I have been reading the materials about Efficient Market Hypothesis. I found that there had been lots of studies on this topic, as expected. Many of the studies deal with one aspect or one implication of the theory, but there is no clear conclusion. I am unable to read and comprehend all the materials, so I guess I will study only some of the papers.
In this post, I will present some arguments for the EMH as well as several pieces of empirical evidence.
The EMH was probably first formulated by a French Mathematician in the 1900s. The hypothesis was made prominent in the 1960s by Eugene Fama. His 1970 paper reviewed the theory and extended it to include three forms of market efficiency and I elaborated them during the last tutorial. Briefly, there is a weak form of efficiency, stating that the current price of a financial asset incorporates all the past information. An implication of this form of efficiency is that technical analysis which is based on historical stock prices cannot sustain an excess return. The second form is the semi-strong form of efficiency which states that current price of an asset incorporates all publically available information, past and present, or in another words, prices adjust immediately to the newly available information to the public. An implication is that fundamentalists cannot sustain excess return. The last form is the strong form of efficiency which claims that prices reflect all information, public and private, insider information for example. There is not much contention on third strong form which seems far from reality.
Here are some arguments for EMH, and I reserve my judgement on them.
In almost all the courses on financial math, we are taught to assume rational investors. If the assumption is valid, the market is efficient. For example, when new information is released, investors adjust their estimates of stock prices rationally (in a way we are taught in the courses I suppose). Of course they will get the "correct" price of the stock. Buyers are willing to bid for price no more than the "correct" one and sellers are willing to offer a price no less than the "correct" one. If there is any transaction, the price will therefore be the true value of the stock.
As you may observe that the first argument is highly ideal. In reality, even when investors receive the same information, they can interpret it in different ways, so here comes the second argument. Investors analyse information independently. Some may overprice the stock while others could underprice it. Market efficiency is achieved when there is equal number of irrational optimists and irrational pessimists.
Offsetting irrationalities at all times may still be unrealistic, so there is a third argument. Assuming there are professional investors who study companies methodologically and price the stock "correctly". And because of their confidence, they are willing to investment large sum when they observe mispriced stocks. For example if the stock is underpriced, they will buy in a large sum therefor bidding up the price and "correct" the stock price.
Now I shall present some evidence supporting the hypothesis. In the book 'Modern Financial Management' by Ross, there is a serial correlation studies on eight stocks. Since there is no acknowledgment, I suppose it was done by the author. The results show the highest correlation is 0.0409, where +-1 implies perfect correlation and 0 indicates no correlation. This means there is almost no correlation between return of a particular stock over different time periods. The finding supports weak form of efficiency.
The second piece of evidence is that the average return of mutual funds over the period 1963-1998 is lower than the market return. Since mutual fund managers rely on public information, just as ordinary investors do, they will not outperform the market index. The result is consistent with the semistrong form of efficiency.
There are some event studies supporting the semistrong as well. For example, the work by Szewczyk, Tsetsekos on dividend omissions, indicates that dividend omission has a significant impact on the stock price only before and on the day of announcement.
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