Efficient Capital Market Hypothesis

STRONG EFFICIENT MARKET HYPOTHESIS RELATIVE TO EXISTING EVIDENCE 1

VALIDITY OF THE STRONG EFFICIENT MARKET HYPOTHESIS RELATIVE TO

EXISTING EVIDENCE

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An arena in which there are many market participants with the same investment goals as well as

access to the same information with active competition is referred to as an efficient capital

market (Read 2013). An example of such a market is the security market whereby there are many

professional who are profit minded as well as private investors who continue to search for

disvalued securities. In this kind of market setting, each competitor aims to maximize returns as

opposed to making losses, certainty as opposed to uncertainty, and low risk as opposed to high

risks among other factors. It is a securities law that both parties to any transaction need to have

equal access to similar material facts (Barnes 2009).

The efficient market theory states that it is impossible constantly to outdo the market.

This represents the rational judgment of numerous market participants in a competing

environment branded by numerous competing venture capitalists, each with same information

access and same objectives (Halsey 2014). The term ‘efficient’ in this context implies the ability

of the market to digest fresh information quickly on the economic market, industry market or an

enterprise value and impounding it accurately into security values. In this scenario, participants

expect to earn just a fair return for their undertaken risks (Fertuk 2007).

For instance, in a market that is efficient, news about the increase of earnings would be

accurately and quickly assessed by the investors’ actions and straightaway reflected in the stock

prices. The alleged outcome of this efficiency is such that only a fair return is expected whether

the stock is bought before, during or after the news of the earnings. It also does not matter

whether there is purchase of the stock or not (Kiyosaki & Lechter 2000).

The EMH sorts to explain why the prices for stock market tend to take the random walk.

This is whereby the daily variation follows the Gaussian distribution and tends to be a random


value (Keane 2008). This hypothesis was originally formulated by Bachelier in the 1900 but was

widely spread from 1953 where it started being considered unusual (Read 2013).

According to the Neo-classical theory, markets normally attain equilibrium over the

medium through the long run and do this by tâtonnement which is the process involved in

finding clearing prices in the market that would exactly equate demand to supply (Ang

Goetzmann & Chaefer 2011).

The concept of EMH originated from Fama in 1965 while writing his PhD thesis. The

random walked in EMH assigns occurrences to probabilities. This implies that the market is

aware of the future existence but its events are not known and cannot be predicted by the market.

Only probabilities can be attached to future events (Palan 2007).

The EMH exists in three forms; the weak form, semi strong form and the strong form

(Read 2013).

The weak form holds that past prices and volumes of stock cannot be able to forecast

future prices and volumes of stock in the market (Sarno & Thornton 2004). To determine the

validity of this assertion, it is of essence to categorize empirical tests in various groupings. Weak

form hypothesis calls for an explicit ‘past’ definition as there are different past categories.

Additionally, some results could be statistically significant although not give a strategy for

profitable investment (Timmermann & Granger 2002).

The weak form is an effective and efficient description for any investor whose aim is to

formulate a strategy of investment based on past prices and volumes of stock information.

However, there is no existence of any empirical evidence or theoretical basis for technical

examination on past data (Timmermann & Granger 2002).


The semi strong form of EMH is the most commonly used to analyze security and is

based on making multiples of price earnings projections as well as earnings per share.

Regrettably, multiples price earnings are subjected to huge swings for which neither empirical

nor theoretical prediction basis is available (Barnes 2009). However, accurate estimates of

earnings provide an investment performance that is above average.

This from of EMH however brings about concerns about the ability of the analysts to

achieve useful forecasts of earnings. Particularly, this form asserts that the examination of

information that is publically available is meaningless due to the fact that such information has

already been revealed in the stock prices (Halsey 2014).

It has been demonstrated that earnings from one period to another fluctuates in a random

walk manner. This implies that it is useless to base future projections of earnings on past

earnings patterns as a common practice in this form (Sarno & Thornton 2004).

It is also clear that this form implies the presence of various competent analysts in the

market who can accurately predict earnings as a whole. Because of the nature of the market

being competitive, it is of great doubt that high forecasters of earnings would outdo the market

(Kiyosaki & Lechter 2000).

The last form of EMH is that strong form. In this form it is held that investors with

advantageous information are not able to use the information in developing investments

strategies that are profitable (Read 2013). Little evidence is however available for this

hypothesis. The insiders normally have greater insights into the future of their companies. It is

also evident that specialists in the stock exchange cause unusual patterns of price movements that

are fractional (Keane 2008).


In all the above forms, the assumption is that there is linear credit cost that is the same for

all investors. Transaction costs are non-existence and there is no information asymmetry (Ang

Goetzmann & Chaefer 2011). Of course this can only be said in theory because the practicability

of this is unrealistic.

