EFFICIENT MARKET THEORY AND TESTS
EFFICIENT MARKET THEORY AND TESTSMarket Efficiency
A market is said to be efficient if prices in that market reflect all available information. Market efficiency refers to a condition in which current stock prices reflect all the publicly available information about a security.
Efficient market emerges when new information is quickly incorporated into the share price so that the price becomes information. In other words the current market price reflects all available information. Under these conditions the current market price in any financial market could be the best (unbiased estimate) of the value of the investment.
The Theory of Efficient Market Hypothesis
The
Efficient Market Hypothesis (EMH) was first defined by Eugene Fama in
his financial literature in 1965. He defined the term "efficient market"
as one in which security prices fully reflects all available information.
EMH
is the theory describing the behavior of an assumed “perfect” market which
states that:
(a). Securities
are fairly priced and that their
expected returns equal their required return.
(b). Security
prices, at any one point, fully reflect
all public information available and react swiftly to new information.
(c). Because
stocks are fully and fairly priced, investors need not waste time trying to find and capitalize on mispriced
(undervalued and overvalued) securities.
Therefore,
the market is efficient if the reaction of market prices to new information
should be instantaneous and unbiased.
The
efficient market hypothesis states that it is not possible to consistently
outperform the market by using any information that the market already knows,
except through luck. Information or news
in the EMH is defined as anything that may affect prices that is unknown in the
present and thus appears randomly in the future.
Evidence in favor Efficient Market Hypothesis Theory
(a)
Stock prices are close to random walks
(b)
Stock returns have low linear correlation
(c)
Stock returns are very hard to predict
(d) Portfolio managers do not beat the market on average and almost no one
beats the market consistently.
Assumptions on the Market Efficiency
(a) Information is available and all investors have access to the available information about the future
(b)
All investors pay close attention to
market price and adjust their portfolio appropriately
(c)
All of information is fully and
immediately reflected in market prices
(d)
Investors make a fair return on their
investments
(e)
Investors believe that the market is not
efficient, investors spend time analyzing securities searching for undervalued
securities and consequently security prices react instantaneously to released
information, which in turn makes the market efficient.
Forms of Market Efficiency
There are three common forms in
which the efficient market theory is commonly stated. They include: The weak
form, the semi strong form and the strong form.
i)
Weak Form of Efficient Market
The weak form EMH stipulates
that current asset prices already reflect
past price and volume information. The information contained in the past
sequence of prices of a security is fully reflected in the current market price
of that security. It is named weak form because the security prices are the
most publicly and easily accessible pieces of information. It implies that no
one should be able to outperform the market using something that
"everybody else knows". This technique of using current and publicly available
information is also called technical
analysis. It is useless for predicting future price changes.
The technic however asserts that it should be possible to predict future stock price movement from historical patterns. For instance Safaricom's
Stock at NSE has increased steadily over the past few months to the current price of Ksh.11, then this price
will already fully reflect the information about the company's growth and
therefore the next change in the stock price could either be upward, downward,
or constant with equal probability. It therefore follows that technical
analysis will not enable investors to make arbitrage profits. In markets that
have achieved this level then security prices follow a trend less random walk.
Studies to test this level have been
based on the principle that:
(a)
The share price changes are random
(b)
That there is no connection between stock
price movement and new stock price changes. It is possible to prove
statistically that there is no correlation between successive changes in price
of securities and therefore trend in stock price changes cannot be detected.
This can be done using linear correlation (auto-correlation) test such as
Durbin Watson Statistics.
ii)
The Semi Strong Form of Efficient Market
The
semi strong form EMH states that all publicly available information is
similarly already incorporated into asset prices. In another words, all
publicly available information is fully reflected in a security's current
market price.
The
public information stated not only past prices but also data reported in a
company's financial statements, company's announcement, economic factors and
others. It also implies that no one should be able to outperform the market
using something that "everybody else knows".
This
indicates that a company's financial statements are of no help in forecasting
future price movements and securing high investment returns. If the market has achieved this level, then fundamental analysis will not enable
investors to earn consistently higher than average returns
Fundamental analysis involves the study of company's
accounts to determine its net value and therefore find any undervalued stock.
Fundamental theory states that every stock in the market has an intrinsic
value, which is equal to the present value of cash flows expected from the
security.
Tests on Semi Strong Form of
Efficient Market
To test for semi-strong form
efficiency, the adjustments to previously unknown information must be of a
reasonable size and instantaneous. To test for this, consistent upward or
downward adjustments after the initial change must be looked for. If there are
any such adjustments it would suggest that investors had interpreted the
information in a biased fashion and hence in an inefficient manner.
