Efficient Market Hypothesis Essay: Explanation, Forms, And Evidence.

Arguments for and against and Evidence of EMH

• Explain the meaning and forms of EMH.

• Explain the logic behind EMH.

• Present the evidence that researchers offer for and against each form of EMH.

• Explain how an asset price bubble can be rational, i.e. consistent with EMH.

• Evaluate the housing and mortgage-backed security price bubbles that brought on the recent financial crisis and concluded on whether they were rational or irrational.

• The essay has been written clearly and concisely and not exceeded the word limit.

In financial economics, many studies have been carried out on efficient market hypothesis (EMH) and this interest has been triggered by various reasons. According to Fama(1970), EMH refers to an investment hypothesis which postulates that it is hard to make abnormal profits due to stock market efficiency.  In this case, an efficient stock market enables the prevailing stock prices to factor in and incorporate entire relevant information within a short period. EMH is divided into three types notably; weak-form, semi-strong form as well as strong form EMH. This classification is dependent on the extent and speed at which the stock prices incorporate any new information that intrudes the market.  Based on the literature, the risk-weighted return is greater in markets that are inefficient in comparison to efficient markets (Sewell, 2012). For this reason, the studies undertaken on stock market efficiency tend to be significant for both individuals as well as institutional investors.

Additionally, strong knowledge of market efficiency is vital among corporate managers as their decisions influence the market value of their firms. Lastly, the EMH is often treated as a supposition in many financial models. The studies conducted on EMH have given rise to numerous contradicting arguments among the scholars. In this regard, this essay presents the arguments for and arguments against the EMH. To substantiate the claims, the essay provides corresponding evidence to the arguments. Then, the essay expounds on the effect of the recent financial crisis on EMH and winding up with a summary of the discussions.  

The initial empirical studies anchoring the viewpoint of randomness in share prices focused on determinants of short-run serial correlations exhibited by consecutive stock price movements. Overall, this study operated on the premise that the stock market lacks memory. This implied that the previous stock behaviour is irrelevant in determining its future behaviour as noted by Cootner (1964). In another research, Lo and MacKinlay (1999) established that short-run serial correlations were non-zero. More so, the presence of unnecessarily many fluctuations towards similar direction drew them to deny the fact that share prices exhibit random walk behaviour. Perhaps, this proved that there was momentum in short-run share prices.

Short-term momentum which involves under-reaction to any information intruding the market

Furthermore, the scholars Lo, Mamaysky and Wang (2000) employed advanced nonparametric statistical methods which detect patterns. Also, they used a number of stock price signals which demonstrated that the stocks prices experience predictive ability to a certain extent. Additionally, many economists as well as psychologists with a bias in behavioural finance believe that short-run momentum adheres to psychological feedback mechanisms. This means that people often observe a stock price increasing and become attracted to the stock market in a manner that describes a bandwagon effect. In this connection, Shiller (2015) attributed the coming to lime light of the United States stock market in the course of 1990s to psychological influence. As a consequence, the U.S stock market experienced irrational exuberance. Further, the behaviourists argued that the short-run momentum was caused by the behaviour of investors failing to react to the information intruding the market accordingly. If for any reason, the complete effect of crucial news announcement can be tapped within some time, then the stock prices can demonstrate a positive serial correlation.

Nevertheless, many factors interplay to offer contradicting implications on whether it holds that the share prices do not follow a random walk. To start with, since the stock market does not display a perfect example of a random walk, it is crucial to strike the difference between statistical as well as economic significance. Markedly, the statistical variables that influence the momentum are negligible which, in other words, imply that cannot allow investors to make abnormal profits. Any individual incurring transaction costs are less probably to institute a trading strategy while relying on the momentum obtained in these researches which will stand out against a buy-and-hold approach. On this note, Camerer et al. (2011) proposed that momentum investors rarely benefit from abnormal profits. On the contrary, some of these investors gained lesser profits in comparison to buy-and-hold investors at the time of candid, positive momentum   established through statistical techniques. This is due to the presence of transaction costs which optimises any level of momentum that is available. In a similar fashion, Abraham (2014) found out that standard strategies are not lucrative due to trading costs associated with their implementation.

