risk involved. For example if Intel announces that it has invented a new way of manufacturing computer chips that will make computers run 10 times faster at half the cost, and that it will take at least a year to be implemented in all their manufacturing plants. In an efficient market this would imply that the stock prices will immediately rise after the announcement (i.e when the information is available not a year later when the technology is implemented or even later when extra profits are received) 2.0 Forms of market efficiency Eugene Fama, a leading researcher on efficient markets, divided the overall efficient market hypothesis (EMH) into 3 sub-hypotheses depending on the information set involved; (i) Weak Form EMH (ii) Semi-Strong Form EMH and (iii) Strong Form EMH. 2.1 Weak Form EMH The weak-Form EMH assumes that current stock prices fully reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data and other market information.

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It therefore, implies that the past rates of returns and other market data should have no relationship with future rates of return should be independent). You should hardly gain from any trading rule that decides whether to buy or sell a security based on past rates of return or any other past market data. This implies that under this form of market, technical analysis is of no value. 2.2 Semi-Strong Form EMH This form of efficiency asserts that security prices adjust rapidly to the release of all public information. Current prices reflect all public information. It encompasses the weak form hypothesis with its market information such as stock prices, rates of return, trading volume but also includes non-market public information such as earnings and dividend announcements, P/E ratios, dividend-yield, book value-market value ratios, stock splits, news about the economy and political news. Thus investors who base their decisions on important new information after it is public should not derive above-average profits from their transactions, considering the cost of trading, because the security price already reflects all such new public information. This implies that fundamental analysis is of no use. 2.3 Strong Form EMH This form of EMH contends that current stock prices fully reflect all information from public and private sources. This implies that no group of investors has monopolistic access to information relevant to the formation of prices and thus no group can consistently derive above-average profits. That is, no investor can beat the market by generating abnormal profits in the market. The implication of this form is that even insider information is of no use. Private (Non-public) information is held by directors and managers of companies, together with those companies' professional advisors. Much of this information would be "price-sensitive", i.e. likely to have an effect on the price of a company's securities if it was to become known. However, the risk here is that these directors, managers and professional advisors would use their greater degree of knowledge about a company to trade on the capital markets. As they have information that is not generally available, they would have a much better chance of trading successfully. This is known as "insider dealing" and is seen as being a misuse of the capital markets. The strong form encompasses both the weak form EMH and the semi-strong form EMH. In addition, all information is cost-free and available to everyone at the same time. 3.0 Tests and Result of alternative EMHs. 3.1 Weak Form EMH Two groups of tests have been prevalent. The first involves statistical tests of independence between rates of return. The second involves a comparison of risk-return results for trading rules that make investment decisions based on past market information.

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3.1.1Statistical tests of independence There are two (2) major statistical tests that have been used. That is the autocorrelation tests and runs test. The autocorrelation tests These measure the significance of positive or negative changes in returns over time. The question is does the rate of return on day t correlate with the rate of return on day t-1, t-2, or t-3? Several researchers have examined the serial correlations among stock returns for several relatively short time horizons including 1 day, 4 days, 9 days and 16 days. The results typically indicated insignificant correlation in stock returns over time. Recent studies focusing on portfolios of stocks have indicated that the autocorrelation is stronger for portfolios of small stocks. The runs test The second statistical test of independence is the runs test. Given a series of price changes, each price change is either designated a plus (+) if it is an increase in price or a minus (-) if it is a decrease in price. The result is a set of pluses and minuses such as +++-++--++--++. A run occurs when two consecutive changes are the same. Two or more consecutive positive or negative price changes constitute a run. When the price changes in a different direction such as when a negative price change is followed by a positive price change, the run ends and a new run may begin. To test for independence one would compare the number of runs for a given series to the number in a table of expected values for the number of runs that should occur in a random series. Studies that have examined stock price runs have confirmed the independence of stock price changes over time. 3.1.2Tests of trading rules These were developed in response to the complaint that the above statistical tests of independence were too rigid to identify the price patterns examined by technical analysts. Technical analysts felt that their trading rules were too complicated to be simulated by rigid statistical tests. In an efficient market investors should not be able to derive abnormal profits using any trading rule that depended solely on any past market information about factors such as price, volume, odd-lot sales or specialist activity. Investigators instead attempted to examine alternative technical trading rules through simulation. The risk-return results derived from such a simulation, including transaction costs were compared to the results from a simple buy-and-hold policy. 3.2 Semi-Strong Form EMH Studies here can be divided into 2 sets: 3.2.1 Studies to predict future rates of return using available public information

