Market Efficiency and Security Return Patterns
“Efficient Markets Hypothesis” (EMH) is a powerful idea that can be traced back to Paul Samuelson, whose contribution is neatly summarized by the title of his article: ‘ ‘Proof that Properly Anticipated Prices Fluctuate Randomly.’’ For a market to be informationally efficient, price changes must be unforecastable if they are properly anticipated, i.e., if they fully incorporate the expectations and information of all market participants (Farmer & Lo, 1999, p.
1).When the term “efficient market” was introduced into economics literature thirty years ago, Fama defined it as a market which “adjusts rapidly to new information and prices fully reflect all available information” (Fama, Fisher, Jensen, & Roll 1969, p.383; Fama, 1970, p.383). It soon became clear, however, that while rapid adjustment to new information is an important element of an efficient market, it is not the only one. In 1991, Fama declared a more reliable definition: asset prices in an efficient market “fully reflect all available information where the marginal benefits of acting on information is lower than marginal costs.”(Fama, 1991, p.1575) This definition emphasizes that the stock market processes information rationally, in the sense that relevant information is not ignored and systematic errors are not made. Fama then made his outstanding but dubious assumption that prices are always at levels consistent with “fundamentals”(Beechey, Gruen, & Vickery, 2000, p.2). Fama defined three different forms of efficiency which will be discussed in detail in the following sub section.
Even though the EMH is an appealing description of competitive market equilibrium, it may have some critical disabilities in regard to market factors. Here, it is crucial to emphasise that there are some deficiencies in defining the efficient market. For one thing, the strong version of the hypothesis could only be true if “all available information” was costless to obtain (Beechey et al., 2000, p.2).
If information was instead costly, there would have to be a financial incentive to obtain it. However, there would not be a financial incentive if the information was already “fully reflected” in asset prices. Additionally, if obtaining information would not make the agents better off, why would agents spend their time collecting information? A weaker, but economically more realistic version of the hypothesis is that prices reflect information to the point where the marginal benefits of acting on the information (the expected profits to be made) do not exceed the marginal costs of collecting it. Secondly, to say that prices are consistent with fundamentals there should be a model which provides an adequate link from economic fundamentals to asset prices. “While there are many models in all asset markets which try to provide this link, no one is confident that any of these models fully capture the link in an empirically convincing way” (Beechey et al., 2000, p. 2). This is important since empirical tests of market efficiency - especially those that examine asset price returns over extended periods of time - are necessarily joint tests of market efficiency and a particular asset-price model (Beechey et al., 2000, p. 2).When the joint hypothesis is rejected, as it often is, it is logically possible that this is a consequence ofdeficiencies in the particular asset-price model rather than in the efficient market hypothesis. This is the ‘badmodel’problem (Fama, 1991, p.1593).
Special interest should be directed to the word “efficient” in Fama’s well known definition. It appears that the term was originally chosen partly because it provides a link with the broader economic concept of efficiency in resource allocation. Thus, Fama began his 1970 review of the efficient market hypothesis specifically applied to the stock market (Fama, 1970, p.383).
The primary role of the stock market is allocation of ownership of the economy’s capital. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms’ activities under the assumption that securities prices “fully reflect” all available information at any given time.
It is possible to argue that there is a link between an efficient stock market, which prices reflects all available information (at least up to the point consistent with the cost of collecting the information), and allocation of resources in an economy efficiently. However, further analysis has made it clear that an informationally efficient stock market does not always generate efficient allocation of resources in the economy. The two concepts are distinct for reasons to do with the incompleteness of markets and the information-revealing role of prices when information is costly, and therefore valuable (Beechey et al., 2000, p. 2).
In an efficient market, new information is quickly included into prices without bias. Prices in the market fully reflect all available information. Market participants adjust the available supply and aggregate demand in response to publicly available information so as to generate market clearing prices. In major stock markets, where millions of dollars are “voting,” it seems plausible that a rational consensus will be reached as to the share prices which best reflect the prospects for future cash flows given available information. Although the EMH may be an elegant economic concept, it is not perfect. It has some important deficiencies (Bowman & Buchanan, 1995, p. 156).
Prices in securities markets may not fully reflect available information. The early literature on market efficiency was widely interpreted as being supportive. But by the late 1970s, the anomalous evidence was growing and beginning to command attention. There is now a substantial body of empirical research which casts doubt upon the degree of market efficiency (Bowman & Buchanan, 1995, p. 156). Even many of the researchers who believe in the concept of the EMH are questioning whether share markets are as efficient as the (semi strong) EMH dictates. However, though there may be some weaknesses in the market pricing mechanisms, few academics would discard the concept all together.
Markets are not simply either efficient or inefficient (Bowman & Buchanan, 1995, p. 157). Market efficiency can be viewed as a continuous running from the perfect market (i.e., precisely strong form efficient) to the inefficient market where excess earning opportunities are around. Any market or securities in a market could be characterised by some degree of efficiency. Following this approach, we might think of the New York Stock Exchange as more efficient than the Borsa Istanbul. Similarly, thin traded shares should be regarded as being priced less efficient in comparing with the actively traded shares. For example TSKB vs Eregli Demir Celik in Borsa Istanbul. It is easy to see evidence of this occurrence in the asset markets around the world. There is a large group of market participants who are not particularly interested in fundamental concepts and definitely reject the idea that shares are efficiently priced. In place of fundamental concepts effecting the market and prices, the participants mainly use their senses - which are biased - in the formation of their trading decisions. Thus these individuals make pricing errors which deteriorate market efficiency. It is argued that, over time, market participants would not develop an unbiased assessment of market efficiency with respect to any given market (Bowman & Buchanan, 1995, p. 157). In the following section, the empirical foundations of EMH will be discussed in brief.