Session 1: Market Efficiency

Session Learning Outcomes
Learners will have knowledge on different forms of market efficiency and what differentiate them.
Important Learning Terms

• Market efficiency
• Efficient capital market
• Efficient market hypothesis (EMH)
• EMH misconception

A. Definition
Market efficiency/Capital market efficiency
The degree to which the present asset price accurately reflects current information in the market place
Efficient capital market
A market in which new information is very quickly reflected accurately in share prices.
Efficient Market Hypothesis
States that all relevant information is fully and immediately reflected in a security's market price, thereby assuming that an investor will obtain an equilibrium rate of return. In other words, an investor should not expect to earn an abnormal return (above the market return) through either technical analysis or fundamental analysis.

B. Efficient Market Hypothesis
The efficient market hypothesis (EMH) implies that if new information is revealed about a firm it will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement.

In an efficient market no trader will be presented with an opportunity for making a return on a share (or other security) that is greater than a fair return for the riskiness associated with that share (or any other security). The absence of abnormal profit possibilities arises because current and past information is immediately reflected in current prices. It is only new information, which causes prices to change.

Note: Stock market efficiency does not mean that investors have perfect powers of prediction; all it means is that the current level is an unbiased estimate of its true economic value based on the information revealed.

In the major stock markets of the world prices are set by forces of supply and demand. There are hundreds of analysts and thousands of traders, each receiving new information on a company through electronic and paper media. The moment an unexpected, positive piece of information leaks out investors will act and prices will rise rapidly to a level that gives no opportunity to make further profit.

Types of Efficiency
Efficiency is an ambiguous word and therefore we have to establish some clarity. There are three types of efficiency;
Operational efficiency – refers to the cost to buyers and sellers of transactions in securities on the exchange. It is desirable that the market carries out its operations at as low a cost as possible. This may be promoted by creating as much competition between market makers and brokers as possible so that they earn only normal profits and not excessively high profits. It may also be enhanced by competition between exchanges for secondary-market transactions.
Allocation efficiency – society has a scarcity of resources (that is, they are not infinite) and it is important that we find mechanisms, which allocate those resources to where they can be most productive. Those industrial and commercial firms with the greatest potential to use investment funds effectively need a method to channel funds their way. Stock markets help in the process of allocating society’s resources between competing real investments. For example, an efficient market provides vast funds for fast-growth sectors such as electronics, pharmaceuticals and biotechnology industries (through new issues, rights issues, etc.) but allocates only small amounts for slow-growth industries.
Pricing efficiency – in a pricing efficient market the investor can expect to earn merely a risk-adjusted return from an investment as prices move instantaneously and in an unbiased manner to any news. It is pricing efficiency that is the focus of this section and the term efficient market hypothesis applies to this form of efficiency only.

The Value of an Efficient Market
It is important that stock/share markets are efficient for at least three reasons:
To encourage share buying – accurate pricing is required if individuals are going to be encouraged to invest in private enterprise. If shares are incorrectly priced many savers will refuse to invest because of a fear that when they come to sell the price may be perverse and may not represent the fundamental attractions of the firm. This will seriously reduce the availability of funds to companies and inhibit growth. Investors need to know they are paying a fair price and that they will be able to sell at a fair price – that the market is a “fair game”.
To give correct signals to company managers – Since the maximization of shareholder wealth can be represented by the share price in an efficient market, sound financial decision-making relies on the correct pricing of the company’s shares. In implementing a shareholder wealth-enhancing decision the manager will need to be assured that the implication of the decision is accurately signalled to shareholders and to management through a rise in the share price. It is important that managers receive feedback on their decisions from the share market so that they are encouraged to pursue shareholder wealth strategies.
To help allocate resources – allocation efficiency requires both operating efficiency and pricing efficiency. If a poorly run company in a declining industry has highly valued shares because the stock market is not pricing correctly then this firm will be able to issue new shares, and thus attract more of society’s savings for use within its business. This would be wrong for society as the funds would be better used elsewhere.

