What is Efficient Market Theory? Evidence, Tests, Anomalies

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What is Efficient Market Theory?

According to Louis Bachelier, a French mathematician, “an efficient market is the one where the market price is an unbiased estimate of the true value of the investment.” This definition includes the following concepts:

  • In an efficient market, it is not necessary that the market price of an asset is always equal to its actual value. However, the changes in the asset price should be valid and unbiased. In other words, the deviation of market price from the true value of an asset should be random.

  • In case deviation in the price of assets from its true value are random, the prices can be either undervalued or overvalued anytime. These and the deviations are also not correlated with any observable variable. For example, the prices of an asset having a low P/E ratio is not undervalued than the prices of assets with high P/E ratio.

  • In an efficient market, investors are unable to find either undervalued or overvalued assets to which the rest of the market is unfamiliar using any of the investment strategies.

All markets are not efficient for all investors but a market can be efficient for an average investors.

Evidence on Efficient Market Theory

Evidence on efficient market theory is classified into the following four sections:

  • Study related to price changes and their time series properties: These are the initial studies on market efficiency that emphasised on the relationship between the time and the change in the asset price. In these studies, tests were conducted using the random walk theory of price movements, which states that the price of as sets changes with time on a random basis. This is an evidence of efficient market as it fulfils the condition of efficient market which states that the changes in the asset prices are random. The studies on market efficiency under this section include:

    • Studies on short-term (daily or weekly) price movements and behaviour

    • Studies on long-term (annually or five-yearly) price movements and behaviour

  • Research related to the efficiency of market reaction to information announcements: New information related to different assets comes to market on a regular basis. So, the reaction of investors on such information is instantaneous and unbiased. Researches show that reaction of markets to the announcements of an innovative investment is different from that of a non-innovative investment.

    Thus, the price of assets or stocks of an innovative investment is more than the non-innovative investments as soon as it enters the market. This validates that condition of efficient market, which says that the movement in asset prices can be possible when the information is valid and unbiased.

  • Return anomalies across firms and over time: Anomalies show the inefficiency of the market in the underlying asset-pricing model. When these anomalies are identified and analysed in academic literature, it is found that the anomalies are either disappeared or reversed. This is because of the difference in the time period of sample collection.

  • Analysis of the performance of analysts, money managers and insiders: This analysis shows that it is not necessary that insiders, analysts, and portfolio managers are able to perform better than the average investors and earn more money.

Apart from the above mentioned evidence, event studies also show the evidence of market efficiency. In these studies, the reaction of market on the information of events like earnings and takeover announcements are used for testing market efficiency.

Tests for Market Efficiency

Tests for market efficiency are carried out to determine whether specific investment strategies help investors to earn more returns on assets in the market, or reduce transactions costs or provide execution feasibility.

Following are important aspects of testing market efficiency tests:

  • In a market efficiency test, the efficiency of market is tested along with the test of validity of model used for determining the expected returns from a market.

  • In a market efficiency test, an excess return from a market shows the inefficiency of the market or the model used for determining expected returns is wrong or both.

  • Investors can evaluate market efficiencies in different ways depending upon the investment scheme under testing.

Different tests of market efficiency have different models for calculating expected returns. In some of the tests, the expected return is calculated using returns on similar or equivalent investments, while in other tests the calculation of expected returns also adjusts for risk using the CAPM or APT Model.

Figure shows the different types of tests used for judging the efficiency of a market:

Random Walk Test

Random Walk Theory was first proposed by a French broker and Jules Regnault in 1863. Later, some points have been added in this theory by Louis Bachelier in 1900. The Random Walk Theory states that the change in the market price of the stock is random and thus, cannot be predicted. In other words, the changes in stock price are evenly distributed and are independent of each other. Thus, as per this theory, the past trend of stock price or market will not affect its movement in the future. For example, Ravi, a stock broker used technical analysis for selecting the stocks for his clients but failed to gain from the resulting portfolio.

