Efficient Markets

A testable hypothesis to answer the

question: How are securities market
prices determined?
The efficient markets hypothesis:

• Securities prices always fully reflect all

available, relevant information about the
security.

• Note the key words of the definition:

“always,” “fully,” and “information.”
 Early thinking about securities
market prices (early 20th
century):
• Observers noticed that the charts that
tracked the pattern of stock market prices
looked similar to a chart of a random event,
such as tossing a coin and marking an
increase if you get a “heads,” or a decrease
if you get a “tails.”
• They wondered why the stock market
behaved like a random walk.
 Important!
• The actual stock price was not seen to be
random, only the CHANGE in the price
appeared to be random in occurrence.
• In particular, using valuation theory, it
should be true that a common stock sells for
a price that is the present value of all the
future cash flows (dividends) expected by
investors.
 What would cause a stock price
to change?
• A reasonable answer is that the price would
change if investors obtain new information
about the stock that causes them to revise
their forecast about the stock’s future
return.
• New information that causes investors to be
more optimistic would cause them to
revalue the stock price higher. Negative
information would result in lower price
revaluations.
Since new information arrives in
the market in an unpredictable
(random) fashion, prices will
change randomly as well.
• Conclusion: New information is the cause
of securities price changes. Since one
cannot predict whether the next piece of
new information will be favorable or
unfavorable for a stock, the future changes
in stock prices are similarly unpredictable.
 Much empirical research has
been done to examine how much
(or how fully) information is
incorporated in market prices.
• Questions about the extent of the
information incorporated has led to several
terms to describe the degree of efficiency
exhibited in a particular market.
• The three terms are “weak form efficient,”
“semi-strong form efficient,” and “strong
form efficient.”
 The Efficient Markets
Hypothesis
• The Efficient Markets Hypothesis (EMH) is
made up of three progressively stronger
forms:
– Weak Form
– Semi-strong Form
– Strong Form
 The EMH Graphically
• In this diagram, the circles
represent the amount of
information that each form All historical prices and returns
of the EMH includes. Strong Form
• Note that the weak form
covers the least amount of Semi-Strong
information, and the
strong form covers all Weak Form
information.
• Also note that each
successive form includes
the previous ones.
All information, public and private
All public information
 The Weak Form
• The weak form of the EMH says that past prices,
volume, and other market statistics provide no
information that can be used to predict future prices.
• If stock price changes are random, then past prices
cannot be used to forecast future prices.
• Price changes should be random because it is
information that drives these changes, and information
arrives randomly.
• Prices should change very quickly and to the correct
level when new information arrives (see next slide).
• This form of the EMH, if correct, repudiates technical
analysis.
• Most research supports the notion that the markets are
weak form efficient.
 Price Adjustment with New
Information

At 10AM EST, the U.S. Supreme Court refused to hear an appeal

from MSFT regarding its anti-trust case. The stock immediately
dropped. This example, one of hundreds available every day,
illustrates that prices adjust extremely rapidly to new information.
But, did the price adjust correctly? Only time will tell, but it does
seem that over the next hour the market is searching for the correct
level.

Notes: Each bar represents high, low, and close for one-minute. Each solid gridline represents the top of an hour, and each
dotted gridline represents a half-hour.
The weak form efficient markets
hypothesis - a definition, and
some evidence:

• The weak form hypothesis maintains that

past stock price changes cannot be used to
earn above average profits. (Because this
information is available to all, and thus,
already incorporated in market price.)
 Weak form evidence:
• Studies show that systems that try to predict
the future course of stock prices based upon
some rule derived from the history (past
days, weeks, or months) of past stock price
changes do not make profit greater than a
simple buy and hold strategy.
• Statistical analysis of successive stock price
changes reveals that the correlation between
price changes is approximately zero.
 If a market is weak form
efficient, then technical analysis
should not be effective in picking
stocks for above average profits.
• Technical analysis is the term describing the
many systems for investing based on
indicators such as charts of past price data,
volume of trading, short selling statistics,
odd lot trading, etc.
Despite the evidence for market
efficiency, there are many
professional investors who claim
that technical analysis can be
effective. Such claims are
largely unproven, but it shows
that not everyone accepts the
efficient market hypothesis.
 The semi-strong form efficient markets
hypothesis - a definition and some evidence:
• The semi-strong form efficient markets hypothesis
maintains that all publicly available information is
incorporated in stock prices.
past stock prices and dividends
published accounts, or filings with government or the SEC
news releases and news paper reports
published economic data on industries or the whole
economy
 The Semi-strong Form
• The semi-strong form says that prices fully reflect
all publicly available information and expectations
about the future.
• This suggests that prices adjust very rapidly to
new information, and that old information cannot
be used to earn superior returns.
• The semi-strong form, if correct, repudiates
fundamental analysis.
• Most studies find that the markets are reasonably
efficient in this sense, but the evidence is
somewhat mixed.
 Semi-strong form evidence:

• Studies show that public announcements of

earnings, dividends, stock splits, etc. cause
stock prices to immediately change to
reflect the new information.
• Studies show that mutual funds (whose
professional managers would be expected to
have access to the very best information
available) do not consistently outperform
the average market indexes.
 If a market is semi-strong
efficient, then picking stocks
based on publicly available
information, should not yield
profits greater than what could be
obtained using a simple buy and
hold strategy.
Evidence of efficient markets has
given great impetus to the
formation of “Index Funds,” for
investors wanting to minimize
research costs and trading costs
while investing in a mutual fund
that closely tracks a given market
index.
The strong form of the efficient
markets hypothesis - a definition
and some evidence:

• The strong form of the hypothesis maintains

that all information obtainable from any
source whatever, is incorporated in market
prices.
 The Strong Form
• The strong form says that prices fully
reflect all information, whether publicly
available or not.
• Even the knowledge of material, non-public
information cannot be used to earn superior
results.
• Most studies have found that the markets
are not efficient in this sense.
 Strong form evidence:

• Studies show that “inside information”

available to corporate insiders or market
specialists could be used to earn above
average trading profits
• Yet, remember that using inside information
is illegal!. Thus, strong form inefficient
markets may not be legally exploited to
earn greater than average profits, either.
 In conclusion:
• There is evidence that markets are weak
form and semi-strong form efficient, but
probably not strong form efficient.
• Yet it must be noted that the tests of
efficiency have largely focused on well
developed markets in the United States.
Foreign markets have been studied less
extensively, and may exhibit less efficiency.
This is especially true of markets in less
developed countries (sometimes called
“emerging” markets).
 Finally, it should be noted that
there is some evidence that
contradicts the hypothesis.
• Some market studies give evidence that a
strategy as simple as buying low P/E ratio
stocks can result in above average profit.
• Other studies give evidence that the Value
Line Investment Survey can be used to earn
superior profits. (This is a stock rating
service available in many public libraries.)
The efficient market hypothesis
has not been “proven,” however,
it is a highly regarded tenant in
modern finance.
• If markets are efficient, investors can expect
that prices are “fair,” and that the rate of
return earned from a diversified portfolio of
securities over time will be approximately
average for that class of securities.