Implications of the efficient market hypothesis


Stock markets tend to exhibit different levels of market efficiency. There are three such levels. These are the weak form, semi strong form and strong form. This article will take a detailed look at each of these forms of market efficiency .

The Efficient Market Hypothesis:


According to the efficient market hypothesis perfect competition in the capital market leads to a fair pricing of securities. Thus any deviations of market prices of securities from intrinsic value are random. It is not possible for anyone to consistently identify under-valued or over-valued securities in the market. No one can beat the market over an extended period of time. The market is the absolute discounting mechanism and factors in everything. Markets have shown to exhibit different levels of market efficiency. There are three such levels. These are:
1) Weak form
2) Semi strong form and
3) Strong form

Let us look at each of these forms of market efficiency in detail:

Weak Form of Market Efficiency:


Under the weak form of market efficiency there is no relationship between past and future price movements. Future prices of securities can't be predicted by analyzing past prices. Excess returns can't be generated in the long run by looking at historical prices. Thus by using technical analysis one will not be able to consistently generate excess returns over the long haul. However by using some forms of fundamental analysis one can generate excess returns.

Great investors like Warren Buffet and Benjamin Graham lend support to the weak form of market efficiency. These investors who have adopted the value style of investing exhaustively analyze the fundamental parameters of companies such as the return of equity, debt to equity, profit margin etc. and attempt to uncover undervalued securities in the market. They have been able to considerably outperform the market over several years.

Great traders on the other hand like George Soros, a famous hedge fund manager whose quantum fund generated returns of nearly 30 percent over a 30 year period from 1970-2000 lend support to the view that markets remain largely in-efficient and can be exploited. Mr. Soros is well known for his bet against the British Pound in 1992. His leveraged $10 billion short position against the British Pound earned him $1 billion in a single day as Britain was forced to devalue its currency.

Semi Strong Form of Market Efficiency:


Under the semi strong form of market efficiency current prices of securities factor in records of past prices and volumes. Share prices also factor in all publicly available information. Thus one cannot use technical analysis to generate abnormal returns consistently. Fundamental analysis also will not help in generating abnormal returns. However access to non-public information can help in generating excess returns.

Though insider trading is illegal and outlawed in most countries, insiders seem to be making considerable returns in markets. It is rather common to observe the share prices of companies being acquired appreciate even before actual merger announcements. Corporate insider selling also tends to accelerate ahead of periods of slow growth. However value investors like Warren Buffet and Benjamin Graham who have consistently beaten the market rather support the weak form of market efficiency.

Strong Form of Market Efficiency:


Under the strong form of market efficiency current prices factor in all available information, both public and private. Thus you cannot use technical analysis to generate abnormal returns consistently. In addition fundamental analysis will not help in generating abnormal returns. Insider information also will not help in generating abnormal returns over the long haul.

Thus under the strong form of market efficiency neither traders, value investors nor insiders can beat the market over the long run. The fact that index funds that closely track the market indices have delivered superior returns than other funds is strong evidence for a strongly efficient market.

Indian markets are increasingly tending towards the strong form of market efficiency. In the early 1980's and 1990's when markets where in their infancy several insider scams occurred proving that the markets were largely inefficient. However after the establishment of an elaborate regulatory mechanism in the early 1990's and the creation of the Securities Exchange Board of India (SEBI)these scams have considerably reduced and markets are becoming more efficient day by day.


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Comments

Author: Mels02 Sep 2014 Member Level: Bronze   Points : 1

Good Coverage of all aspects of the efficient market hypothesis. very useful

Author: Pravat Kumar Das21 Sep 2014 Member Level: Gold   Points : 4

Indian stock market has not yet touched the strong form. It is because first of all everybody should know that our 70% liquidity comes from Foreign institutional investors (FIIs). As they start pumping money, there would be great uptrend and once they pull out their money, market would face huge crash. So small investors from India (whether new or experienced) are not able to handle such situation. So Indian Government should create awareness among retail investors and common people to start investing in Indian equity market to make our market big and broader.



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