EFFICIENT MARKET HYPOTHESIS (FAMA 1960)

The efficient market hypothesis is concerned with establishing the share price of securities and states that the price reflects fully and fairly all available information (Fama, 1960). Efficiency relates to the speed and quality of the price adjustment to new information. According to this it is impossible to beat the stock market efficiency and make abnormal returns, because share prices always absorb and incorporate all available information.

ASSUMPTIONS OF EMH There are a large number of profit-maximizing market participants who, independently of one another, analyze and value stocks Profit maximizing investors adjust security prices rapidly to reflect the effect of new information New information on securities comes to the market in a random fashion RANDOM WALK THEORY The outcome of EMH is that share prices should follow a random walk The theory states that all current prices reflect all available information Any changes in prices occur in response to new information, which is random and unpredictable Therefore any attempts to predict stock prices using technical or fundamental analysis is futile, as information comes into the market RANDOMLY AND UNPREDICTABLY. The best prediction for tomorrows price is todays price.

There are 3 forms of MARKET EFFICIENCY: WEAK FORM EFFICIENCY Markets are weak form efficient if the share prices reflect all historical information, such as past share price movements
[Share prices reflect all information that can be derived by examining past market trading data: past share prices; trading volume, etc]

Abnormal returns cannot be made in this market by: Using technical analysis to study past share price movements. Abnormal returns can only be earned where: Investors have public or private information about the firms present / future performance Because share prices reflect completely all past information, it isnt possible for investors to predict future share prices. Share prices change as new information arrives at random; hence share price movements will also appear random. This is supported by the RANDOM WALK HYPOTHESIS

SEMI-STRONG FORM EFFICIENY Capital markets are semi-strong form efficient if current share prices reflect all historical information AND all publicly available information, AND if all share prices react quickly and accurately to incorporate any new information as it becomes available.
[Past share price data; trading data; financial statements; forecasts of future firm, industry and economic conditions]

Abnormal returns cannot be made in a semi-strong efficient market by: Studying public available information Using fundamental analysis. Exploit information on past share price data Abnormal Returns can only be earned where: Investors have private information about the companys present / future performance

STRONG FORM EFFIECIENCY Capital markets are said to be strong form efficient if share prices reflect all information, whether it is publicly available or not.
[Past share price data; trading data; financial statements; forecasts of future firm, industry and economic conditions; insider information]

If markets are strong, NO ONE can make abnormal returns from share dealing, not even investors who use insider information Capital markets clearly do not meet all the conditions for strong form efficiency, since some investors DO make abnormal returns by using insider info. Therefore are not taken to be strong form efficient. It is suggested that markets are semi-strong from efficient. However abnormal returns have been known to be made in semi-strong form efficient market with trading strategies and fundamental analysis due to certain anomalies, showing that markets may not respond quickly and accurately to new information which indicates a form of market inefficiency. These Market anomalies suggest a form of market INEFFICIENCY. Calendar effects Trading at particular times of the day can lead to negative or positive returns. Trading during last 15 minutes of day, share prices tend to rise Monday mornings produce negative returns, known as weekend effect High returns noted in particular months, e.g. April = UK, January = US

Size Anomalies - Returns from investing in small companies have been shown, in long run, to be greater than average returns from all companies. Because small firms have higher risk, hence higher return

- Value firms V Growth Firms. Returns from value firms give more return than that of growth.

Accounting anomalies - Firms with reporting unexpectedly high earning outperform firms reporting unexpectedly low earnings - Firms with high (low) levels of accruals to total assets experience negative (positive) future abnormal returns

IMPLICATIONS OF THE EFFICIENT MARKET HYPOTHESIS To investors: Paying for investment research will not produce above-average returns Studying published accounts and investment tips will not produce aboveaverage returns There are no bargains (underpriced shares) to be found on the stock market

To a company and its managers: Share price of a company fairly reflects its value and market expectations about its future performance and returns. The financial manager should therefore focus on making good financial decisions which will increase shareholder wealth as the market will interpret these decisions correctly and the share price will adjust accordingly. Cosmetic manipulation of accounting information, whether through window dressing of financial statements or by massaging EPS, will not mislead the market Timing of new issues of shares is NOT important since shares are NEVER underpriced.