Current Issues in Stock Market Efficiency and the EMH
Table of Contents
Table of Contents 2
Current Issues in Stock Market Efficiency and the EMH 2
Chapter 1: Introduction 2
Chapter 2: Literature Review 3
Historical Review and Development of Theories and Hypothesis 4
The Random Walk Model of Effective Markets 5
Efficient Market Hypothesis Appraisal 6
Weak form tests 6
Semi-strong form test 7
Strong-form tests 7
Technical Trading 7
Beating the Market and the Real World View 8
Chapter 3: Results and Analysis 9
Chapter 4: Recommendations and Conclusions 10
Chapter 5: Appendices 12
The share portfolio 12
Chapter 6: Bibliography 13
Current Issues in Stock Market Efficiency and the EMH
Chapter 1: Introduction
In the recent past, most analysts are questioning the notion that stock markets are efficient. Analysts argue that participants fail to consider any knowledge and information about forthcoming rewards, but rather concentrate on the previous or current performance of the company. They end up buying large amount of shares in the well-performing companies making such company’s shares to rise only for them to return to normal or even fall with time causing losses. An efficient market is the one whereby all operators correctly present all the information they have about the market promptly and without delay. The prospect of future returns forms the basis for the evaluation of the stock prices, and they are deemed to be perfect because information about the market flows accurately and timely. The future returns, on the other hand, can only be affected by new information about changes in the market patterns that could lead to a change in prices. For instance, if a company invents a new method of production, its prices will rise because the chances of making profits in the future will also be high due to improved output. However, the stock prices can also fall if a competing company accesses the new invention first. The paper, therefore, seeks to analyze the current stock market situation, and relate it to the previous theories to assess their viability in the 21st century (Barnes, 2012, p. 48).
Chapter 2: Literature Review
This field has been under thorough research for the whole of the 19th century. Many articles have been written to evaluate the validity of these hypotheses. The first economist to conduct a research, although many scholars ignored his work for a very long time is Bachelier (Bachelier, 2011). He gave paramount principles and tests for the behavior of prices where he made a conclusion that the speculation should be zero. There was an extensive body of empirical results works in search for a rigorous theory. However, it was the Mandelbrot-Samuelson theory that defines the role of fair game returns model and its relationship with the theory of random walks. After the invention of computers, Kendal Maurice examined the behaviors of weekly changes in the industries in Britain’s share prices and spot charges for cotton and wheat. Van Uytbergen also conducted an empirical research on market efficiency with respect to accounting information in which he emphasized on analyzing previous studies and later he concludes by identifying threats to the validity of accounting-based efficiency market tests. This field has had many research work done which make it hard to review all of them, and therefore this paper only discusses a few of them.
Historical Review and Development of Theories and Hypothesis
The empirical work in the field of market efficiency preceded the development of the theories. However, this paper will present the main features of an efficient market. Then, it will discuss the run walk model and show its relation to the other ideas to ease the evaluation of the empirical results and identify which are relevant. The paper will then review the practical works and their results later.
The first feature of an efficient market is that big companies, making enormous profits sell their shares at a higher value than the underperforming companies. The stock prices, therefore, are a relative indication of the performance of the venture; that is eventually measured by the profits it makes; the company with highly priced shares eventually is the successive one. This characteristic of the market is important in the market because it ensures that investment funds are put to the most productive use by investing in the most prospective opportunities which are provided by the profitable companies.
The second fundamental feature of an efficient market structure states that in an efficient market, the actual returns on stock capital should be constant and equal to the real interest rate. If the interest rate is constant over time, the earned amounts of dividends are affected by the price increase. Therefore, the returns on the stock are constant and equal to the rate of the interest
The third feature is that the only things that can cause real change in the returns of the stock shares is acquiring of new information about the future of the share prices. An example is if a company announces an increase in the amount of dividends it will pay for its stock shares. Such a move would attract even more investors, causing an increase in such a company’s share rate over a very short duration of time. However, in the absence of such a case, the investors make their decisions based on the stock prices because this communicates all they want to know about the future.
Also, efficient market participants should expect equal returns in the future. Thus, even if the onset is of higher or lower returns they ought to know that the opposite would happen later. This phenomenon helps to ensure a normal growth at the expected rate (Samuelson, 1965).