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This involved the use of information such as prices and trading volume considered in the weakform tests. These studies involved either time-series analysis of returns or the cross- section distribution of returns for individual stocks. 3.2.2 Event studies that examine how fast stock prices adjust to specific significant economic events. An outcome would be used to test whether it is possible to invest in a security after the public announcement of a significant event and experience significant abnormal rates of return. 3.3 Strong Form EMH Tests of this form of EMH have analysed returns over time for different identifiable investment groups to determine whether any group consistently received above average risk-adjusted returns. Four major groups of investors have been investigated (i) Corporate insiders (ii) Stock exchange specialists (iii) Security analysts (iv) Professional Money Managers. On the whole the tests generated mixed results, but the bulk of relevant evidence supported the hypothesis. Most notably, the performance by professional money managers who are highly trained full-time investors could not consistently out perform a simple buy-and-hold policy on a risk-adjusted basis. Thus it appears that there is substantial support for the strong-form EMH as applied to most investors.

4.0 Implications of efficient capital markets Numerous studies indicate that the capital markets are efficient as related to numerous sets of information. At the same time, studies have uncovered a substantial number of instances where the market apparently does not adjust rapidly to public information. Given these mixed results, market professionals arm themselves with against the academic onslaught with one or two tools or techniques called fundamental analysis and technical analysis. It is important to consider the implication of the EMH for technical analysts, investment analysts and portfolio managers.

4.1

Technical analysts

The Technical analysts believe the principle that stock prices tend to move in trends. They assume that a stock that is rising will continue rising and that that is stagnant will remain stagnant. These analysts (at times called chartists) are traders not long term investors. Clearly their assumptions of technical analysis directly oppose the notion of efficient markets. Technicians hypothesise that stock prices move to a new equilibrium after the release of new information in a gradual manner, which causes trends in stock price movements that persist for

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certain periods. This belief contradicts with the advocates of the EMH who believe that security prices adjust to new information very rapidly. EMH advocates do not claim that prices adjust perfectly - which means there is a chance of over-adjustment or under-adjustment. Still because it is not certain whether the market will over or under-adjust at any time you cannot derive abnormal profits from adjustment errors. 4.2 Fundamental analysts

The Fundamentalists believe the market to be 90% logical and 10% psychological. Their major objective is to establish the proper value of a security. This intrinsic value is related to the growth of the company, dividend payout, interest rates and risk. Depending on whether the Intrinsic value is less or greater than the market value this will determine the investors buy and hold or sell decision. The fundamentalists constantly look for under priced stocks. Accordingly the market will in the short run adjust itself to equilibrium. With regard to aggregate market analysis, the EMH implies that if you examine only past economic events it is unlikely to help you out perform a buy-and-hold policy because the market adjusts rapidly to known economic events. A fundamental analyst relying on only historical data will not experience superior risk-adjusted returns. The market is close to semi efficient. The EMH does not contradict the value of aggregate market, industry or company analysis but implies that you need to (i) understand the relevant variables that affect rates of return and (ii) do a superior job of estimating movements in the valuation variables. Some strong form tests have shown the likely existence of superior analysts. For example, price adjustments that usually follow the publication of analysts recommendations point to the existence of superior analysts.

If you want to determine if an individual is a superior analyst or investor you should examine the performance of numerous securities that this analyst or investor recommends over time in relation to the performance of a set of randomly selected stocks of the same risk class. The stock selections of a superior analyst or investor should consistently out perform the randomly selected stocks. We know the relevant variables that the fundamental analysts should analyse and all the important techniques they use but actually estimating the relevant variables is as much as an art and a product of hard work as it is a science. If the estimates could be done on the basis of a mechanical formula one could program a computer to do it, and there would be no need for analysts. Thus the superior analyst must understand what variables are relevant to the valuation process and have the ability to do a superior job of estimating these variables. 4.3 Efficient markets and portfolio management

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As noted above, studies have indicated that professional money managers cannot beat a buy-andhold policy on a risk-adjusted basis. One explanation is there are no superior analysts and the cost of research forces the results of merely adequate analysis into the inferior category. Another explanation, which has some empirical support, is that money management firms employ both superior and inferior analysts and the gains from the recommendations of the few superior analysts are offset by the costs and poor results due to the recommendations of the inferior analysts. This raises the question should a portfolio be managed actively or passively? A portfolio manager with superior analysts can manage a portfolio actively looking for undervalued securities and trading accordingly. Without superior analysts it only makes sense and value to manage passively. Superior analysts need to concentrate on the second tier of stocks. These stocks possess the liquidity required by institutional portfolio managers, but because they do not receive the attention given the top-tier stocks, the markets for these neglected stocks may be less efficient than the market for large well-known stocks. A portfolio manager without access to superior analysts needs a different procedure. First the manager needs to measure the risk preferences of his/her clients, then build a portfolio to match this risk level by investing a certain proportion of the portfolio in risky assets and the rest in a risk-free asset. The manager must completely diversify the risky asset portfolio on a global basis so it moves consistently with the world market.

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