B: The Levels of Market Efficiency
Economists have defined different levels of efficiency according to the type of information, which is reflected in prices. Three levels of market efficiency can be identified.

Weak-form efficiency – share prices fully reflect all information contained in past price movements. It is pointless basing trading rules on share price history, as the future cannot be predicted in this way.

A Weak-form Efficiency Test Example: Technical analysts employ a vast range of trading rules. Some recommend buying shares that have performed well relative to the rest of the market, maintaining that their performance will continue in that vein. Others advise a purchase when a share rises in price at the same time as an increase in trading volume occurs. Overwhelmingly the evidence and weight of academic opinion is that the weak form of the EMH is to be accepted. The history of share prices cannot be used to predict the future in any abnormally profitable way.

Semi-strong form efficiency – share prices fully reflect all the relevant publicly available information. This includes not only past price movements but also earnings and dividend announcements, rights issues, technological breakthroughs, resignations of directors, and so on. The semi-strong form of efficiency implies that there is no advantage in analyzing publicly available information after it has been released, because the market has already absorbed it into the price.

A Semi-strong form Efficiency Test Example: The semi-strong form tests focus on the question of whether it is worthwhile expensively acquiring and analyzing publicly available information. If semi-strong efficiency is true it undermines the work of millions of fundamental (professional or amateur) analysts whose trading rules cannot be applied to produce abnormal returns because all publicly available information is already reflected in the share price.

Fundamental analysts try to estimate shares’ true value based on future returns. These are then compared with the market price to establish an over- or under valuation. To estimate the intrinsic value of a share the fundamentalists gather as much relevant information as possible. This may include:

• macroeconomic growth projections,
• industry conditions,
• company accounts and announcements,
• details of company’s personnel, tax rates,
• technological and social change and so on.

The range of potentially important information is vast, but it is all directed at one objective: forecasting future profits and dividends. Some evidence for and against the semi-strong form of market efficiency has been discovered in the following:

• Information announcements: This concerns the issue of whether trading in shares immediately following announcements of new information (for example announcements on dividends or profit figures) could produce abnormal returns. The evidence supports the EMH, and excess returns are nil. It has been discovered that most of the information in annual reports, profit or dividend announcements are reflected in share prices before the announcement is made.
• Stock splits: Stock splits imply that existing shareholders receive more shares in proportion to their existing holding. Because no new money is raised for the firm, and the fundamentals of the business such as cash flows are unchanged, prices should not react purely to a stock split. However, the split itself is an insignificant part of the information given to the market around the time of the announcement, as splits tend to occur when firms are doing well. The split is often taken as a final confirming signal that the firm anticipates continued growth and that dividends will rise. Fama et. al. (1969) showed that share prices rise by an abnormal amount relative to the market prior to the split.
• Manipulation of earnings: Published accounts are an important source of information about companies. An efficient market will incorporate this information into share prices. But, as is well known, there is a great deal of leeway when it comes to drawing up accounts. One way of altering accounts is to openly and honestly reflect the changing underlying economies of the business by changing, say, the depreciation policy.

If this is taken a stage further we have creative accounting, which obeys the letter of the law and accounting body rules but involves the manipulation of the accounts to show the most favourable profit figures and balance sheet. Finally, there is outright fraud and lies. The conclusion of efficiency in this case seems reasonable because investors are aware of the nature of the accounting change, but doubts have been raised about market efficiency if there is wholesale creative accounting.

Strong-form efficiency – all relevant information, including that which is privately held, is reflected in the share price. Here the focus is on insider trading, in which a few privileged individuals (for example directors) are able to trade in shares, as they know more than the normal investor in the market. In a strong-form efficient market even insiders are unable to make abnormal profits (note that the market is acknowledged as being inefficient at this level of definition).

