Economic Theory Suggests That Markets Are Efficient and Security Prices Are Determined on the Basis of Fundamental Value

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¡§Economic Theory Suggests that Markets are Efficient and Security Prices are Determined on the Basis of Fundamental Value¡¨

Market efficiency requires that security prices react immediately in an unbiased way to the receipt of new information (Robert Shiller S1998). In other words, an efficient capital market is one in which stock prices fully reflect available information. In addition, there are three conditions for market efficiency; information flows freely, market is composed of rational investors where all competing against each other with the objective of maximizing wealth and there is no market imperfections. In efficient market, investors actively compete in the market based upon perceived mispricing derived from an analysis of
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Best example recently would be the internet stocks from 1996 through 2002 where the price of the internet stock roses over its fair value until the market forces the price back to its original level (Russell J. Fuller 1995).

The above argument can fall into the theory of representativeness and conservatism. The principle of representativeness implies overweighting the results of small sample. Financial economists have argued that representativeness leads to overreaction in stock returns (Eugene Fama F1998). In the case of internet companies, great revenue growth for a short time in the late 1990s, causing many to believe that this growth would continue indefinitely. Stock prices rose (too much) at this point. When, at last, investors realized that this growth could not be sustained, prices plummeted. On the other hand, the theory of conservatism states that individuals adjust their beliefs too slowly to new information. A market composed of this type of investor would likely lead to stock prices that under-react in the presence of new information. This is shown in the example of earning surprises .

It could be said that both representativeness and conservatism have opposite implications for stock prices. Fama reviewed the academic studies on anomalies, finding that about half of them show overreaction and about half show under-reaction. He concludes that this evidence is consistent with the market

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