This was because the market exhibited random walk characteristics. Technical analysis relies exclusively on past trading data to forecast future price movements. As a test for market efficiency, Random Walk Theory depicts that the change in prices of stock will take a random and unpredictable path. It also states that an investor cannot outperform the market if the additional risks are not taken into consideration. However, the critics of this theory say that stocks maintain certain price trends over a period of time. So, an investor can outperform the market by choosing the right times to enter into and exit from the market.

Weak Form Tests

According to weak from tests, a market is said to be efficient if it reflects all information available in the market at a given point of time. This theory assumes that the rates of returns in the market do not depend on any factor and there is no impact of past rate of market return on its future rates. For example, Shikha is a stock broker who works at Bombay Stock Exchange. She notices that the price of ICICI Bank drops on Monday and rises on Friday.

On Monday, 4 January 2014, Shikha purchased 100 shares of ICICI Bank at ₹500 per share. However, she was disappointed to learn that the price fell to ₹490 per share on Friday, 8 January 2014. This happened as the market was weak-form efficient not allowing Shikha to earn excess return by just picking stocks based on historical price patterns.

Weak form tests can be of the following types:

  • Statistical Tests for Independence: These tests are further classified as auto correlated tests and run tests. They check whether the rate of return from the market is significantly correlated over a period of time. On the other hand, in runs tests, it is tested whether the change in stock price is independent of time.

  • Trading Tests: These tests are conducted to confirm that the past returns do not help in predicting the future rate of returns from a market.

Semi-strong Form Tests

The semi-strong form tests show that the market reflects all the publicly available information related to the different stocks and their prices in the market. Warren Buffet, whose portfolio has for the past consistently outperformed the market portfolio, supports semi-strong form tests which state that an investor cannot earn above the market return using historical data.

Semi-strong form tests are of the following types:

  • Event Tests: This test analyses a stock before and after the announcement of an event like earnings or merger of an organisation. As per this test, an investor cannot earn an above average return by purchasing or selling assets based on the information of an event.

  • Regression/Time Series Tests: This test helps in forecasting future returns from the market based on the historical data. Thus, an investor cannot earn an above average return by applying this method.

Strong Form Tests

Strong form tests show that the market is efficient if it is able to reflect all information related to public or private sector securities. This test depends only on a group of investors who have the maximum information about the securities in the market. Karan works at Crux Automobiles as a chief engineer. Karan was engaged in a project for advanced model of automobiles. He was confident that his company’s project would lead to an increase in price due to which he purchased 10,000 shares of Crux Automobiles for ₹25 per share.

However, he was surprised to learn that even after the news of the project being a success was circulated, the same did not reflect in the share price. The price of the company’s share did not increase. This was because the market was strong form efficient. It had already incorporated the news in Crux Automobiles’ stock price for the expected net present value of the new project, which implies that the stock price already reflected the inside information.

The investors on which strong-form test depends can be the following:

  • Insiders: These are the people inside the company who have access to all information related to the organisation. Thus, Securities and Exchange Board of India (SEBI) forbids them from using this information to earn above average returns from the market.

  • Exchange Specialists: They can recall runs on the orders for a specific equity. Exchange specialists can earn returns above the market average with specific order information.

  • Analysts: They provide opinion and suggestions that enable investors to achieve above average returns. Analysts can create stock movements in a particular direction by focusing on particular stocks. They can cause significant movements along the equities they focus on.

Market Anomalies

In simple words, an anomaly refers to the occurrence of an unusual event. In the language of finance and investing, anomalies refer to the instances in which a particular security or a portfolio shows opposite performance to the beliefs of the efficient market theory. We have studied earlier in the chapter that according to the EMH, the performance of securities should reflect the available information of the market. However, anomalies take place when contrary to this rule occurs.

In an efficient market, anomalies should not occur and these should not definitely persist. There is no unanimous conclusion on why anomalies take place. There are many opinions regarding the occurrence of anomalies. It should be noted that an efficient market is more of a theoretical concept. However, in practice it is hard to achieve an efficient market because of constant release and dissemination of new information in the market.

Many market anomalies take place once and then they disappear. On the other hand, there are anomalies that are continuously observed. Therefore, investment professionals study these recurring anomalies to find a pattern and exploit them while investing. Now, let us discuss the major reasons of occurrence of anomalies in the market in the following sections.

