Eugene Fama in 1970 introduced the forms of efficient markets in the Journal of Finance. Titled “Efficient Capital Markets: A Review of Theory and Empirical Work”, this seminal article outlines the capital markets. He states markets function in three formats:
The forms are described with respect to available information that is reflected in the price.
Weak form of market efficiency reflects past market data. Semi-strong format reflects past market data and public information. The strong format reflects in addition to past market data and public information, private information as well.
In an efficient market abnormal returns are defined as excess returns over expected returns given security risk and market return. It has been found though that investors do earn abnormal returns based on information available to them, a sign of an inefficient rather than an efficient market.
In a weak form of market, according to Fama, the security will reflect all past market data including historical prices as well as trading volume information. Securities in such a market already reflect historical data and cannot be extrapolated to show future prices. In weak form efficiency, trading rules will try to exploit historical trading data. If such a rule helps produce abnormal risk-adjusted returns after trading costs it contradicts.
Semi-strong format of efficient markets securities will reflect publicly available data such as financial reports, corporate investments etc. Since all publicly available data reflects in the prices, analyzing public data to identify either underpriced or overpriced stocks is not useful. Any new information that is available is quickly shown in stock prices, since this information is available to all parties.
A researcher wanting to assess a semi-strong market will conduct an event study. The researcher will identify a sample period and the companies that paid a special dividend in this period as well as the date of announcement. The expected return on the share for the event date will be calculated. The difference between actual and expected return is tabulated. Statistical tests are then run on this data to see if abnormal returns vary from zero. What this means is that like an efficient market the public information has reflected quickly on the stock prices. If however post the date of announcement abnormal returns are noted there exists trading opportunities. Developed securities market can be considered to be semi-strong efficient markets. The same is not true for markets in developing nations.
The strong form of efficient markets reflect both public and private data. An important inclusion is private data that is otherwise privy only to the company management. Insider trading is prohibited in many markets. It has however been seen that availability of non-public information can yield abnormal returns.
What therefore are the implications of the efficient market hypothesis?
- Securities markets are weak form efficient and traders cannot use past data to earn abnormal returns.
- Securities markets are semi-strong efficient in the sense that publicly available financial information is reflected quickly on securities prices.
- Securities markets are not strong form efficient as private information cannot be used to trade as per securities rules and regulations.
Let us look at these market formats with respect to fundamental analysis, technical analysis and portfolio management.
In fundamental analysis publicly available data is examined to estimate the intrinsic value of shares. Fundamental analysis helps in spreading value-related information and thus create a semi-strong efficient market.
In technical analysis past patterns are studied for possible abnormal returns. If yes, they reduce when they are exploited. Technical analysts who understand and use these patterns to their benefit help create and maintain a weak-form efficient market. Further abnormal returns cannot be booked since such opportunities would have been used already.
Portfolio managers therefore cannot beat the market if they are in the weak or semi-strong formats. However fund managers do not aim to beat the market but meet long-term financial objectives by creating portfolio that is diversified such that it takes into account the risk considerations and tax implications of the investor.