Critical Analysis of Efficiency Market Hypothesis
Critical Analysis of Efficiency Market Hypothesis
In this essay, firstly, the Efficient Market Hypothesis (EMH) is given an appraisal in relation to random walk, as well as its definition, revealing theories in context of empirical evidence. A brief explanation of the 3 forms of EMH is highlighted alongside a brief description of its tests for validity.
The main focus of discussion is whether or not Technical & Fundamental Analysis can determine abnormal returns by investors strategically using a set of information to formulate buying and selling decisions to beat the efficient market. (Graphs and sets of equations may be applied). Following general empirical studies, the theory of Efficient Market typically asserts that, it would be impossible to consistently outperform the market by means of technical & fundamental analysis, consequently, in the light of this assertion, technical, fundamental and other anomalies are revealed that may suggest some levels of market inefficiencies.
Finally, a conclusion, subjectively underlining the relevant points expressed above, putting to perspective facts conveyed through the topic of critical discussion.
Appraisal of the Efficient Market Hypothesis and Random Walk The efficient market hypothesis is a financial theory widely accepted by most academic financial economists. It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay.
Thus, when the term ‘efficient market’ was introduced into the economics literature in the 1960s , it was defined as a market in which prices at any time “fully reflect” and ‘adjusts rapidly to new available information’ (Eugene F. Fama, 1970, p 383.). In the context of this hypothesis, “efficient” empirically, means that the market is capable of quickly digesting new information on the economy, an industry, or the value of an enterprise and accurately impounding it into securities prices. In such markets, participants can expect to earn no more, nor less, than a fair return for the risks undertaken, hence failing to provide abnormal returns. Random Walk, is a Theory closely associated with the efficient market hypothesis, was originally created by Louis Bachelier (1900), and developed by Kendall, in 1950s.
Kendall (1953) found that stock and commodity prices follow a random walk. Random walk varies with regard to the time parameter. According to capital markets theory, the expected return from a security is primarily a function of its risk. The price of the security reflects the present value of its expected future cash flows, which incorporates many factors such as volatility, liquidity, and risk of bankruptcy. However, while prices are rationally based, changes in prices are expected to be random and unpredictable, because new information, by its very nature, is unpredictable. Therefore stock prices are said to follow a Random Walk.
Versions of the Efficiency Market Hypothesis and tests Following the concept of information, as stated in the above paragraph, it is useful to distinguish among three versions of the EMH, Fama (1970) identified as: the weak, semi-strong, and strong forms of the hypothesis. These versions differ by their notions of what is meant by the term “all available information.” The tests for each form, summarized in brief, empirically shows evidence in favor of EMH: According to Fama (1970), Weak form efficiency claims that all past prices of a stock are reflected in today’s stock price. Therefore, technical analysis cannot be used to predict and beat a market.
The Weak Form Tests. The test of the weak form of the EMH is generally taken to comprise of; an autocorrelation test, a runs test and filter rule test. An autocorrelation test investigates whether security returns are related through time. On the other, a runs test, for example, measures the likelihood that a series of two variables is a random occurrence. A filter rule (or trading test) is a trading rule regarding the actions to be taken when shares rise or fall in value by x%. Filter rules should not work if markets are weak form efficient.
Overall, the tests highlighted, statistically tests for independence, to establish the weak-form holds, thereby invalidating strategic rules for technical analysis, to obtain abnormal profits. Following the weak-form EMH, is the Semi-Strong form efficiency in which Fama (1970) states that security prices reflect all publicly available information.
The Semi-Strong Test. Tests for the semi-strong, significantly and reveals Event Study. The first event study was undertaken by Fama, Fisher, Jensen and Roll (1969), though the first to be published was by Ball and Brown (1968). An event test analyzes the security both before and after an event, such as earnings announcements, stock splits and analyst’s recommendations. The idea behind the event test is that an investor will not be able to reap an above average return by trading, on an event including the Fundamental Analysis strategy.