A Strong form Efficiency Test Example: It is well known that it is possible to trade shares on the basis of information not in the public domain and thereby make abnormal profits. In this respect stock markets are not strong form efficient. Trading on inside knowledge is thought to be a “bad thing”. It makes those outside of the charmed circle feel cheated. A breakdown of the fair game perception will leave some investors feeling that the inside traders are making profits at their expense. If they start to believe that the market is less than a fair game they will be more reluctant to invest and society will suffer. To avoid the loss of confidence in the market most stock exchanges attempt to curb insider dealing and it is a criminal offence for most exchanges (if not all). Insider trading is considered to be, besides dealing for oneself, either counselling or procuring another individual to deal in the securities or communicating knowledge to any other person, while being aware that he or she (or someone else) will deal in those securities.

C: Misconceptions about the Efficient Market Hypothesis
There are three classic misconceptions:

1. Any share portfolio will perform as well as or better than a special trading rule designed to outperform the market.
   A monkey choosing a portfolio of shares from the “Financial Times” for a buy and hold strategy is nearly, but not quite, what the EMH advocates suggest as a strategy likely to be as rewarding as special inefficiency-hunting approaches. The monkey does not have the financial expertise needed to construct broadly based portfolios, which fully diversify away unsystematic risk. A selection of shares in just one or two industrial sectors may expose the investor to excessive risk. So it is wrong to conclude from EMH evidence that it does not matter what the investor does, and that any portfolio is acceptable. The EMH says that after first eliminating unsystematic risk by holding broadly based portfolios and then adjusting for the residual systematic risk, investors will not achieve abnormal returns.
2. There should be fewer price fluctuations.
   If shares are efficiently priced why is it that they move every day even when there is no announcement concerning a particular company? This is what we would expect in an efficient market. Prices move because new information is coming to the market every hour, which may have some influence on the performance of a specific company. For example, the governor of the Central bank may hint at an interest rate rise, or the latest industrial output figures may be released, etc.
3. Only a minority of investors is actively trading, most are passive therefore efficiency cannot be achieved.
   This too is wrong. It only needs a few trades by informed investors using all the publicly available information to position (through their buying and selling actions) a share at its semi-strong-form efficient price.

D: Implications of the Efficient Market Hypothesis
The efficient market hypothesis has a number of implications for both the investors and the companies.

For Investors
For the vast majority of people public information cannot be used to earn abnormal returns (that is, returns above the normal level for that systematic risk class). The implication is that fundamental analysis is a waste of money and that so long as efficiency is maintained the average investor should simply select a suitably diversified-portfolio, thereby avoiding costs of analysis and transaction.
Investors need to press for a greater volume of timely information. Semi-strong efficiency depends on the quality and quantity of publicly available information, and so companies should be encouraged by investor pressure, accounting bodies, government rulings and stock market regulation to provide as much as is compatible with the necessity for some secrecy to prevent competitors gaining useful knowledge.
The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers.

For Companies
The EMH also has a number of implications for companies:
Focus on substance, not on short-term appearance: Some managers behave as though they believe they can fool shareholders. For example creative accounting is used to show a more impressive performance than is justified. Most of the time these tricks are transparent to investors, who are able to interpret the real position, and security prices do not rise artificially.

There are some circumstances when the drive for short-term boosts to reported earnings could be positively harmful to shareholders. For example, one firm might tend to overvalue its stock to boost short-term profitability, another might not write off bad debts. These actions will result in additional, or at least earlier, taxation payments, which will be harmful to shareholder wealth. Managers, aware that the analysts often pay a great deal of attention to accounting rate of return, may, when facing a choice between a project with a higher NPV but a poor short-term ARR, or one with a lower NPV but higher short-term ARR, choose the latter.

The timing of security issues does not have to be fine-tuned: Consider a team of managers contemplating a share issue who feel that their shares are currently under-priced because the market is low. They opt to delay the sale, hoping that the market will rise to a more “normal level”. This defies the logic of the EMH – if the market is efficient the shares are already correctly priced and it is just as likely that the next move in prices will be down as up. The past price movements have nothing to say about future movements.

The situation is somewhat different if the managers have private information that they know is not yet priced into the shares. In this case if the directors have good news then they would be wise to wait until after an announcement and subsequent adjustment to the share price before selling the new shares. Bad news announcements are more tricky – to sell the shares to new investors while withholding bad news will benefit existing shareholders, but will result in loss for the new shareholders.