Stock market efficiency - Dissertation Example

? Stock market efficiency Contents Introduction 3 Efficient market Hypothesis 3 9 Conclusion 14 Reference 16 Introduction Efficiency in market means that there is absence of any systematic way to beat the market. The efficient market hypothesis states that the information about the value of the firm is fully reflected in the current stock prices. It also states that the firm will not be able to earn to excess profits i.e. profits over and above the profits made by the other players in the market by using this information. The hypothesis deals with two of the fundamental questions in finance. The first of them is why there is price change in the market for securities while the second considers how the change actually occurs. Investors involve themselves in identifying the securities that are expected to witness an increase in their value in the future. Moreover, they always try to identify those securities which will witness the maximum increase in their value. They are of the opinion that they have the capability to select only those securities that are expected to perform unexpectedly well in the market and drive the others out. In the process they use different forecasting techniques as well as some valuation methods. The combination of the techniques helps them in their decisions regarding investments. However the hypothesis states that the techniques are not effective and no one has the capability to predict the outperformance of the market. If the investors enjoy any advantage it is supposed not to exceed the incurred cost of transaction and research. Efficient market Hypothesis The theory suggests that it is extremely difficult to profit by predicting the movements in the prices. If in a market, the prices can adjust quickly without being biased to new information, such a market is called efficient markets. The availability of new information can lead to change in prices. The available information is reflected in the current prices of the securities taking a period under consideration. Adjustment in the price level takes place before an investor has sufficient time to trade and accrues profit from new information. Competition among the investors to accrue profit is one of the foremost reasons for the existence of efficient markets. Many are also involved in identifying the stocks that are mispriced. When more and more investment advisors or the market analysts spend time in taking the advantage from the stocks that are either lowly priced or highly priced, the probability of detecting the securities that are mispriced becomes smaller. In a situation characterized by equilibrium, only a small number of analysts will be able to gain from the mis-priced securities because of the chance factor. All investments performing in the market are priced fairly. But it does not imply that they will perform in similar fashion because of the effect of rise or fall in the price level. The capital market theory states that the return expected from a security is a function of the risk. As the nature of the new information is unpredictable, the changes in the prices are expected to be random and the prices of the stocks follow the random walk theory. There are three versions of the hypothesis namely the weak form, the semi-strong form and the strong form of hypothesis. The weak form of efficiency states that the information about the history of prices only are incorporated in the current prices and that is why nobody can detect the securities that are mis-priced and gain from the gain by analyzing the prices of the past. The semi strong form of the hypothesis states that the current price reflects all the information that is available publicly. The last form of hypothesis that is the strong form asserts that all types of information namely public and private are reflected in the current price. The aim of all investors is to accrue maximum gains. The newly generated techniques to predict the movements in price have not been as successful as expected. If the risks and the costs of transaction are taken into account then active management of security is a losing proposition. Although there is no such theory that can be called efficient from all perspectives yet the empirical evidence supports the hypothesis under consideration. There are some opponents who are against the hypothesis but the evidences they provide are not strong enough to undervalue the propositions of the hypothesis (Clarke, Jandik and Mandelker, n.d. pp. 1-22). a) The fundamental analysts of investment use the factors which are thought of as fundamental to the organization. Such kind of analysts may have the inclination to recommend purchase decisions or the company operates in the sector which the analyst believes will witness the brighter side in the near future. But the technical analysts think that the fundamental factors are completely reflected in the behavior of the stock in the market. Therefore all data are internal to the company and the prediction of the movement of the stock prices is possible by examining the past prices of the stocks. Therefore, recent changes in volume as well as changes in the prices might influence the analyst to recommend the purchase decisions. The analysts are slightly uncomfortable to deal with the hypothesis and they are of the opinion that the hypothesis is far from the reality. The serial correlations in the short run supported the view that the market for stocks does not possess a very good memory. Some of the findings show that the correlations are not zero and successive movement in same direction leads to rejection of the hypothesis. There is tendency that the investors will under react to the newly available information. If the effects of the information are found for a period of time then the prices of the stocks will witness a positive correlation. The implications of the hypothesis is of concern as the fundamental analysis reveals the fact that analysis of historical data is of no help as the information is already incorporated in the prices of the assets. The assumption the hypothesis is that the participants of the market at the forecast of rational expectation. This implies that the participants of the market have similar expectations on the returns of future securities. The buyer forecasts a rise in the price of the assets while a seller expects the asset price to fall. The forecasted value of the price of the assets clusters around the central value. Any deviations from the central value are distributed in random fashion and this implies that the profits and the loss are distributed randomly. Therefore the errors are found to be random. However if different