Efficient Market Hypothesis

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Introduction

Efficient Market Hypothesis (EMH) in the past four decades was regarded as a fundamental finance proposition; in the mid-1970s, there existed strong empirical and theoretical evidence in support of EMH that gave the impression that it was invincible. Currently, counterarguments have emerged disproving the EMH which entails how prices are quickly affected by information Elton, Gruber, Brown, and Goetzmann, 2007). EMH assumes that investors who are informed look for information to “beat the market” (Pilbeam, 2005) and is the foundation of random walk theory which asserts that prices of shares track random walk (Brown, 2009). Presently there is no proof to whether prices track the random walk although there is evidence that they contradict it. As a result EMH no longer embraces the resistant place it once held in finance, therefore the presumption that prices of share trail random walk is currently uncertain (Pilbeam, 2005).

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Russel and Torbey (2006) argue that the forecast of returns mirrors the psychological aspect, noise trading, social movement, and speculative market fashion of irrational investment. The argument whether returns forecast stands for rational discrepancies in likely returns or occurs because of irrational speculative divergence from hypothetical values has offered the drive for keen intellectual investigations in later years. This paper’s focus is mainly on this concern, plus it put greater importance on speculative factors.

Evidence contrasting EMH

Market anomalies

The EMH turned out to be contentious particularly after the discovery of some anomalies in the market (Pilbeam, 2005); a number of these major anomalies have been identified as follows;

  • January Effect: this is a calendar-related financial market irregularity where share price rises in January. This generates an opening for the investors to purchase shares at lower prices before January plus sell them once the price increases. This form of price behavior pattern in the financial marketplace supports the argument that the market is not completely efficient (Pilbeam, 2005). The major ordinary theory clarifying this occurrence is private investors’ response to income tax and who excessively hold little stocks, sell shares because of tax at the end of the year, and plow back at the year start (Russel and Torbey, 2006).
  • Weekend Effect: an occurrence in economic markets that Monday stock returns are frequently less than those directly preceding Friday. Several theories which describe the effect feature the trend of firms to discharge unpleasant news on Friday following the close of the market to lower Monday stock prices. Others declare that the effect may be related to short-selling that affects stocks having high short-interest positions. Otherwise, the effect may be merely due to investors’ declining confidence from Friday to Monday (Russel and Torbey, 2006).
  • Day-of-the-week Effect: the allocation of returns differs based on the day of investment; the Monday return average is considerably lower than the return average on the rest of the days of the week. The day constancy is not restricted to the equity market of the U.S. The important variances in likely proportion difference for prices depend on the day when investment trade is carried on. The investors can thus buy at the day-end on Monday and sell on Friday (Kiymaz and Berument, 2001).
  • Small Firms Effect: this theory holds that minor companies having an undersized market capitalization do better than larger firms. This market irregularity is an aspect utilized in describing greater returns within the Three-Factor Model which consists of market return, undersized stock capitalization plus firms having greater book-to-market values (Pilbeam, 2005). Small capitalized firms also tend to have a more unstable business environment plus the problem improvement may lead to greater price appreciation (Kiymaz and Berument, 2001). Given that the market is efficient, an investor would anticipate the share prices of the firms to rise to a range where the risk-adjusted returns to potential investors would possibly be normal, although this does not occur (Kiymaz and Berument, 2001).
  • P/E Ratio Effect: it is a distortion of the market price that shares having fewer P/E tend to outperform the market later on since investors take less P/E as an undervaluation but this effect is not supported by EMH (Pilbeam, 2005).
  • Seasonal Effect: the month-end and holidays affect the price of stocks; in the U.S. returns on stocks are considerably greater at the month-end. Returns are also superior one day before the holiday than the rest of the trading days (Pilbeam, 2005).
  • Standard & Poor’s (S&P) Index Effect: a stock insertion in the S&P 500 Index announcement leads to a rise in the share price. Information is the only factor that changes price in an efficient market; the positive share price response appears to diverge from EMH since no new firm’s information except its addition into the index (Brown, 2009).
  • Closed-end Funds pricing: The secondary market prices are dictated by forces of the market (demand and supply) that may be indirectly related to the fund’s fundamentals. The closed-end market valuation of firm share mirrors mispricing; generally, the funds indicate that there is a trade discount which challenges the EMH value addition principle (Kiymaz and Berument, 2001).
  • Distressed Securities Market: the well-liked press has often assumed that share pricing might not be efficient throughout bankruptcy time (Pilbeam, 2005).

For instance, the stock of Continental Airlines went on with trade on AMEX at a share price of $1.50, even after the firm and its creditors had settled on a plan, which would offer no allocation to pre-petition equity-holders (Pilbeam, 2005).

The Weather: very few individuals would propose that sunshine places individuals in a favorable mood; individuals in positive moods normally make more confident judgments and choices (Elton et al, 2007). The NYSE index tends towards being negative when the weather is cloudy and the returns of the stocks are positively related to sunshine within most nations while rain and snow usually do not have predictive power. These occurrences have been correctly denoted as anomalies since the existing EMH concept cannot be used to explain the phenomenon (Elton et al, 2007).