The Random Walk Model of Effective Markets
This model assumes that the available information is a full reflection of the current prices. This statement means that changes in price are independent, and are also presumably equally distributed in the market. These are the basis of the model. This model is considered to be an extension of the general extension model in that it makes a thorough statement about the economic environment. This model arises in a context where the business environment is unpredictable, such that the evolution of the investor sense of taste and the process of generating new information produces balance in which return distributions repeat themselves through time. Therefore, empirical tests of the model support it then tests of the additional pure independence assumption. However, the independence of returns over the time is weak. The model fails to consider the fact that information about past proceedings is of no value in assessing the distributions of future returns (Fama, 1970, p. 48).
Efficient Market Hypothesis Appraisal
The EMH was developed by Eugene Fama the 60s, and he assumed that all information in the market is useful, and therefore stock prices reflect the current market value of its expected future income stream. According to Fama, if prices are less than the worth of the income, there demand for it’s the shares will rise. This situation will lead to an increase in the prices until it equals the current value of the returns (Fama, 1990, p. 10). There are three forms of efficient markets hypothesis:
Weak form tests
In these studies, the information subset of interest is just past price histories. It derives its results from the random walk literature. This theory developed from the accumulation of evidence in the mid-50s and early 60s that the behavior of many types of stocks and other hypothetical prices could be well estimated by a random walk. Economists found the need to offer some rationalization. They developed and explained the theory in terms of random walks, but usually suggesting a rather general fair game model. It was Samuelson and Mandelbrot that studied the role of expected returns patterns in evaluating the concept of efficient markets and the relations between these models and the theory of random walks (Benoit, 1996). Even though the Bachelier model had been there even before the development of the above studies, it had been overlooked and unconsidered for many decades. His principle for the behavior of prices was that speculations should be a fair game and be unpredicted in particular; the expected returns to the investor should be zero (Bachelier, 2011).
Semi-strong form test
These studies arose with the arising of tests that supported the efficiency hypothesis. The concern here is the speed of price adjustment to other obviously publicly available information. Every test concerns about the changes in the charges for information; thus they all aim at presenting supportive evidence for the model, having the supposition that they will establish the validity of the model. Economists do not take the splits and the adjustments of stock prices as new information that could affect the business equilibrium. Entrepreneurs have a presumption is that associate splits with the appearance of more fundamental important information. The idea is to analyze security returns of splits to see if they portray any abnormal tendencies and if so, they show how much the relationships between divisions and variables can account for it.
The primary concern of these studies is whether any investor or groups enjoy a monopoly in the access to any crucial information relevant to the formation of prices. These studies focus on whether the prices reflect all the information in the market held by the participants. The concern is that no individual should enjoy a higher trading profit because he has a monopolistic access to certain critical information.
Technical trading is the analysis of price activities with the assumption that all the relevant information is known by the market participants, and this affects stock returns during a particular period. This hypothesis assumes that the availability of the information that is presumed to be indicated by the share prices, this leads to recurring price patterns that can be used to foretell future decisions.
Fundamentalism is a concept that refers to a system in which market analyzes is done using economic data to forecast prices and to determine if markets are over or undervalued. Such can include stock prices against expected returns or by gauging the actual value of a company’s assets compared to their book value. The belief here is that every stock has an inherent value, and the future streams of earnings and dividends are the ones that determine it. Fundamentalist studies, financial statements, industry and firm prospects, managerial ability, government policies, and any other variable that they believe will affect future returns. They then estimate the future incomes of a share, and if its price is less than its inherent value then, they deem it attractive.
Beating the Market and the Real World View
Beating the market is a concept used to denote a situation in which the company realizes better returns than the set targets in the market and also higher than those achieved by competitors. Firms that beat the market get giant profits, even when the stock market is not performing well, when the markets are stagnant and churning.
The first strategy employed by companies seeking to make exemplary profits is predictive of future price relationships between convertible securities and their common stock instead of predicting individual securities. This approach allows them to make preparations and investments before others do. Such companies also invest heavily in research and investigation of advisory services and mutual funds instead of solely depending on current or previous market performance. Such investors are critical readers and reviewers of any book or any available material that could give them crucial information pertaining to the business environment so that they are confident while taking even the highest risks.
