EFFICIENT MARKET THEORY AND TESTS
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 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.
(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.
(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.
Senior Accountant, Dreamcatcher Productions LimitedCPA, BBM (Moi University, Finance and Banking)