individual has different knowledge then the forecasted value calculated on the basis if the knowledge will be different. The success of the prediction of the price of the assets will not be random completely but is also attributable to the knowledge of each individual. The market for stocks does not have the life span of its own. So the investment is stocks can be regarded as investment in business. The criteria for the investors to employ their capital are to invest only in those activities which are in top priority from the consumers’ point of view. The need to satisfy the wants of the consumers has the potential to produce profits and this act as the guide to the investors. Suppose the Central bank reduces the rate of interest which was anticipated. According to the hypothesis this sort of news will not have effects on the market but in reality the process of the business cycle will feel the impact. The income of the individuals will also be affected and as a result the prices of the assets will be affected. It must be taken into account that the investors will require some time to assess the situation of the market and understand the changes in real data and the prices of the assets. If one of the causes is anticipated it would not imply that the investors had previous knowledge regarding the cause and was therefore discounted. The effect of some causes which occurs with only few individuals and then spreads its implications is hard to assess across time. The participants of the market apart from having the information regarding the preferences of the consumers also have the information about how the preferences will change. However one cannot predict the preferences of the consumers before the consumer has actually acted. Analysts are often concerned about the profits. The proponents of the hypothesis are of the opinion that the anything over normal profit cannot be secured out of the information of the public. They argue that any measure to make profits will be self-defeating. Anything over and above the normal profit is unsustainable. The hypothesis has ignored the reasons behind such outcome. When the entrepreneur realizes that the undervaluation of the certain factors relative to the potential value of the same factors at the time of the employment there is emergence of profits. In order to nullifies the discrepancy for further profit. The recognition of excess profits points out that the entrepreneur enjoying the profit must have some more information relative to the others and possession of this sort of information suggests profits are not the outcome of the random events. The entrepreneurs who have the potential or the capability to assess the preferences of the consumers will be able to enjoy the profits. This contradicts the propositions of the hypothesis. There are certain unforeseen errors which tend to upset the expectation of the analysts. Errors play an essential role in the navigational tools. The efficient market hypothesis depends on the extensive statistical tests which tests the validity of the theory. The tests assume that the returns on the investment are all independent and the probability distributions are constant across time periods. While dealing with cases which are non-homogeneous the risk cannot be pooled but the probability distribution of the risk is known. The activity of the entrepreneur is unique and it does not allow the establishment of probability distributions. There can be repetition of the activity of the entrepreneurs and the probability distributions of the returns are known. The preferences of the consumers are never constant. This makes establishment of the probability distributions extremely difficult. The proposition of the efficient market hypothesis states that the probability distributions can be arranged. The proposition is absurd. The proposition points to machines that are incapable to change their preferences and not to the world of human beings. The statistical tests that reveal that the probability distributions on asset returns are computable are error prone. The tests take into account the historical data seta and conclude that the average returns will also have its relevance in the coming periods. The historical data is erroneously represented as time series and displays the information pieces that are non-homogeneous. The observations in the historical data are unique and are caused by the responses of the individuals. This implies that to make sense there is no need to analyze those using statistical techniques. It can be concluded that the markets for assets will not be in equilibrium as the real causes are likely to show effects on the real data. This will provide the opportunity to gain the benefits from analyzing the data in order to forecast the direction of the movements of the prices of the assets. In order to judge, the analyst takes into consideration past data. The process of interpretation and the analysis is an important input for the decision making procedure of the analyst. The assessment of the implication of the policies of the government as well as the Central bank requires possessing the skills and the requisite trainings. However possession of the skills does not imply that the analysts will be forecast accurately. The criticism of the hypothesis are similar to those of the theories of the long run equilibrium which focuses mainly on the outcomes at the equilibrium and do not consider the activity of the entrepreneur that forms the basis to generate the outcomes. The propositions of the efficient market hypothesis assert that there is difference between investing capital in the stocks and investing the capital in business. The success or the failure of the investment that were made in stocks will ultimately depend upon the same factors that pave the way for the success or the failure of the business activity. The statistical tests which are responsible to test the validity of the hypothesis are based on the methods that are full of flaws and the validation of the theory is at stake. b) The researchers were involved in comparing the indices of the prices of the shares, the computed averages, the closing prices on daily basis, the closing prices for the end of the week as well as the closing prices for the end of the month with the aim to compute the validity of the hypothesis. A research was conducted taking a sample of twenty three shares which were listed in the stock exchange of Nepal during the month of mid July, 1997 to the same month but for year 2000. Adequate care was taken in order to exclude the shares from the study that had no transaction in the weeks considered in the time period. The closing prices of the shares were