Secondly, as a behavioural theory on bandwagon effects as well as under reaction to the latest information may appear sufficiently reasonable, the proof that such impacts happen in a systematic manner in the equity market is inadequate. For instance, Fama (1998) investigated the significant collection of empirical studies on events studies which tailored towards establishing whether equity prices behave efficiently to new announcements in the market. In this case, the events encompassed announcements on return surprises, share splits, activities on dividends, mergers, latest exchange listings as well as IPO or initial public offerings. Fama found out that clear under reaction to new information is as obvious as an overreaction. Also, he established that post event consistency of abnormal returns occurred in the same manner as post event reversals. Furthermore, Fama indicated that the majority of return inconsistencies occurred only in situations where specific models are used. However, these findings tend to diminish when a variety of models for anticipated normal earnings are employed to incorporate risks. This occurs in tandem with the use of distinct statistical approaches are employed. For instance, research that offers identical weights on post announcement earnings of various stocks can give rise to varying findings from research that allocates weights to the stocks based on their intrinsic value.

Long-Run Return Reversals

As discussed in the short-run, the returns are determined using a number of days and the common argument countering market efficiency entails the occurrence of positive serial correlation. However, various studies have proved that there is negative serial correlation within an extended period. At some point, this is referred to as return reversals. For instance, Fama and French (1988) established that twenty-five to forty percent of the changes in long-term earnings can be projected on the basis of negative correlation with previous earnings. Likewise, Poterba and Summers (1988) confirmed that there is a significant mean reversion exhibited by stock market returns in the long-run.

A number of researchers have claimed that this projection is caused by the behaviour of the share prices to overreact. In this connection, DeBondt and Thaler (1985) contended that investors are influenced by optimism as well as pessimism which make prices diverge systematically from their basic values and afterward exhibit mean reversion. These scholars attributed this overreaction to previous events is in tandem with the hypothesis of behavioural decision suggested by Camerer et al., (2011). This theory states that investors are intrinsically overconfident in their efforts to project future share prices. These results add weight to investment methods that subscribe to contrarian strategy. Contrarian strategy involves purchasing of stocks that have seemed unattractive over a long period and shying off from stocks that are characterized by long-term run-ups.

Although there is significant evidence to substantiate negative long-run relationship in the stock earnings, the results indicated by mean reversion has proved to differ across various researches. In particular, this correlation has shown a different degree of strengths from one period to the other. Notably, the strongest empirical is manifested in times like the Great Depression. This period gives rise to stock patterns that do not give a definitive generalization. Furthermore, these mean reversals, in general, may demonstrate a behaviour that tally’s with market efficiency. The rationale for this is that they are partially engendered by interest rate volatility as well as the interest rate behaviour to return reverse.  Because of the condition that stock return has to increase or decrease to increase its competition with earning from the bonds, it is likely that there will be fluctuations in the interest rate accordingly. In the instances where interest rate adjusts back to the mean within certain duration, this changing pattern will give rise to return reversals such that the pattern corresponds to the efficient market operation.

Furthermore, it may be difficult to generate profits when single stocks show return reversal behaviour. Fluck et al.(1997) modelled a strategy that involved buying of stocks within thirteen-year duration in the course of the 1980s as well as early 1990s which experienced poor earnings over the previous 3-5 years. These scholars established that equity with extremely low returns within the 3-5 years duration displayed greater earnings in the subsequent periods. On the other hand, the shares characterized by high earnings within the previous 3-5 years demonstrated lower earnings in the subsequent periods. Therefore, it was concluded that there is extremely strong statistical proof of mean returns. Nevertheless, the scholars also established that earnings in the subsequent period were indifferent to both groups. For this reason, the scholars were unable to prove that contrarian strategy would give rise to higher-than-average returns. Therefore, it can be concluded that although strong statistical pattern associated with mean returns was manifested, no indication was available that confirm that market inefficiency would empower investors to realise abnormal earnings.

