In markets and financial analysis, Efficient Market Hypothesis (EMH) that is also popularly known in finance language as the Random Walk Theory is a phenomenon that gives that the current stock prices fully reflect all and any available information or data pertaining to the value of the firm or company. According to this hypothesis, it is assumed that there is no way an earning of excess profits is possible by the investors when this information is used. According to Mendelker. G, Clarke J & Jandik T, the efficient market hypothesis deals with one of the most fundamental and interesting( exciting) issues in finance which try to address the questions of why prices of stocks do always change in the security markets and how these changes also take place. So efficient market hypothesis is has very important implications for investors and brokers as well as the financial managers and analysts in the security markets.
According to Fama (1970), an efficient market is one that has a very large number of rational profit maximization driven investors who actively compete in the market and attempting to forecast the future market prices of individual securities. In this case all important information is almost freely available to all the investors and fairly.
Efficient market hypothesis manifests in three clear distinct forms in economic and financial theory. These forms are in such a way that a stronger form of efficiency also incorporates all the previous weaker forms of market efficiency.
Weak-Form Efficient Markets
In this form of efficient market, stock prices in the market reflect all the available market trading information and any other data that can be derived from the same. An example of trading in this form of EMH is when past prices in the market, the volume of trading in the past and the short rates are used to compute the future stock prices. It is given that in this form of market efficiency, the stock prices are known to be constituted and composed of only three main components which; the last period prices, the expected stock rate of return and the random error term added to the two whose expected value is zero. This random error is mainly due to new information unexpectedly released for the period under observation. This form of market efficiency is a pre-requisition for a number of asset pricing models that include the capital asset pricing model (CAPM) and the Black Scholes and Cox/Ross/Rubinstein models.
Semi Strong Form Efficient Markets
Apart from incorporating the weak form of market efficiency, the semi strong form of market efficiency, reflects all the public information available that is likely to influence the firm’s valuation of stock. In this given model all the data that pertains to the products of the company, its operations, and patents, financial statements (balance sheet, cash flows, and income statements) are priced in the model.
Strong Form of Efficient Markets
The strong form of market efficiency specifies that the stock prices exhibit all the most important information and this may include the data that may only be known to company insiders. This also implies that the company or firm insiders having information they are privy to before it is known to the public are not permitted to use it to make profits from the company stocks. It is theoretically known in financial markets that if the insiders attempt to use insider information for trading, the market automatically shall recognize them and that prices then readjust themselves before such insider trading can even go through.
According Palan S (2004), in academic world there are proponents that say that if insider information is not available to investors, then strong form of market efficiency is considered to hold without regard to whether there may be insider information available that may lead to excess returns or not. However, for strong form of market efficiency to hold, then the weak and semi-strong of market efficiency shall be holding as a must.
Financial Market Anomalies
In financial and security market analysis, a market anomaly is an indicator of inefficiency on the financial market. Some of these indicators happen once and normally vanish or disappear while others are known to last long (continuous) or appear more frequently.
In standard finance theory, financial market anomaly is taken to mean a situation in which performance of a stock or a group of the stocks deviate from the assumptions that clearly define the efficient market hypothesis. According to (Silver 2011), these market events or movements may not be fully explained by the efficient market hypothesis.
Efficient market anomalies are broadly divided into three types which are fundamental anomalies, technical anomalies and calendar or seasonal anomalies (Madiha,L etal 2011). The efficient market anomalies are listed below.
Calendar or seasonal anomalies are also classified into weekend effect, turn of the month effect, turn of the year effect and the January effect.
The fundamental anomalies are also grouped into value anomaly, low price to earnings (P/E) anomaly, high dividend yield anomaly, low price to sales (P/S) anomaly and the neglected stock anomaly (Karz G 2011)
Technical analysis anomaly is known to include a number of techniques used to forecast future stock prices on the basis of the past prices and given the relevant historical past data or information. In technical analysis, this includes aspects like the resistance or support of the prices as well as the moving averages and several other technical indicators that may be derived from market information.
Researchers including Bodie etal (2007) find that when a market holds a weak form of market efficiency, then prices already should be reflecting the past information and technical analysis may be irrelevant at this point. Therefore the investors may not be able to go around the market by earning abnormally on the basis of being very good technical analysts and having used well the past information.
The financial and securities market being what they are and given the constant search for profits by investors and the individual egos of investors and brokers alike, cannot be fully considered free of some these anomalies. This is backed by the rampant corrupt tendencies of the world, the security and financial market included. There are therefore cases of inefficiency that manifest. Therefore critics correctly argue that there many instances in the recent history in the markets that show that prices could not possibly have been determined only by rational investors and it is given that psychological considerations may have played some role atleast.
A case in point is when the stock market lost about one-third of its value in from early to mid October 1987 and yet with essentially no changes in the general economic environment at the given time. In similar form, it is also widely believed that the internet pricing stocks in the early 2000 could only be explained by the behavioral investors rather than the rational investors.
For the market crash of October 1987, the behaviorists believe that the one-third drop in market value could be explained by over reliance on psychological considerations, given that the basic elements of valuation had no changed rapidly over that observable period. According to Malkiel B G (2003), the logical considerations could explain a sharp change in the market as that of 1987. It is important to note that a number of factors may rationally change an investor’s view about a proper value of a given stock on the market. Besides a number of events can fundamentally or rationally increase risk perceptions like an announcement by the chairman of the federal reserve in a given time period. This is not to mention that share prices can be highly volatile and sensitive as a result of rational responses to small changes in short rates and perceptions of risks.
Another stock market event we can site to support the behaviorists as evidence of irrationality of markets is the internet bubble of the late 1990. This could have been due to the outlandish and unstoppable claims that were being made regarding the internet growth.
Bibliography
Bodie,Z.A.Kane.A.J. Marcus (2007). Essentials of investments, 6th edition, McGraw- Hill / Irwin
Fama, E. (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance 2, 383-417.
Silver, T. (2011). Making Sense of Market Anomalies.[online] retrieved from www. Investopedia.com.
Karz, G (2010). Historical Stock Market Anomalies. Retrieved From Http://Www.Investorhome.Com/Anomaly.Htm.[Accessed 11 March 11, 2013].
Madiha L, etal (2010). Market Efficiency, Market Anomalies, Causes, Evidences and Some Behavioral Aspects of Market Analysis. Research Journal of Finance and Accounting. Retrievd from www.iiste.org
Malkiel B G (2003). The Ef. cient Market Hypothesis and Its Critics. Journal of Economic Perspectives—Volume 17, Number 1—Winter 2003—Pages 59 – 82
Mendelker G, Clarke J & Jandik T (2003). Efficient Market Hypothesis.
Palan S (2004). The Efficient Market Hypothesis and its Validity in Today’s Markets