taken into consideration for the study. When the closing prices were not available then the closing price of the previous day were used. The tests for the correlation were performed on the basis of the first differences of the logarithms. Let Ri,t denotes the changes in the price in natural logarithm of the ith stock, Pi,t denotes the price of the ith security which was observed at the end of tth day, Pi(t-1) denotes the price of the ith security which was observed at the end of (t-1)th day. Then the following equation can be raised: Here i, t=1(1)n. There are some reasons which can be accounted for using log prices instead of the simple changes in price. The log price change is the yield from security holding for that day. The variability of change in price can be taken as the increasing function of the stock price level. In order to measure the successive number in series the statistical tool that is used is called serial correlation. It can be utilized in measuring the possible dependence in the changes in the price if shares as well. The serial correlation measures the relationship between the values of the earlier period and the value of the random variable. It points out the influence between the price changes at the current period with the price changes occurred at the earlier period. The tests like the runs tests take into consideration the theory of runs and the signs ignoring the absolute values. They are concerned with the direction of the changes under a certain period of time. One can find three types of price changes in the series of share piece namely, the positive, negative as well as the no-change ones. In the run test it is assumed that the price changes are independent and is performed by comparing the actual and the expected runs. If the differences turn out to be significant then the price changes are assumed to be dependent. It is a non parametric test. When the company takes the initiative to increase the paid up capital, the price of the shares rises. Three ways to increase the share price are calling up the balance, issuing bonds and shares as well as issuing the right shares. In this kind of situations, the price is required to be adjusted immediately after the change of the prices. In the sample taken in consideration above the situation of the calling up the balance did not arise. However some of the companies issued the right or the bonus in the period of time. The serial correlation tests for the twenty three shares of the stock exchange of Nepal were performed. The results showed the observed first order coefficients as negative. The first order coefficients were also significant for some of the active shares on the stock exchange. A small value of the serial coefficient can be statistically significant but such a value can imply the dependence which has no significance on the basis of the economic considerations. So the serial dependence displayed by the equity shares cannot be used to predict the future movements. In the overall ranks of the utility of the current share prices priorities were given to the decision of buying and selling, to forecast the average run of the future, and to forecast the prevailing prices for the future, to differentiate between the shares categorized as good or bad. An investigation was on progress which took the opinions of some with respect to some of the major aspects of the price of the shares in the country of Nepal. The investigation took more than one hundred financial executives who were required to answer a questionnaire. The value of the Chi-square computed was 0.88 at the significance level of 0.05. It can be asserted that similar decisions existed between the responding groups and no significant differences can be observed between the usefulness of the current prices of the shares. The factors that have the potential to influence the prices of the shares the responding groups gave priority to dividends as well as the retained earnings. The majority of the respondents were of the opinion that the public information is suitable in identifying the securities that are either overvalued or undervalued. A majority of the respondents opined that the publication of the financial reports of a company can have influence on the prices of the shares. c) The factor of market efficiency usually has to go through a lot of test on constant basis. Some of the inferences of the conducted studies reflect that there should be no constraints on insider trading. This will pave the way for strong efficiency in the market where there is possibility of usage of all available information. Again some of the researches argue that regulations are needed in order to maintain competition in the market and uphold the integrity in the market. The laws existing in the country of United States restrict some insider trading. Therefore the market should abide by the semi-strong form of efficiency. The act of purchasing or selling the stock of a corporation or other securities by an individual who have the potential to access the non-public information regarding the company is defined as insider trading. Such an act by the officers, directors, employees as well as the shareholders is considered legal if and only if it is disclosed according to the regulations of the Securities and Exchange Commission. But trading based on material or non public information is considered as illegal. In many cases the investors try to follow the path of the insiders which shows that the market considers the trading as an important source to gather information regarding the long run prospects of the firm or the corporation. The value of the firm under consideration can be affected by the trading of the insiders of the corporation and the level of efficiency persisting in the market have the potential to determine whether any investor will be able to enjoy anything over and above the normal profit level. The definition of the insider can also be broadened to include any individual that responses to non public information. An exception of the insider trading can be thought of as the overhearing of the information that is non public provided there is no connection with the informer. A fine line exists between legality and non-legality of the insider trading and many cases arrive in courts because of this reason or further investigated by the concerned authorities. An example of insider trading is the tipping off the friends and relatives by an official of a company outside the boundaries of that company. If the person in consideration takes the necessary actions on the basis of the information shared with the others, they are considered as the fiduciary relationship breakers. The value of the stocks can