The recent fall in economic performance, as well as turmoil experienced in the financial market coined as the global financial crisis, was condemned for the failure of the financial markets between 2007 and 2008 internationally(Milner, 2009). In this regard, the concept of EMH has been employed by many scholars to explain the effect of the financial crisis.  Indeed, the financial crisis paved the way for fresh scrutiny as well as a critique on the EMH. Notably, market strategists such as Grantham asserted absolutely that the efficient market hypothesis accounted for the financial crisis in that the trust in the EMH made corporate leaders to acute underestimation of the consequences of occurrence of asset bubbles (Nocera, 2009) .This is evidenced by the words of Roger Lowenstein(Fox, 2016).

In the meeting organised by International Organisation of Securities Commissions, the debate on EMH was among the key agenda. In the meeting, Martin Wolf- the premier Financial Times staff- rejected the fact that EMH is not related to the real operation of the market. In the same meeting, McCulley- the MD of PIMCO presented a subtle view that EMH had not failed, though had a lot of errors in its application as it ignored the human nature (Stevenson, 2009).  In addition, Posner Richard deviated from the EMH and exerted more weight on Keynesian economics. In his criticism, he contradicted some prevailing perspectives by maintaining that the decision to liberate the financial sector had exceeded the limits through exaggerating the pliability of laissez-faire capitalism (Cassidy, 2010).

Despite the criticisms, the effect of financial crisis on EMH was grounded on two major conceptions. To start with, the perspective that competition puts in force a relation between revenues as well as costs. This implies that, in a scenario of abnormal profits, new entry lowers the costs. Secondly, there is a perspective of treating fluctuations in asset prices as determined by the information flow in the equity market. When these two perspectives are used jointly, the EMH results as noted by Ball (2009).

This basic conception offers more insights on a startling projection on financial market response to any information that is freely made public. In competitive equilibrium situations, the returns derived from the use of information released to the public ought to commensurate with the cost incurred in using it. However, in reality, public information is priceless which implies that it is freely found. As consequence, the returns associated with such information ought to be equated to zero (Kim, Shamsuddin and Lim, 2011). Therefore, no one can earn abnormal profits from such information that has been factored in the prices.

During the financial crisis, it was established that the assumption of efficient market was relaxed (Ball, 2009). This implied that the market prices did not reflect all the information that was available on the market. As such, there was an asset bubble which was characterised by increasing and falling of stock prices by huge differences than usual. At this point, some prudent investors benefited from the opportunity that was presented by the market. At the same time, a number of investors recorded significant losses. 

Conclusion

From the essay, it is apparent that there is diversified and contradicting opinion about the validity of the efficient market hypothesis. In the essay, if the stock price demonstrated random walk behaviour, the equity market was regarded as of Weak-form market efficiency. On the other hand, if the stock prices indicated that it does not follow random walk behaviour then it was regarded as inefficient. This meant that the previous stock data can be used to predict future prices. On this note, some studies found out that the stock prices exhibit random walk behaviour. In particular, this studies include Cootner (1964), Lo and MacKinlay (1999) and Fama(1998). Conversely, Lo, Mamaysky and Wang (2000) established that there is some degree of predictability in the stock market. The EMH acknowledges the fact that it is difficult for any investor to make supernormal profit in an efficiently operating stock market.

Furthermore, the global financial crisis was associated with the EMH. However, it has been argued that it is incorrect to assume that EMH caused the market bubbles. Instead, the essay has clarified that the occurrence of the financial crisis is pegged on overreliance on the belief of EMH. During this time, some the prevailing assumption of EMH did not hold which resulted in the famous global financial crisis.

References

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