Earnings Announcement

Companies periodically announce their earnings reports and other corporate reports that are important to the stakeholders. Earning announcements are made on certain dates. The earning announcements cause various market anomalies, such as:

Stock Split Effect

In a stock split, the number of outstanding share is increased and the values of the outstanding shares are decreased. However, stock split does not have any effect on the market capitalisation of a company.

However, it has been empirically seen that the stock price of companies goes up after the announcement of stock split. This increase in the stock price after the announcement of stock split is known as stock split effect. Therefore, investors take stock split as a signal that the share price of the company will continue to go high.

Short-Term Price Drift

After companies make announcement, the stock price also immediately reacts in the same direction. For example, in case of announcement of positive news, such as higher earnings, there may be an immediate movement in the stock prices in the positive direction.

However, in case of short-term price drift, the stock price movement continues to take place quite a long time after the announcement of news. This is because information does not always immediately reflect in the stock prices of the companies.

Merger Arbitrage

It has been seen that in case of announcement of mergers and acquisition, the value of stocks of the acquired company tends to go high while the value of the acquirer goes down. This phenomenon is known as merger arbitrage.

Low Price/Earnings Ratio

Price/earnings ratio refers to the ratio of price of a stock and its earnings. It has been observed that portfolios consisting of low P/E securities perform better than the portfolios consisting of high P/E securities. This is because many investment professionals, on the basis of CAPM and other portfolio models, have concluded that low P/E stocks presumably involve greater risks; therefore, they have more potential to give better return.

P/E ratio can be calculated as follows:

P/E Ratio = Current Share Price / Earnings per Share

For example, suppose a firm is trading at ₹500 a share. The earnings of the form for the last 12 months were ₹50 per share. The P/E ratio for the stock would be calculated as

P/E Ratio = 500 / 50 = 10

This implies that when P.E ratio is 10, investors are willing to pay 10 times of company’s earning to buy that stock.

Firm Size Effect

Empirical studies have shown that small-sized firms or the firms with low market capitalisation, outperforms large companies. Therefore, this theory is also known as “Small Firm Effect”. The theory that smaller companies possess higher growth potential than larger companies give rise to various market anomalies. The theory is rooted to the facts that the small companies tend to operate in a relatively volatile market; therefore, correction of problems causes share price to appreciate.

In addition, the price of the small cap stocks tends to be low. Therefore, the price appreciations taking place in the small-cap stocks tend to be higher than the same of the large-caps stocks. An organisation’s economic growth forms the driving force behind its stock’s performance. Smaller firms tend to have more capacity for growth compared to the larger companies, which have already reached the saturation price levels.

For example, a big company such as Microsoft would need an additional $6 billion in sales to grow 10% whereas a small start-up might only require additional sum of $70 million in sales for the same growth rate. Therefore, smaller firms are often able to grow much faster than larger companies, which are reflected in their stock prices.

January Effect

Stock prices have a general tendency to go up in the month of January. Generally, this appreciation in the stock prices happens because of an increase in buying followed by a drop in stock prices in the month of December. It has been observed that small caps are more affected by the January effect than the mid or large caps. However, the January effect has been less prominent in the recent years because markets have adjusted for it to a great extent. For instance, investors wait for the year end to abandon their underperforming stocks to utilise their losses to equalise their capital gains taxes.

It is also observed that the selling pressure often independent of the company’s actual fundamentals or valuation. Due to this tax-selling pressure of companies, large number of stocks becomes available at attractive prices for buyers in January. Similarly, investors too wait until January to buy underperforming stocks as they elude purchasing such stocks in the fourth quarter to avoid getting involved in this tax-loss selling. Consequently, the excess selling in the year end and excess buying of stocks after January 1 lead to January effect.

Monday Effect

The Monday effect is also known as Weekend Effect. It has been seen that there is a general tendency of the stock prices to go down on Mondays. In other words, investment experts have observed that returns in the market on Mondays is mostly lower than returns on other days of the week.

An example of average rate of return on weekdays is shown in Table:

Example of Average Rate of Return on Weekdays

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