There is empirical proof that generally in the long run no one investor is able to

constantly outdo the market (Jagric Podobnik & Kolanovic 2005). This means that prices are

normally accurate and fair and thus the strongest EMH form is applied in most cases, resorting at

the worst to semi strong in liberal capitalists’ economies like the United Kingdom (Palan 2007).

It is worth noting that EMH necessitates venture capitalists to be rational which is echoed by the

neo classical economists. It is also clear that past market information is meaningless and thus

experts and fund managers are not deserving of the paid fortunes they get.

The strong form of EMH is the most compelling and satisfying in theory but not

applicable in practice. This has led to the criticism of the EMH. Several arguments have thus

been raised concerning this. Majority of the critics focus on the market anomalies like the small

cap stocks’ January effects that asserts that the prices would increase abnormally in the first

couple of days in the first year of trading (Kiyosaki & Lechter 2000). There is also an argument

case concerning successful investors like George Soros and Warren Buffer, although the prima-

facie problems are huge theoretically (Barnes 2009).

Asymmetry of information is one criticism of the strong form EMH. This asserts that new

information must reach all the investors as quickly as possible. It is expensive to generate

accurate and quality information and loses its value very fast as more and more people access it

(Fertuk 2007). There is empirical evidence implying that investors normally hoard good


information. Investors have also been seen to disseminate misinformation deliberately before it

reaches other investors (Bodie Kane & Marcus 2011).

Another argument is the fact that some investors are not rational (Keane 2008). Investors

are just like any other human being who sometimes act irrationally. Markets also do undergo

some fashionable trends just like the skirt length fashion market. This means that some industries

in the market will be in the fashion trend thus causing confidence boost or decrease in investors

(Bodie Kane & Marcus 2011). In responding to the rising market for bull in the US in 1996, the

public was warned against irrational exuberance and thus who ignored this suffered great losses

as the market increased really fast and the crash neared unexpectedly (Ang Goetzmann &

Chaefer 2011). Just like Keynes asserted, it is possible for markets to persist irrational for a

longer time than a person can remain solvent (Read 2013).

Another contention is the act that too often the stock market does crash. According to the

strong EMH, considerable movements in the stock market are supposed to be rare and at the

same time not severe because of the randomness of normal distribution characteristics

(Hrishikesh 2004). However, in general, market crash is common especially in competitive

markets. The stock market is a very competitive market where each investor has a motive of

making profits and information is the same and accessible to all investors (Sarno & Thornton

2004).

The validity of the strong form of the efficient market hypothesis is challenged when one

considers the fluctuations of stock prices over time. According to Keane 2008, analysts are

sometimes at loss to explain why the stock price of a particular company keeps moving the way

it does. More often than not, the price is reacting to a myriad of small factors that are simply too

many or too varied to sufficiently keep track off. Therefore, the assertion that the stock price is


being affected by information that is held in private or public is quite inaccurate since the share

might be reacting to something totally different.

Strong form of EMH asserts that an investor is not able to make excess returns from

information that is stale (Kiyosaki & Lechter 2000). Defining stale information is not a

challenge, but, excess return determination depends also on an assessment that is accurate that is

related to holding a share (Bodie Kane & Marcus 2011). Despite all the effort put to enhance this

study area since 1960s, no single widely acceptable and verifiable risk measurement is available

in investment holding context (Palan 2007). Those supporting strong EMS can argue that

anomalies in pricing are more obvious than real as they could be based on risk measurements

that are inaccurate (Read 2013).

Conclusion

Given the above evidence in the essay, despite the criticism, the stock market can be

describes accurately as a nearly efficient one. It is clear that any chance of obtaining inordinate

returns cannot go unnoticed if it presents itself in the market. This is because of the strong form

EMH that basically characterizes efficient markets. In this context, it is expected that prices

would deviate so much from what is perceived as fair by numerous participants in the market.

However, the strong EMH seems to be only a theory which cannot be actually be

practiced in theory. This has been analysed by the various arguments put forth by several critics.

Some of the reasons include asymmetric information, rationality of investors, market crashing as

well as the fluctuations of stock market prices over time.

Thus there really little evidence to prove the validity of strong EMH as those who have

managed to beat the market could have done it based on the expertise they possess, knowledge

and skills. Therefore, the stock market might be seen as a nearly efficient market theoretically


but cannot be done in the real world. Generally each human being or investor is profit minded

thus it is true that the numerous market participants could be having the same objective but the

issue of accessing same information at the same time is not realistic. The essay has discussed

how one investor might hold information or misrepresent it and take advantage before the rest of

the participants get access to it.


Bibliography

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STRONG EFFICIENT MARKET HYPOTHESIS RELATIVE TO EXISTING EVIDENCE

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Efficient Capital Market Hypothesis