Efficient Markets
A market is generally considered “efficient” if all pertinent information is released to all market participants simultaneously and prices adjust immediately in response to information. The Efficient Market Hypothesis (EMH) states that the stock market and the prices of traded securities are efficient because they fully reflect available information. Essentially, the EMH implies that it is impossible to consistently outperform the market on a risk-adjusted basis over time. There are three versions of the EMH - weak, semistrong, and strong - each distinguished by what it considers the term “available information.” Although the EMH is commonly referred to in the classroom and the industry, many disagree with its idealistic points and cite various market anomalies as evidence that the stock market is far from 100% efficient.
ELEMENTS OF EFFICIENT MARKETS
Profit-Maximizing Investors: Investors who believe they can outperform the market and intend to maximize their profits in doing so
Complete Transparency: Information is widely available to all market participants at the same time and at low cost
Large Trading Volume: A large number of buyers and sellers must continuously trade market securities
Low Transaction Costs: Transaction costs must be less expensive than the expected profits generated from trading
High Liquidity: Assets must be able to be traded quickly and converted easily in the marketplace
EFFICIENT MARKET HYPOTHESIS
1. Weak-form EMH: The weak-form EMH asserts that stock prices reflect all historical information from past trading. This implies that factors such as the history of past prices, trading volume, and short interest are already accounted for in the current stock price of a firm. Under this assumption, technical analysis techniques cannot consistently outperform the market, but excellent fundamental analysis techniques may produce excess returns.
2. Semistrong-form EMH: The semistrong-form EMH asserts that all publicly available information is reflected in the stock price of a firm. This assumption implies that in addition to historical information, factors such as future earnings forecasts, balance sheet composition, patents held, management personnel, etc. are already accounted for in the current stock price of a firm. Therefore, neither technical analysis techniques nor fundamental analysis techniques are likely to produce excess returns.
3. Strong-form EMH: The strong-form EMH asserts that all information relevant to a firm, including both public and insider information, is reflected in its stock price. In addition to the assumptions of the weak-form and semistrong-form EMH, this version claims that current stock prices account for not only everything the public knows, but everything the corporate insiders know as well. Therefore, no particular individual or technique should ever consistently outperform the market over time unless it is completely attributed to luck.
MARKET ANOMALIES
P/E Effect: Firms with lower price/earnings ratios have outperformed firms with higher price/earnings ratios on a risk-adjusted basis
Small-Firm Effect: Small-capitalization firms have outperformed large-capitalization firms on a risk-adjusted basis
Book-to-Market Effect: Firms with higher book value to market value ratios have outperformed firms with lower book value to market value ratios on a risk-adjusted basis
Initial Public Offerings: Initial public offerings tend to experience excessive short-term returns
January Effect: The month of January has historically outperformed other months.
Individual Outliers: Warren Buffett, Peter Lynch, George Soros. These men and their strategies are living proof that the market can be outperformed.