Efficient Market Hypothesis (EMH)

Efficient Market Hypothesis, or EMH, is a much-debated theory, with strong reasoning for and against. In this discussion, we will be defining the broader concept, detail three common forms of EMH, provide conflicting views and finishing with a topical example.

What is Efficient Market Hypothesis

Efficient market hypothesis assumes that all financial markets are efficiently priced, therefore the price of a stock includes all the public knowledge and is reflecting the collective opinion of all investors about future prospects. The hypothesis goes on to state that it is not possible to outperform the market on a consistent basis by using any information that the market is already aware of. Information in the EMH refers to anything that may affect the stock price that is presently unknown and therefore appears randomly in the future. This information will cause the future stock price to change.

One of the assumptions of EMH is that when investors become aware of new information on a particular stock, a portion will overreact and a portion will under react, but the sum effect will be that the stock price will be its intrinsic value (fairly priced).

Three Common Forms

•  Weak-form efficiency states that fundamental analysis (the study of financial statements) might be able to earn excess returns but technical analysis techniques will not. Additionally, no strategy based on historical share price or other financial data will work.
• Semi-strong efficiency states that fundamental analysis techniques will not be able to outperform the market. When new information is released about a company, trading on that information will not geneerate additional returns.
• Strong-form efficiency states that the share price reflects all known information and that even insider information is of no real use. However, although some fund mangers outperform the market doesn't necessarily make the theory redundant because there may be an equal amount of fund managers who underperformed, thereby overall (assuming a normal distribution curve) the returns will be equal with the market.

Those Not in Favour - The Arguments Against

For all the studies "For" and "Against", there is still a divide. Opponents class behavioural finance as bunk. Behavioural finance proposes that emotional biases create anomalies in the market place. An oft-quoted example is the market crash in 1987, where tremendous market highs preceded the crash.

Other arguments against are that individual market participants will have differing reasons for market inefficiency, such as the slow assimilation of market information, the unbalanced 'strength' of some market participants (large financial institutions) along with the existence of sophisticated professional investors.

For example, the EMH theory cannot explain the existence of investors like Warren Buffet, who are said to disagree with the EMH theory. Other contradicting theories include, the January effect, the weekend (Monday) effect, P/E ratio effect, the weather and over/under reaction of stock prices to earnings announcements.

Example

The graph below is on Coles (CML) from July to October 2006.

On August 17th (Point 1) the company released their quarterly report of which many analysts said was a good result and in line with many expectations. The price surged from the news suggesting that CML was inefficiently priced. EMH couldn't explain this occurrence. This suggests the market was not operating efficiently at all. Conversely, EMH supporters might suggest that some market participants knew about the impeding offer for CML. Point 3 is the 6th of September where the company announced that it had been approached for a takeover on the 18th of August (Point 2). The takeover was one of the worst kept secrets, however it would be difficult to interpret when many new about the offer.

The paradox of efficient markets hypothesis is that if every investor believed the stock market was efficient, then the market would not be efficient because no one would analyse securities. In other words, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market. The cynics may say that those who have lost money on the market believe in EMH and those who have made money on the market disagree with EMH.