Unpredictability tests, fads, and noise trading

Most mixes in academic circles have been made by the outcomes of unpredictability tests, these tests are created to test for consistency of market behavior by examining the unpredictability of share prices about the instability of the basic variables that affect share prices. The earliest two studies about these tests were by two authors, LeRoy and Porter (1981) and Shiller (1981). Both authors LeRoy and Porter used this test for the bond while Shiller tests a model in which present stock prices are discounted value of future dividends. The studies revealed a significant unpredictability in both bond markets and stock, therefore the fluctuation in real prices superior to those implied by changes in the basic variables affecting the prices are inferred by Shiller as being the outcome of waves of positive or negative market psychology. Schwert, (1989) tested for a correlation between economic activity and stock returns instability and found that raised instability in financial assets return during downturns might have proposed that functioning leverage raise during declines.

The author also found that raised unpredictability during periods where part of new debt issues to new equity issues is bigger than a company’s existing capital structure. Thus, this may be interpreted as evidence of financial leverage affecting unpredictability; nevertheless, neither of these factors plays a dominant role in explaining the time-varying unpredictability of the stock market.

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The empirical facts made provided by unpredictability tests suggested that movement in stock prices cannot be credited purely to the rationale expectations of investors but also engage an illogical constituent, which has been highlighted by Sheifer and Summers (1990), in their exhibition of noise trading.

They argued that they are two kinds of investors in the market namely: arbitrageurs which is an investor who trades based on information, the other kind of investor is noise traders who trade based on imperfect information (Sheifer and Summers, 1990). Every time the noise traders trade on the imperfect information they will make the prices diverge from their stability values while on the other hand, the arbitrageurs play the critical role of stabilizing prices, therefore they dilute such moves in prices and do not abolish them completely. Hence the authors assert that the assumption of perfect arbitrage made under EMH is not realistic since the authors observed that the arbitrage is limited by two types of risk that are fundamental risk and unpredictability of future resale price. Given restricted arbitrage, they argued that security prices do not just respond to information but also to changes in sentiments that are not fully justified by information.

Models of human behavior

In the market consisting of human beings, it appears rational that explanations rooted in social psychology and person would hold large promise in progressing the understanding of stock market behavior. The current research has tried to explain the perseverance of anomalies by adopting a psychological standpoint, the evidence in the psychology literature shows that individuals have inadequate information processing abilities and are prone to displaying systematic bias in processing information making mistakes, and frequently tend to depend on the view of others. Kahneman and Tversky (1986) spearheaded the destructive attacks on the supposition of person rationality in their well-researched article on prospect theory in which they found that the expected utility theory has been used predicatively and descriptively in the economic and finance literature. The authors contended that when an individual is faced with the multifaceted task of allocating likelihoods to unsure results, the individual frequently tends to use cognitive heuristics which help minimize the task to a controllable part, and this heuristics frequently direct to systematic biases.

The research in investor behavior in the security markets is speedily growing with very astonishing outcomes, still, effects that frequently oppose the concept of rational behavior abounds. The sunshine is strongly linked with daily stock returns, while culture, distance, and language influence stock trade. The efficient market perceptive of price demonstrating reasonable valuation of basic factors has also been challenged by some authors such as Summers (1996) who views the market to be extremely inefficient. The author also suggests that pricing has to encompass a random walk as well as a fad variable; the fad variable is modeled as a gradually way reverting stationary procedure. That is stock prices should employ some impermanent aberrations but should go back to their equilibrium price level eventually.

All these arguments aside, the stock market crash of the year 1987 persists to be difficult for the supporters of EMH, and any effort to accommodate 22.7% deflation of the stocks within the hypothetical framework of EMH would be a formidable challenge. Therefore it appears sensible to presume that the turn down did not take place due to a main move in the perceived peril. The crash of the year 1987 offered further credibility to the argument that the markets include an important number of speculative investors who are directed by non-financial factors, hence the assumption of rationality in conventional models must conform to reality (Summers, 1996).

Conclusion

Without a doubt, the various researches on EMH created very useful contribution in comprehending the securities market although there appears to be developing dissatisfaction with EMH. The inadequate research on the modern literature indicates that EMH criticism has earned both momentum and voice in the current years. Whilst it is right that the market reacts to the latest information, currently, it is evident that there are more variables influencing security valuation in addition to information. In modern times, new researchers’ wave has offered reflection-provoking, theoretical point of view and empirical evidence supporting it, indicating that prices may diverge from their stability values owing to fads, noise trading, and psychological factors.

References

Brown, S. J. 2009. The Efficient Markets Hypothesis: The Demise of the Demon of Chance? Web.

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Elton, E. J., Gruber, M.J., Brown, S.J & Goetzmann, W. N. 2007. Modern Portfolio Theory and Investment Analysis, 7th Edition. New York, Wiley.

Kahneman, D. and Tversky, A. 1986. Choices, values, and frames. American Psychologist, 1: 341-350.

Kiymaz, H. & Berument, H. 2001. The Day of the Week Effect on Stock Market Volatility. Journal of economics and finance, 25(2):181-189.

LeRoy, S.F. and Porter, R.D. 1981. The present-value relation: Tests based on implied variance bounds. Econometrica, 49:555-574.

Pilbeam, K. 2005. Finance and Financial Markets, 2nd edition.London, Palgrave Macmillan.

Russel, P.S. & Torbey, V. M. 2006. The Efficient Market Hypothesis on Trial: A survey. Web.

Schwert, G.W. 1989. Why does stock market volatility change over time? Journal of Finance 44:1115-1153.

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Shiller, R.J. 1981. Do stock prices move too much to be justified by subsequent changes in dividends? American Economic Review, 71:421-435.

Shleifer, A. 1986. Do demand curves for stocks slope down, Journal of Finance 41: 579-590.

Summers, L.H. 1990. The noise trader approach to finance, Journal of Economic Perspectives, 4:19-33.

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