The use of Efficient Market Hypothesis - Free Essay Example

According to Eugene Fama, a market in which prices always fully reflect available information is called efficient . Fama also suggests that the ideal market is one in which prices contain precise signals for the allocation of resources. In other words, a market where production-investment decisions are made by firms and where investors can choose securities, assuming that prices fully reflect all the available information in the market. This is the basis for the Efficient Market Hypothesis (EMH). The more informationally efficient the market, the more random price changes in that market must be, and the most efficient market of all is one in which price changes are totally random and unpredictable. In finance literature, this is known as random walk. The EMH has implications for both firms and investors. According to this hypothesis, firms are not able to obtain valuable financing opportunities by timing their stock issue (the financing decision). Therefore, assuming the market is efficient, the financing decision will not effect the value of the firm but only the investment decision does. Firms should only expect to receive the fair value for the securities they have issued. From the point of view of the investors, the EMH states that because information is immediately reflected in prices, investors should not expect to make any abnormal returns. In an efficient market, prices would adjust before the investor tr ades after he is fully aware of the new information. Andrei Shleifer argues that there needs to be at least one of three conditions present for there to be efficiency. These conditions are: Rationality all investors act rational. In other words, as new information is published, investors always act in a rational way and this information is immediately reflected in the stock prices. Independent Deviations from Reality The market does not need rational investors but only countervailing rational actions. Over-optimistic or under-optimistic irrational decisions will cause prices to rise or fall according to market efficiency. Arbitrage In a world composed of irrational amateurs and rational professionals, the professionals would buy underpriced securities and would sell overpriced ones as then would know the true value of securities. The markets would still be efficient if the arbitrage of professionals dominates the speculation of amateurs. Fama classifies efficiency into three, namely, weak form, semi-strong form and strong form efficiency. Weak form efficiency suggests that past prices (or returns) reflect future prices (or returns). The semi-strong form asserts that stock prices reflect all information that has been made public. The strong form of EMH suggests that prices reflect all available information including private/insider information. Seyhun (1986, 1998) provides enough evidence that insiders gain abnormal returns by trading on private information, implying that strong form efficiency is ineffective in a world with an uneven playing field. However, the semi-strong form has formed the basis for most empirical research in this area. Also, recent research has included the weak form of EMH when testing for market efficiency. The EMH may probably be considered as the most controversial issue in finance. Empirical evidence provided by the numerous tests on the issue efficiency is used to support or reject this theory in financial market s. The fact that the majority of these empirical tests show no evidence in favour of EMH is a major challenge for the hypothesis itself. (Include Reference Sardar M.N. Islam) By the early twentieth century, many financial economists and statisticians started claiming that stock prices are at least partially predictable, challenging the intellectual dominance of the EMH. Moreover, some even stated that investors can easily make excess risk-adjusted returns by trading based on predictable patterns. Criticism of the EMH grew rapidly as certain anomalies started being detected in the capital market. These empirical challenges to the EMH are the following: The Calendar Time Effects The January Effect Rozeff and Kinney (1976) were the first to present evidence of higher average returns in January when compared to other months. They found out, using NYSE stock between 1904-1974, that the return for January was 3.48% compared to only 0.42% in other months. This effect persist even in more recent studies, namely Bhardwaj and Brooks (1992) and Eleswarpu and Reinganum (1993). Gultekin and Gultekin (1983) also show this effect in other countries and Chang and Pinegar (1986) documented this effect for bonds. Bhabra, Dhillon and Ramirez (1999) found that this effect has become stronger since 1986, the year in which the Tax Reform Act was enacted. These studies may all together explain a tax-loss selling reason for this effect. The Day of the Week Effect also known as the Monday effect, this was presented by French (1980) who derived that there is a tendency for stock returns to be negative on a Monday and positive for the rest of the week. A trading strateg y that would be profitable in this case would be to buy stocks on Monday and sell them on Friday. Steely (2001) however finds that the weekend effect in the UK has disappeard in the 1990s. Other Seasonal Effects both holiday and turn of the month effects have been documented over time across countires. For example, Lakonishok and Smidt (1988) have shown that stock returns within the US at the turn of the month (defined as the last and first three trading days of the month) are significantly higher. Lakonishok