The efficient market hypothesis
And why it does not hold
The efficient market hypothesis (EMH) states that asset prices reflect all available information in the market, suggested by Eugene Fama in 1970. This means that consistent alpha generation is impossible, as stocks are left neither undervalued nor overvalued. It provides basic logic for modern risk-based theories of asset prices and implies that the only way to obtain higher returns is by taking more risk; this is a grey area in defining and reflecting on the levels of risks taken within a portfolio.
Fama identified three distinct levels of the theory, strong-form EMH, semi-strong-form EMH and weak-form EMH. These reflect the degree to which the EMH applies to markets.
Strong-form EMH
This level suggests that all relevant information about an asset is quickly and accurately reflected in the market price, leaving no time for investors to profit on short-term movements in stock prices. If an asset is undervalued, holders of private information will buy up the share until it reaches the price supported by their interpretation of the news. However, this has not been proved as it would require the cooperation of inside traders, who are unwilling to reveal their identity, let alone partake in financial market research. As a result, trading on private information still generates no consistent alpha as news is immediately factored in. Despite this, someone must be the first to trade on inside information and therefore generate excess returns without taking on more risk.
Semi-strong-form EMH
The next level theorises that all relevant publicly available information is quickly and accurately represented in the market price of financial assets. The publication of new, relevant information is digested quickly and is then used to move the price to a new equilibrium level where the supply and demand for the asset have been reflected in response to the new information. Dissimilarly to the strong-form EMH, it implies that trading on inside information can generate excess alpha. Despite this, identifying ‘relevant publicly available information’ is challenging due to its ambiguity. Investors will have contrary views on what new news is relevant, and there is no distinct boundary between public and private information. Consequently, any public information (fundamental analysis) study is considered aimless and cannot yield consistent excess returns. This raises questions about financial services’ purpose, particularly investment research and analysis, whose business models revolve around the fundamental analysis to generate alpha.
Weak-form EMH
The final level of the hypothesis concludes that future prices cannot be predicted from a study of historical price changes following new information, like any ‘new’ information, by definition, is different from previous information. The effects on the share price are therefore unpredictable. Instead, the development of prices assumes characteristics of a random walk, where the response of new information cannot be predicted from previous movements. This invalidates and objects to studying past patterns in price behaviour (technical analysis), and alpha can only be generated through pure luck.
Why it may not hold
Despite the strong evidence that the efficient market hypothesis is present, in either one of its levels, in financial markets today, I do not believe it can fully explain price movements. In general, it suggests that price movements are entirely unpredictable, and alpha cannot be generated consistently. However, recent innovations in behavioural finance propose other factors that influence market swings.
Herd instinct, the tendency for investors to follow the actions of others, can be considered a significant factor in determining prices. When the world has never been more interconnected via the internet, rumours can spread, and people are more exposed to others’ behaviours in the financial markets, exaggerating this herd behaviour further.
Further research into behavioural finance reveals the tendency for investors to underreact or overreact to newly available information due to greed or fear. This can create distortions in the prices of the underlying assets, which aligns with the EMH. However, the difference lies whereby the idea behind over/under-reacting leads to price movements above or below the equilibrium level, whereas the EMH assumes it comes to an immediate equilibrium. This opens up opportunities for investors to exploit other greedy/fearful investors and thus generate alpha without taking on any more risk. However, this is only a short-term strategy as eventually, the price will return to its intrinsic value.
Additionally, other patterns have been identified in financial markets but are often considered anomalies when faced with the efficient market hypothesis. The ‘small firm’ effect, which proved that companies with small capitalisations tended to deliver higher returns than larger companies, demonstrates opposition to the theory, as a key pattern has been identified. Due to the persistence of the outperformance, it cannot be considered a distortion in the EMH. Instead, it is a contradiction.
Furthermore, the reversion to the mean has been identified as another key market trend whereby, in the long run, stock prices will revert to a long-term average. Although not a thorough proof, investors can generate alpha by entering stocks during downtrends expecting them to revert to the mean follow a period of outperformance. Again, this contradicts that asset prices are unpredictable and appropriately priced at all times.
The January effect is another hypothesis that realises the tendency for stocks to outperform in successive January’s. This is generally attributed to increased buying during the new year following a drop in December when investors sell their assets to harvest tax losses. This is another discernible trend that the EMH should have harvested away, should it stand. However, since the theory developed, investors have executed the strategy by buying during the sell-off in December; as a result, it raises the prices prematurely. Consequently, the strategy is no longer applicable as the annual coming of January is not exactly fresh news.
Despite not providing evidence against the EMH, the theory can be considered partly responsible for the financial crisis in 2008 as it resulted in politicians, central bankers and regulators placing excessive reliance on market rationality. This gave a false sense of security which resulted in a potential lack of intervention in the markets when intervention was very much necessary. If the EMH did not stand, policymakers could have realised the severity of the financial markets’ situation and taken more drastic action to try and limit the potential downside risk. George Soros argued that the bubble which preceded the crisis was influenced by ‘the prevailing misconception… that financial markets are self-correcting and should be left to their own devices.’
Overall, despite a robust explanation for the movement of asset prices within markets, I believe that behavioural factors, particularly herd instinct and the irrational reactions to new news stories, are a more significant force behind market swings, followed closely by fundamental analysis and valuation methodologies. This is evident by the fact that Warren Buffett achieved market-beating returns over the long-term, which cannot be put down to luck, but due to rational value investment methods and understanding the behaviours of other investors, his competition.
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Ted Jeffery
