Efficient Market Hypothesis (EMH)

What are the implications of efficient market hypothesis (EMH) for investors who buy and sell stocks in an attempt to “beat” the market?

The Efficient Market Hypothesis (EMH) has implications for investors:

·  Rationality – imagine all investors rational, when new information is released in the market place, all investors will adjust their estimates of stock prices in rational way. For example, while FCC’s price $40, no one would now transact at that price. Anyone interested in selling would sell only at a price at least $45 (=$40 + 5). And anyone interested in buying would now be willing to pay up to $5. in other words, the price would rise by $5. Thus, perhaps it is too much to ask that all investors behave rationally, but the market will still be efficient if the following scenario holds.  

· Independent Deviations from Rationality – due to emotional resistance, investors could just as easily react to new information in a pessimistic manner. If investors were primarily this type, the stock price would likely rise less than market efficiency would predict. But suppose that about as many individuals were irrationally optimistic as were irrationally pessimistic. Prices would likely rise in a manner consistent with market efficiency, even though most investors would be classified as less than fully rational. Thus, market efficiency does not require rational individuals – only countervailing irrationalities. 

· Arbitrage – Imagine a world with two types of individuals: the irrational amateurs and the rational professional. Arbitrage is the word generates profit from the simultaneous purchase and sale of different, but substitute, securities. If the arbitrage of professionals dominates the speculation of amateurs, markets would still be efficient.

 

What are stock market anomalies with the context of an efficient market?

· Limits to arbitrage – behavioral finance suggest that there are limits to arbitrage. That is, an investors buying the overpriced assets and selling the underpriced assets does not have a sure thing. Deviations from parity could actually increase in the short run, implying losses for the arbitrageur.

· Earnings surprises – common sense suggest that prices should rise when earnings are reported to be higher than expected and prices should fall when the reverse occurs. However, market efficiency implies that prices will adjust immediately to the announcement, while behavioral finance would predict another pattern. Prices adjust slowly to the earning announcements, why do prices adjust slowly? Behavioral finance suggests that investors exhibit conservatism because they are slow to adjust to the information contained in the announcements.

· Size – in 1981, two important papers presented evidence that in the US, the returns on stocks with small market capitalizations were greater than the returns on stock with large market capitalizations over most of the 20^th century.

· Value versus growth – a number of papers have argued that stocks with high book value – to – stock – price ratios and/or high earnings – to – price ratios (generally called value stocks) outperform stocks with low ratios (growth stock). Value stocks have outperformed growth stocks in each of market researched, but further research is needed.

·Crashes and bubbles – the stock market crash of October 19. 1987. The market dropped between 20% and 25% on Monday following a weekend. A drop magnitude for no apparent reasons is not consistent with market efficiency.  Perhaps stock market crashes are evidence consistence with bubble theory of speculative markets. That is, security prices sometimes move wildly above their true values. Eventually, prices fall back to their original level, causing great losses for investors.

Reference: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.