and Smidt (1988), Ariel (1990), and Cadsby and Ratener (1992) all provide evidence of above average returns the day before a holiday. Moreover, Brockman and Michayluk (1998) describe this pre-holiday effect as being one of the oldest and most consistent of all seasonal irregularities. The Small Firm Effect this is also known as the size effect and was discovered by Banz (1981). Banz analysed the period 1936-1975 and found out that excess return could be earned by holdin g stocks of low capitalization companies. Reinganum (1981) supports this evidence by showing that the risk-adjusted returns of smaller firms was greater by more than 20%. If the EMH holds true, one would expect that there would be no difference in the risk-adjusted returns of any firm. P/E Ratio Effect research carried out by Sanjoy Basu (1977) indicates that investors owning stocks of companies with low P/E ratios earned a premium during 1957-1971. In other words, according to this empirical study, a portfolio composed of low P/E stocks earned higher returns than that a portfolio that held the entire sample. Campbell and Shiller (1988) sustain these findings by showing that P/E ratios have reliable forecasting powers. Value Line Enigma Value Line is an American corporation that provides investment research on stocks, funds, options and other investment opportunities. It divides firms into five groups and ranks them according to estimated performance based on publicly availa ble information. Researchers, such as Stickel (1985), found out that forming trading strategies based on Value Line rankings could possibly make above average returns for investors, thus challenging the EMH. Reaction of Stock Prices to Earnings Announcements ÂÂ ­- substantial evidence contradicts what the EMH states about information being impounded into prices instantaneously. This evidence shows that over and under-reaction are present when information about earnings is released. For instance, DeBontt and Thaler (1985, 1987) provide evidence of stock prices over-reacting with current changes in earnings. They report positive (negative) abnormal stock returns for portfolio that previously generated inferior (superior) stock price and earning performance. Standard Poors (SP) Index Effect assuming the market is efficient, that is that the EMH holds, the inclusion of a company in the SP index would have no effect on the price since no new information has been made public. However, Harris and Gurel (1986) and Shleifer (1986) found an increase in share prices of up to 3% when a stock is announced to be included in the SP Index. Pricing of Closed End Funds In general, various studies have shown that closed-end funds trade at a discount relative to their net asset value. In fact, between 1970 and 1990 it was shown that on average this discount ranged between 5 and 20%. The existence of discounts goes against the principle of efficient and frictionless markets. Distressed Securities Market a great number of academics, such as Ma and Weed (1986), Cornell and Green (1991) and Buell (1992) argue that stocks in distress securities markets are efficiently priced. However, the financial press has frequently indicated stock pricing inefficiency during the bankruptcy period. This happened with the shares of Continental Airlines which continued to trade at $1.50 per share even after the company had agreed with creditors that no distribution would be provi ded to equity holders (WSJ, 1992). The Weather Effect some may say that sunshine put people in a good mood who would in turn make more optimistic choices and judgments because of their mood. In 1993, Saunders shows how the NYSE index tends to be negative when it is cloudy. Quite recently in 2001, Hirshleifer and Shumway found out that stock market returns (for most of the 26 countries that were analysed) are positively correlated with sunshine. According to their study however, snow and rain had no predictive powers. Crashes and Bubbles The bubble theory of the speculative markets states that security prices occasionally move well above their true value but eventually, the bubble bursts and prices fall back to their original level. This is what happened in the October 1987 market crash and the internet bubble of the late 1990s. In the October 1987 stock market crash, prices dropped by 20%-25% on a Monday following a weekend in which little surprising news was released. Many argue that the explosion of prices in the Internet Bubble was nothing more than irrational excitement. One might also add the frequent real estate bubbles, the latest of which was closely related to the sub-prime mortgage crisis of 2007. If the market is truly efficient, how do these bubbles occur? Reasons for this could include psychological and/or behavioural considerations. Whilst giving the due credit to the EMH, which has acted as a basis for many studies of an invaluable contribution to the understanding of the securities market, there seems to be a growing disapproval with this theory. Recent literature has shown that the criticism of this hypothesis has gained both voice and momentum. It has become clearer that information is no longer the sole variable effecting security valuation. New researchers have come forward with thought provoking, theoretical arguments and empirical evidence that suggests that security prices could deviate from their equilibrium because of psycho logical factors, fads, and noise trading. While the argument on the EMH continues, Russel and Tobey (quote endnote) expect that the final outcome of the raging debate will be a compromise between competing schools of thought.