get affected by the dividend as well as the bankruptcy decisions. Insider trading can also shed its impacts on the responses of the market because of those activities. It is expected that the firms with net selling before the announcement of dividend initiation will witness a more negative response from the market compared with the firms with either insider purchases and even with no trading. Insider trading cannot be thought of as the future performance of the company. The profitability from such trading depends on whether the reaction of the market follows the efficient market hypothesis. The firm can experience positive response from the market when there are unexpected insider purchases but the purchases need to be before the announcement of the repurchase. The insider trading can influence the reaction of the market and can also act as the reflection of the confidence of the officers of the corporation. Uncertainty regarding the future is signaled by insider sales and it has been expected that the response of the market will be negative and the value of the firm will fall. The situation is just the opposite for the insider purchases. Investors have the potential to respond immediately in the next trading course when some announcement regarding the insider purchase or selling is made. It is expected that the value of the stock will increase for the company if the announcement is regarding insider purchases which signals the investors to buy more stocks. The company will experience just the opposite scenario if the announcement is regarding insider sales. In the purview of the efficient market hypothesis the announcement of the insider trades reduces the reaction time of the market and also affects the price discovery process. The forecasted insider profits will take the path downwards because of the announcement. Therefore, it follows that the efficiency of the market is enhanced by the announcements of insider trades. Yet some argue that the market efficiency can also be hampered because of public disclosure. If restrictions are absent then the efficiency would increase as the prices will reflect all the available information. Such increase in the efficiency will reduce the gains from the private information as the market will respond quickly for the insider who wants to accrue the gains from the purchase or the selling mechanisms. The views on the efficiency of the market takes into account some of the conclusions regarding the crash of 1987. The prices of the stocks were close to the fundamental value prior to the slump. If the perspective of the market efficiency is considered then the policies that inhibit the crashes in the future are not guided. The interpreters of the crash argue that if the market were efficient both before and after the crash then the decline or the reduction in price is the resultant of new available information regarding the cash flows of the future or about the rate by which the flow of the cash were to be discounted. In 1987, the press published the speculation that the Federal Reserve is expected to raise the discount rate. The government announced the initiative the depreciation of dollar against the mark. The fundamental values are not observable and therefore researchers were forced to use the indirect approach to test the aggregate level of prices. The common method is to test the observed returns which are expected to be consistent with some models of equilibrium. An indirect way to examine the efficiency of the market is to take the news and the announcement along with the changes in the large stocks in consideration. If the markets are operating in efficient fashion and the prices are equal to the fundamental values then the information that has the potential to change the fundamental values also has the potential to affect the changes in the prices. Economists are of the opinion that the evidence of efficiency can be thought of as the ability of the market to distinguish between the real change and the cosmetic change. If the prices are equal to the fundamental values then a change in each price will show the change in the fundamental value. The observed changes in prices have been ignored by the economists. Economists blame the fundamental models than direct to examine the relation between the observable as well as the unobservable information rather than observing the failure to predict the price change as inefficiency. Conclusion The researches all direct mainly to one fundamental conclusion. Fully efficient markets are not possible logically and can be regarded as myth. Since it is not possible for the market to operate at the full efficiency level the estimates of the damages based on the efficient market hypothesis and the analyses after the movement in the prices of the stocks will frequently overestimate the damages and the estimation will be significant. The hypothesis only takes into consideration the situations where the decline in large in the large stocks can be observed and in this kind of situations there can be exaggeration of small emerging inefficiencies. The market should not be deemed to be efficient for the purpose of estimating the damages. The efficient market hypothesis ignores how to use the information variables to generate the actual estimates. However, one can change the definition of the efficiency in the market to cover up this aspect. The continuous profit seeking behavior of the investors can generate efficient type of markets. But the hypothesis does not rule out the existence of many other variables that are not deemed for the strategy of profit seeking. If the weak form of efficient market hypothesis is studied it can be observed that the historical movements in prices are of no utility in order to predict the future price movements under this form. The magnitude or the direction of the price movements will be of no help either. The semi-strong form of hypothesis asserts that the all the publicly available information is of no help to predict the future movements in price. Thus this form contradicts the concept or the proposition proposed by the fundamental analysts. Instead of calling the market as perfectly efficient, the market can be regarded as reasonably efficient mainly for two reasons. Firstly, if the markets are deemed to be non-efficient then it would not been possible to study the market portfolio theory. The anomalies in the market for stocks can be explained by the behavioral biases as well as the imperfections in the institutions. Reference Clarke, J., Jandik, T. and Mandelker, G. n.d. The Efficient Markets Hypothesis. [pdf]. Available at: http://comp.uark.edu/~tjandik/papers/emh.pdf. [Accessed:8th May, 2012]. Read More