Capital Market Analysis: a Dicussion on Efficient Market Hypothesis

Capital markets provide a function which facilitates the buying and selling of long-term financial securities to increase liquidity and their value, Watson & Head (2013). Hence, the Efficient Market Hypothesis (EMH) explains the relationship that exists with the prices of the capital market securities, where no individual can beat the market by regularly buying securities at a lower price than it should be. This means that in order to be an efficient market prices of securities will have to fairly and fully reflect all available information, Fama (1970). Consequently, Watson & Head (2013) believe that market efficiency refers to the speed and quality of how share price adjusts to new information. Nevertheless, the testing of the efficient markets has led to the recognition of three different forms of efficiency in which explains how information available is used within the market. In this essay, the EMH will be analysed; testing of EMH will show that the model does provide strong evidence to explain share behaviour but also anomalies will be discussed that refutes the EMH. Therefore, a judgment will be made to see which structure explains the efficient market and whether there are some implications with the EMH, as a whole.

As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the

In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another

Under the idea that markets are efficient, stock prices reflect new information quickly and accurately. Furthermore, Morningstar (n.d.) contributes details on the strongest supportive theory of efficient markets, EMH exists in three forms: weak, semi-strong and strong. The hypothesis calls for the existence of informationally efficient markets, were current stock prices reflect all information, and attempts to outperform the market will only come in the form of riskier investments. Also, because of a large number of independent investors actively analyzing new information simultaneously as it enters the market, investors react accordingly and is immediately reflected in the stock

The efficient markets hypothesis (EMH) is a dominant financial markets theory developed by Michael Jensen, a graduate of the University of Chicago and one of the creators of the efficient markets hypothesis, stated that, “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Markets Hypothesis” [Jensen, 1978, 96]. This paper analyzes whether it is possible to measure if markets are efficient in the strong form of EMH. A generation ago, the efficient market hypothesis was widely accepted by academic financial economists; for example, Eugene Fama’s (1970) influential survey article, “Efficient Capital Markets.” It was generally believed that securities markets were

Another concern relates of insider trading of market efficiency of stock market. In his classical study Fama (1970) proposes efficient market Hypothesis, which suggests that stock price reflects all available information (historical price, public and private) in

Last but not least important, an efficient capital market is one in which stock prices fully reflect all available information. However, the paradox is that since information is reflected in security prices quickly, knowing information when it is released does an investor little good. Furthermore, it is impossible to create a portfolio which would earn extraordinary risk adjusted return. As a consequence, all the technical and fundamental analysis are useless, no one can consistently outperform the market, and new

There is a fierce debate on whether stock market is efficient all these years. Some people advocated Fama’s research in 1960s, and they believe that the Efficient Markets Hypothesis has been well established. However, others do not agree with. They found some evidence to prove market inefficient by empirical researches. This essay mainly focuses on the Efficient Markets Hypothesis, and there are six parts to discuss. Firstly, it will compare the random walk theory and the weak-form of the Efficient Markets Hypothesis; Secondly, it will choose two empirical studies against the weak-form of the Efficient Markets Hypothesis; Thirdly, it will assess the semi-strong form with the weak-form the Efficient Markets Hypothesis; Fourthly, it will evaluate the semi-strong form of the Efficient Markets Hypothesis by two of empirical studies; Fifthly, it will identify the contrast between the strong form of the Efficient Markets Hypothesis with both weak form and semi-strong form; Last but not least, it will use one empirical study to judge the strong form.

“An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximizes’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.”

A lot of criticism on the CAPM has arisen over the last decades. One finding by Basu in 1977 is often used by opponents of the model in order to take down the foundation of the CAPM. Basu[3] found that stocks with a low price –earnings ratio, called value stocks, tend to outperform stocks with a high price-earnings ratio, named growth stocks. As the CAPM only allows for fundamental risk to explain excess returns on stocks, the finding that stocks from companies with high fundamentals (earnings, sales, dividends) relative to price outperformed growth stocks was in contradiction with the classical CAPM.

Proponents of market efficiency (or academics) would say that technical analysis is a waste of time and cannot result in abnormal profits. This is because in a weak form, semi-strong or strong form efficient market, share prices should have already reflected historical price and volume data, and no-one can earn an abnormal return from strategies based in this information. Thus, we could also say that technical analysts or chartists do not believe in any form of market efficiency.

Financial markets are said to be efficient when security prices fully reflect all available information. In such a market, security prices adjust very rapidly to new information.

Following Fama’s (1970) landmark research papers, which explained the principals of the efficient market hypothesis, capital market efficiency has been a pre-eminent and ongoing research topic. Capital market research ‘explores the role of accounting and other financial information in equity markets.’The assumptions of market efficiency are central to capital market research. Market efficiency is considered important because if information is not assimilated into stock market rapidly of if new information appears in an anticipated manner, individuals may exploit this information.‘A market in which prices always fully reflect all available information is called efficient’ (Fama,1970:383). Markets are not

Even though deviations will occur and there will be periods when securities are over or undervalued, these anomalies are expected to disappear as quickly as they appeared, thus making it almost impossible to profit from them consistently. The weak form of market efficiency theorizes that the current price does not reflect fair value and is only a reflection of past prices. It further states that the future price cannot be determined using past or current prices. The semi-strong form of market efficiency theorizes that the current price reflects all readily available information. This information might include annual reports, annual filings, earnings reports, announcements, and other relevant information that can be readily gathered. The strong form efficiency states that the stock prices reflect all information from historical, public and private sources, so that no investor can realize abnormal rate of return. Though theoretical literature talks of market efficiency, in practical terms the market is not perfectly efficient. Anomalies do exist and there are investors and traders who outperform the market. So, the EMH has very important implications for both investors and authorities that regulate and control the market. 2

The popularly accepted theory of how the stock market works is the Efficient Market Hypothesis (EMH) which says that share prices always reflect the available information about the market and the companies in question (Shleifer 2000). The theory tests three assumptions: