The Efficient Capital Market Theory - Essay Example

?'A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of informationto formulate buying and selling decisions.’ Introduction On October 19, 1987, the Dow Jones Industrial Average suffered a loss of $500 billion in a single day. Aggregately, the Dow Jones Industrial Average reduced 508.32 points (22.6 percent). This loss of billions of dollars in a single day raises some questions about the efficacy of the efficient capital market theory. A close scrutiny of economic and financial facts and figures before, during or after the market crash of 1987 leaves more questions than the answers about this theory! The supporters of efficient capital market theory claim that the stock prices are efficient enough to fully represent information. But, the efficient capital market theory remains silent when the median revenue before the 1987 crash were $18.6 million, and right after the two years of crash, the median revenue increased to $34.7 million. Before the market crash of 1987, the standard deviation of revenue was $276 million, but after two years of crash, the standard deviation of revenue increased to the level of $327 million. On the one hand, capital markets crashed; on the other hand, the median revenue and standard revenue were steadily increasing. In this paper, a critical evaluation of efficient capital market theory is carried out in the following parts of the essay. Besides, types of capital markets, technical analysis and fundamental analysis are incorporated into this piece of writing. Definition An efficient capital market is such type of stock market where the current stock prices fully reflect information, including the information of risk (Schweser, 2004). In the year of 1970, Eugene Fama (1970) introduced the concept of ‘Efficient Capital Markets’. In which, efficient capital markets are clearly defined. Stock prices rapidly respond as soon as a new piece of information arrives. With the arrival of new information, stock prices adjust accordingly in order to fully reflect and represent information. Additionally, price changes in an efficient market are equally likely to be negative or positive (Siegel, 2000). Furthermore, this theory is more applicable to large companies buying and selling the large securities. And, this theory is less relevant to small and medium sized companies. As the small and medium sized companies do not have sufficient volume and sufficient size of capitalization in stock markets, the application of this theory would not serve any of their major objectives. An efficient capital market is based on certain assumptions: first, this theory assumes that the market participants fully understand stocks. And, on the basis of this understanding, they value stocks. Second, a piece of information appears in a random fashion; all pieces of information are independent of each other with regard to timing. Third, fund managers instantly start evaluating the prices of stocks as soon as a new piece of information arrives. In order to make appropriate investment decisions, they carefully monitor the stocks movements. Types of efficient market Weak-form efficient markets In this type, stock prices reflect the historical market information. This type of efficient market is based on the assumption that stock prices reflect currently available historical market information. Consequently, no relationship exists between past and future stock prices. The historical value of information is already incorporated into the current prices. Hence, it would be of no value to study the previous stock prices. Additionally, this type of efficient market hypothesis may be implausible in many situations (Poterba and Summers, 1988; Pesaran and Timmermann, 1995,2000). Semi-strong form efficient market In the semi-strong form, stock prices rapidly adjust to information that is publically available. This stock price adjustment can be upward or downward. It depends upon the nature and type of information available publically. Even if, the stock prices fully reflect the publically available information; still investors cannot earn more returns on the stocks with the use of fundamental analysis. Therefore, fundamental analysis would be of no use in determining whether a stock is overvalued or undervalued. Strong-form efficient market In the strong-from efficient market, stock prices fully reflect both publically and privately available information. The private information comes from a company whose shares trade in a stock market. And public information comes from market and from the general public. On the basis of this information, it can be understood that no group of investors can enjoy a monopolistic access to information relating to stocks. Also, strong form of efficient market represents itself as an example of perfect market where information can be accessed easily; and this access to information is free of cost; no amount is paid to obtain access for a particular piece of information. Technical Analysis Technical analysis is based on the concept of demand and supply. Technical analyst believes that the stock prices can be predicted with the help of historical prices and trading pattern of investors. In order to forecast the future prices, technical analyst uses different charts, diagrams to identify trends in the market or individual stocks. Additionally, technical analyst assumes that in terms of direction and magnitude, a market can be forecasted. And the direction of stock prices is mostly determined and controlled by the various demand and supply forces. Additionally, technical analyst assumes that stock prices consistently move in trends, and these trends persist for long durations of time. On the basis this assumption, technical analyst tries to identify the pattern of stock prices and the identification of pattern helps the technical analyst to predict the future stock prices. Fundamental analysis Fundamental analyst evaluates a company’s stock on the basis of examination of the firm’s financial statements. Fundamental analyst takes into account the aggregate financial health, political and economic conditions, management quality; aspects of marketing, industry factors and future prospects of the company. Fundamental analysts tries to identify whether stock is under-priced, over-priced. Fundamental analyst uses some tools like ratio analysis, vertical analysis and horizontal analysis. By using these tools, fundamental analyst becomes in a position to understand the relative measure of the financial condition and operating performance of the company. Criticism The Stock Market Crash of 1987 raised many questions over the efficiency of capital market theory. On October 19, 1987, Dow Jones Industrial Average declined 508.32 (22.6 percent) in a single day. And the S&P 500 index fell by 20.46 percent; the NASDAQ fell by 11.35 percent in its value. The worst stock market history condition recorded after the event of Great Depression of 1930. In the month of October 1987, the House Ways and Means Committee was planning to introduce a tax bill restricting takeovers. But, Congress did not pass the tax bill, but stock markets did not respond accordingly and most of the stock markets crashed; resulting in the loss of billions of dollars (Mckeon and Netter, 2009). Additionally; Malkiel (2003) observed that two months before the mid of October, 1987, the yields of the long term Treasury bonds were increased from 9 percent to 10.5 percent. This should have had a positive effect on the stock markets; they should have shown upward stock movement; rather most of the stock markets miserably crashed. Moreover, the median revenue, before the crash of 1987 was $18.6 million, and it jumped to the figure of $34.7 million two years after the crash (Ang, Boyer, 2009). Instead of decreasing, the median revenue significantly increased. Also, the standard deviation of revenue before the crash was $276 million; it peaked to the level of $327 million two years after the event of stock markets crash. Furthermore, a similar pattern can be seen in the net income figures before and after the crash. The mean net income prior to the 1987 crash was $3.38 million, which rose to $5.13 million post crash to 1989. If the stock markets were efficient enough to represent information fully, then the market crash of 1987 should not have occurred. Two contrasting financial realities were happening simultaneously. On the one hand, stock markets were crashing, on the other hand, the median revenue, standard deviation of revenue and mean net income were increasing. If the stock markets were efficient, then, aggregately revenues and income should not have been increasing; rather, they should have been decreasing. The Initial Public Offerings (IPOs) is a way to raise funds for the purpose of investment. The increased number of IPOs showed the confidence of companies over the stock markets and their stable growth during and before the market crash of 1987. Surprisingly, before the market crash of 1987, the average size of IPO was $44.7 million, whereas after the event of market crash, the average IPO size increased to $59.1 million (Ang and Boyer, 2009). If the stock markets were efficient, they must have remained stable in October 1987; but, almost all of the stock markets crashed and left many unanswered questions about the validity and efficacy of efficient market theory. Additionally, a return of equity is another way to measure the efficiency of stock markets. Before the market crash of 1987, an average ROE of 15.51 percent was announced; but after the crash, the average ROE increased to the level of 17.17 percent. Moreover, the return to equity ratio did not show a decline rather show an upward movement after the market crash of 1987. Prior to the crash, the return to equity ratio was 16.88 percent, whereas after the crash, this ratio doubled to the figure of 33.27 percent. On the basis of above financial information, the stock markets should have remained stable since the majority of financial information was financially encouraging and promising; the financial information was not showing a negative or unstable pattern of behavior. Despite so much positive, encouraging and healthy financial information, the stock markets did not represent them as they should have represented them according to the efficient market theory. Conclusion A single day loss of $500 billion was considerably huge. On October 19, 1987, this loss occurred in the Dow Jones Industrial Average. Many critics believe that this single day loss was worst financial reality after the event of Great Depression. Yet, some supporters of efficient market theory still believe on this theory. But, they have no strong evidence to prove the validity of this theory when the event of stock market crash occurred in the month of October 1987. Before the market crash, the median revenue was $18.6 million, and this figure surprisingly increased to $34.7 million after the market crash. Also, the standard deviation of revenue was $276 million before the market crash of 1987, and after the market crash, this figure reached $327 million. Furthermore, mean net income was around $3.38 million prior to the market crash, $5.13 million was the point where mean net income reached after the market crash. Additionally, the average size of IPOs before the crash was $44.7 million that reached to the level of $59.1 million after the crash. In the same way, the figure of return on equity before the market crash was 15.51 percent and became 17.7 percent after the crash. And the ROE ratio before the crash was 16.88 percent and reached to the level of 33.27 percent after the crash. They are healthy financial data. They must encourage stock markets to perform well. And, stock markets should give a look of healthy future prospects. On the basis of above mentioned healthy financial information, investors prefer to put their confidence on the stocks and they remain ready to invest more and more. Despite these promising financial statistics, the stock markets crashed in the year of 1987, raising more questions on the validity and efficacy on the efficient market theory, which proclaims that the stock prices truly reflect the information as soon as the information reaches stock markets. However, the questions raised by the market crash of 1987 are still remained unanswered. As a result, the efficient market theory is being criticized by not clearly explaining the crash of stock markets in 1987. References 1. Schweser, 2004, “Corporate Finance, Portfolio Management, Markets, and Equity,” Kaplan: USA 2. Malkiel, BG 2003, “The Efficient Market Hypothesis and Its Critics,” The Journal of Economic Perspectives, Vol.17, No.1, pp. 59-58 3. Siegel, J., 2000. Dictionary of accounting terms 3rd ed., Hauppauge  N.Y. Barron’s Educational Series. 4. Poterba, JM, Summers, LH 1988, "Mean reversion in stock prices: evidence and implications", Journal of Financial Economics, Vol. 22 pp.27-59. 5. Pesaran, MH, Timmermann, A 1995, "The robustness and economic significance of predictability of stock returns", Journal of Finance, Vol. 50 pp.1201-28 6. Malkiel, BG 2003, “The Efficient Market Hypothesis and Its Critics,” The Journal of Economic Perspectives, Vol.17, No.1, pp. 59-58 7. Ang, J. & Boyer, C., 2009. Has the 1987 crash changed the psyche of the stock market?: The evidence from initial public offerings. Review of Accounting and Finance, 8(2), p.138-154. Available at: [Accessed March 19, 2011]. 8. McKeon, R. & Netter, J., 2009. What caused the 1987 stock market crash and lessons for the 2008 crash. Review of Accounting and Finance, 8(2), p.123-137. Available at: [Accessed March 19, 2011]. 9. Pesaran, MH, Timmermann, A 2000, "A recursive modelling approach to predicting UK stock returns", The Economic Journal, Vol. 110 pp.159-91. 10. Fama, EF 1970, "Efficient capital markets: a review of theory and empirical work", Journal of Finance, Vol. 25 pp.383-417 Read More