Efficient Market Hypothesis Theory

In the mid 1960s Eugene Fama introduced the idea of an ‘efficient’ capital market to the literature of financial economies Put simply the idea is that the intense competition in the capital market leads to fair pricing of debt and equity securities. This is indeed a sweeping statement. No wonder it continues to stimulate insight and controversy even today.

In the early 1950s, Maurice Kendall examined the behavior of stock and commodity prices in search of regular cycles. Instead of discovering any regular cycle he found that prices appeared to follow a random walk implying that successive price changes are independent of one another.

An efficient Market is one in which the market price of a security is an unbiased estimate of its intrinsic value. Note that market efficiency does not imply that the market place equals intrinsic value at every time. All that is says is that the errors in the market prices are unbiased

The statement that prices reflect all available information represents the highest order of market efficiency. it is useful to distinguish three levels of market efficiency, weak form efficiency, semi-strong form efficiency, and strong form efficiency.

The weak form efficient market hypothesis says that the current price of a stock reflects all information found in the record of past prices and volumes. This means that there is no relationship between the past and the future price movements.

Three types of tests have been commonly employed to empirically verify the weak form efficient market hypothesis: (1) serial correlation test; (2) runs tests; and (3) filter rules tests. By and large these tests have been overwhelmingly in favor of the weak form efficient market hypothesis.

The semi-strong form efficient market hypothesis holds that stock prices adjust rapidly to all publicly available information. This implies that using publicly available information investors cannot earn superior risk-adjusted returns.

Two kinds of studies have been conducted to test the semi-strong form efficient market hypothesis: event studies and portfolio studies. An event study examines the market reactions to and excess returns around a specific information event like earnings announcement or a stock split. A portfolio study examines the returns earned by a portfolio of stocks having some observable characteristics like low price earnings multiple or small market capitalization.

The results of event studies are mixed. Most event studies support the semi-strong form efficient market hypothesis. Several even studies, however, have cast their shadow over the validity of the semi-strong form efficient market hypothesis.

The results of portfolio studies too, are mixed. Some portfolio studies suggest that it is not possible to earn superior risk-adjusted returns by trading on observable characteristics. However, other portfolio studies have documented various inefficiencies and anomalies. The more important anomalies are: (1) Stocks of small capitalization companies see to out perform stocks of large capitalization companies. (2) Low price earnings multiple stocks tend to outperform high price earnings multiple stocks.

The strong form efficient market hypothesis holds that all available information, public or private, is reflected in stock prices. Obviously this represents an extreme hypothesis and we would be surprised if it were true.

To test the strong form efficient market hypothesis, researchers analyzed the returns earned by certain groups who may specially be privileged in terms of access to information. Empirical evidence broadly suggests that corporate insiders and stock exchange specialists earn superior risk adjusted rates of return whereas Mutual Fund managers do not, on average earn superior risk adjusted rates of return.

Apart from standard tests for various forms of market efficiency many other studies have been does not explore the behavior of security prices and interest rates. Further, economists have reflected on certain financial episodes like the crash of 1987.