In the real world, however, beating the market is not common. Only a few and prosperous entrepreneurs such as Peter Lynch, and Warren Buffet have been able to enjoy such fortunes. Many unmentioned investors have tried but failed. One of the challenges of beating the market is the need to make giant investments. For example, an investment in the 500 index funds performs proportionally to the amount invested. However, the investor will have to deduct the investment fee from the realized returns thus hindering the market-beating. Taxes are another barrier to market-beating because the payment of taxes reduces the profits significantly and even worse an increase in the amount of income earned translates to a higher amount of tax that the investor will have to pay. Entrepreneur’s perception also presents a hindrance because they tend not to be patient enough to wait for the opportune time to sell their stocks. Most investors buy their shares when the prices are high, but when the prices fall a little, they sell them out of panic thus failing to realize any sensible returns.
Chapter 3: Results and Analysis
In the twenty-first century, most economists believe it is possible to predict stock prices to some extent basing on various variables. They argue that proprietors should access the future stock prices on the basis of the preceding performance. Economists using sophisticated nonparametric statistical techniques that recognize patterns have found out that some of the stock market trends can be predictive. Such includes head and shoulder formations and double bottoms used by technical analysts.
They also argue that investors forecast future performance patterns, and this enables them to realize enormous amounts of risk-adjusted returns. They argue that stock prices do not respond to information such as mergers, stock splits, dividends, initial public offerings, etc. The 21st century economists put more focus on cases where investors may earn abnormally high profits due to circumstances such as an investor learning about the future opportunity and implement it early before others. Eventually, other players will come to learn about the opportunity and exploit it to the extent that it no longer gives the exaggerated returns. However, this scenario happens in the short-run.
In the long-run, research has shown a negative relationship in returns. These are explained to be due to investors who tend to have positive or negative attitudes towards market tendencies that cause them to either buy or neglect shares in a particular field thus affecting the prices. There also tendencies for investors buying stock shares in underperforming investments because they are cheap, with the hope that they will improve in the future for them to make profits. They in return avoid shares of a well-performing business because they fear that the enterprise may reach its peak and start recessing.
Chapter 4: Recommendations and Conclusions
From studies conducted especially during the Great Depression period, there are market reversals that keep alternating. It’s, therefore, possible to find a situation where stocks that are performing well for a particular period are the ones that perform poorly in another and vice versa. The interest rates, bond prices, and stocks keep on changing to keep the market competitive.
Another change that has occurred in today’s measurement of market efficiency is the use of dividend yields to predict future returns. In the past, companies used to buy shares capitals with relatively high initial profits in order to earn high rates of returns. However, that has changed in the current business world whereby companies now prefer to repurchase their shares than to increase the dividends. Contrary to the previous phenomenon of big companies making giant profits thus attracting investors, it has been observed that small businesses stocks generate higher returns than the larger companies.
This paper has made a number of recommendations on how to go about measuring a markets efficiency or inefficiency. The following are their outline:
I. Entrepreneurs should not use the previous performance of the enterprise as the sole method of predicting its expected performance in the future. The study has shown that the business environment keeps on changing.
II. Predicting a business’s future action cannot be used as the only basis for making investment decisions.
III. It is not possible to attain perfect information in a market setting. Some players have access to information that others don’t, and this leads to them having a market advantage.
IV. To be a leader in the market involves taking higher risks than other players in the market.
This paper concludes that even though there have been changes that have occurred in the market currently, the efficient market hypotheses are still important in evaluating the capital market system. They can still be used together with other factors to assess the market environment.
Chapter 5: Appendices
The share portfolio
Ryanair Holdings PLC
National Grid PLC
Blackrock investment Trust
Chapter 6: Bibliography
Fama, E. F. (1990). Efficient Capital Markets, II. The journal of Finance 25.2, Chicago: Center for Research in Security Prices, Graduate School of Business, University of Chicago, 383-417.
Bachelier, L. (2011). Louis Bachelier’s Theory of Speculation: The Origins of Modern Finance. New Jersey: Princeton University Press,.
Barnes, P. (2012). Stock Market Efficiency, Insider Dealing, and Market Abuse. Aldershot: Gower Publishing, Ltd.
Benoit, M. (1996). “Forecast of future Prices, Unbiased Markets, and Martingale Models.” Journal of Business, 39, 242-255.
Samuelson, P. A. (1965). “Proof That Properly Anticipated Prices Fluctuate Randomly.” Industrial Management Review, 6, 41-49.