Tests to prove semi-strong form of efficiency have concentrated on the ability of the market to anticipate stock price
changes before new information is formally announced. These tests are referred
to as Event studies e.g. if two
companies plan to merge, stock prices of the two companies will change once the
merger plans are made public. The market would show semi-strong form of
efficiency if it were able to anticipate such changes so that stock prices of
the company would change in advance of the merger
plans being confirmed. Other events that can affect stock prices are:
(a) Stock splits
(b) Changes in dividend policy
(c) Investment in major profitable projects
(d) Share repurchase programs
(e) Other stocks and bond sales
Examples of publicly
available information are
(a) Annual reports of companies
(b) Capital market reports
(c) Central Bank reports
(d) Earnings estimate disseminated by companies and security analysts.
iii)
Strong Form of Efficient Market Theory
The
strong form EMH stipulates that
private information or insider information too, is quickly incorporated by
market prices and therefore cannot be used to reap abnormal trading profits (past, present and future information).
Thus, all information, whether public or
private, is fully reflected in a security's current market price. That
means, even the company's management (insider) are not able to make gains from
inside information they hold. For example, they are not able to take the
advantages to profit from information such as take over decision which has been
made ten minutes ago.
The
rationale behind this support is that the market anticipates in an unbiased
manner, future development and therefore information has been incorporated and
evaluated into market price in much more objective and informative way than
insiders.
If the theory is correct, then the mere publication of information that was
previously confidential should not have impact on stock prices. This implies that insider trading is impossible.
Tests on the Strong Form of Efficient Market
Theory
To test for strong form efficiency,
a market needs to exist where investors cannot consistently earn excess returns
over a long period of time. Even if some managers are consistently observed to
beat the market, no refutation even of strong-form efficiency follows: with
tens of thousands of fund managers worldwide even a normal
distribution of returns (as efficiency predicts) should be expected to produce
a few dozen "star" performers
Tests that have been carried out on this level have concentrated on activities of fund managers and individual investors.
If the markets have reached the strong form levels, then fund managers cannot
consistently perform better than individual investors in the market. Examples of strong form of efficient market
information are:
(a)
Imminent corporate takeover plans;
(b)
Extra ordinary positive or negative future
earnings announcements;
(c)
Mergers and acquisitions.
i)
The timing of investment policy:
If the market is efficient, price follows a trend less random walk and it
is impossible for managers to know whether today’s price is the highest or
lowest in order to issue new stocks. Timing other policies e.g. release of
financial statements; announcement of stock splits, e.t.c. has no effect on
Share prices.
ii) Project
Evaluation Based upon NPV
When evaluating the projects, investment managers use the required rate of
return particular project may be determined by observing the rate of return by
shareholders of firms investing in projects of similar risk. This assumes that
securities are fairly priced for the risks that they carry (i.e. the market is
efficient). If the market is inefficient, however, financial managers should be
appraising projects on a wrong basis and therefore making bad investment
decisions since their estimate on net present value (NPV) is unreliable.
iii)
Creative Accounting:
In an efficient market, prices are based upon expected future cash flows
and therefore they reflect all current information. There is no point therefore
in a firm attempting to distort current information to their advantage since
investors will quickly see through such attempts. Studies have been done for
example to show that changes from straight line depreciation to reducing balance method, although it may result to
increasing profit, may have no long-term effect on share prices.
iv) Mergers and Takeovers
If shares are correctly priced then the purchase of a share is a zero NPV
transaction. If this is true then, the rationale behind mergers and takeovers
may be questioned. If companies are acquired at their correct equity position
then purchases are breaking even. If they have to make significant gains on the
acquisition, then they have to rely on synergy in economics of scale to provide
the saving. If the acquirer (or the predator) pays the current equity value
plus a premium, then this may be a negative NPV decision unless the market is
not fully efficient and therefore prices are not fair.
v)
Validity of the current market price
If markets are efficient then they reflect all known information in
existing stock prices and investors therefore know that if they purchase a
security at the current market price they are receiving a fair return and risk
combination. This means that under or
overvalued stocks do not exist. Companies should not offer substantial
discounts on the security issues because
investors would not need extra incentives to purchase, the securities.
Looking at the current trend, our own, trading platform, the NSE, is in the
right direction, though not moving ads fast as most fund managers would want. But
we are getting there.
Godfrey Chege
Senior Accountant, Dreamcatcher Productions Limited
CPA, BBM (Moi University,
Finance and Banking)
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