Market Efficiency and its implications for Macroeconomic Behaviour - Essay Example

Discussion on how predictable can asset prices can be without violating the efficient markets hypothesis The emerging discipline of behavioral economics has challenged the Market hypothesis, which supposedly incorporates all information rationally, and instantly. The argument is based on that markets are not rational, but are driven by fear and greed. There has been a lot of research in the cognitive neurosciences, which suggests that these two perspectives are opposite to each other. This paper studies all aspects of market efficiency and its implications for macroeconomic behavior When money is put into the stock market, it is done with the aim of generating a return on the capital invested. Many investors try not only to make a profitable return but also to outperform, or beat, the market. However, market efficiency hypothesis (EMH), according to Fama in 1970 - suggests that, at any given time, prices fully reflect all available information on a particular stock and/or market. Thus, according to the EMH, no investor has an advantage in predicting a return on a stock price .The paper will start by defining market efficiency and it various aspects. Introduction: In efficient markets, prices become not predictable but random, so no investment pattern can be discerned. A planned approach to investment, therefore, cannot be successful. In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be reasonable to see markets as essentially a mixture of both, wherein daily decisions and events cannot always be reflected immediately into a market. If all participants were to believe that the market is efficient, no one would seek extraordinary profits, which is the force that keeps the wheels of the market turning. In order for a market to become efficient, investors must perceive that a market is inefficient and possible to beat. Investment strategies intended to take advantage of inefficiencies are actually the fuel that keeps a market efficient. Accepting the EMH in its purest form may be difficult; however, there are three identified classifications of the EMH, Roberts [1967]. 1. Strong efficiency - This is the strongest version, which states that all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage. 2. Semi-strong efficiency -This form of EMH implies that all public information is calculated into a stocks current share price. Neither fundamental nor technical analysis can be used to achieve superior gains. 3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in todays stock price. Therefore, technical analysis cannot be used to predict and beat a market. Efficient Market hypothesis and the current debate: The evidence suggests that asset prices can be predicted with a fair degree of dependability. Two competing explanations have been offered for such behavior. Proponents of EMH (e.g. Fama and French [1995]) maintain that such predictability results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken. Critics of EMH (e.g. La Porta, Lakonishok, Shliefer, and Vishny [1997]) argue that the predictability of stock returns reflects the psychological factors, social movements, noise trading, and fashions or "fads" of irrational investors in a speculative market. The question whether predictability of returns represents rational variations or arises due to irrational speculative deviations has provided the momentum for keen intellectual investigation in the recent years. The efficient market hypothesis states that asset prices in financial markets should reflect all available information; as a consequence, prices should always be consistent with the ‘fundamentals’. The efficient market hypothesis is almost certainly the right place to start when thinking about asset price formation and its predictability. Recent research tells us that EMH has not been able to answer most of the important concerns of asset market behavior. The Predictions of the Efficient Market Hypothesis: The efficient market hypothesis has a number of interesting predictions about the behavior of financial asset prices and returns and some of them are even testable. Consequently, a vast amount of empirical research has been devoted to testing whether financial markets are efficient. While the ‘bad model’ problem plagues some of this research, it is possible to draw important conclusions about the informational efficiency of financial markets from the existing body of empirical research. According to the survey conducted by (Beechey.M, Gruen.D &Vickery J [2000]) some prediction were approximately true according to the empirical evidence including, ‘asset prices move as random walks over time’ and ‘fund managers can not systematically outperform the market’. There were also other prediction that were examined under the empirical evidence such as: Can Current Information Predict Future Excess Returns? In an efficient market, information that is available publicly should be reflected in the asset price. In the stock market, for example, public information on price-earnings ratios, cash flows or other measures of value should not have implications for future assets returns. The only reason it could happen if these variables reveal information about the risk of the asset. Similarly, in the foreign exchange market, the forward exchange rate should not help predict excess returns from holding interest-bearing assets in one currency rather than another. It is believed that features of asset-market behavior seem much harder to match with the efficient market hypothesis. Supporters of the efficient market hypothesis can argue that many violations of the hypothesis are instead examples of the ‘bad model’ problem. Under this scenario, predictable excess returns represent compensation for risk, which is incorrectly measured by the asset-pricing model being used. Asset Price Predictability: Hong and stein [1999] developed an information diffusion hypothesis according to which stock price under react to private information, leading to stock return predictability. According to the theory, all stock prices should rapidly include information about the future as it becomes available. However, studies indicate that the speed at which valuable information is transmitted to stock prices varies among asset classes (Lo and MacKinJay [1990]; Badrinath et al. [1995]; Hong et al. [2000]; Chordia and Swaminathan [2000]; Ratner et al,[2004]), In recent years financial economists have increasingly questioned the efficient market hypothesis. But surely if market prices were often irrational and if market returns were as predictable as some critics have claimed, then professionally managed investment funds should easily be able to outdistance a passive index fund. According to Malkiel [2004], some predictability of returns exists; there is no evidence of any systematic inefficiency that would enable investors to earn excess returns. Many financial economists now believe that our securities markets are at least partially predictable. According to him the logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, tomorrow’s price change will reflect only tomorrow’s news and will be independent of price changes today. But true news is by definition unpredictable; thus, resulting price changes must be unpredictable and random. According to Pesaran [2003] stock market returns will be non-predictable only if market efficiency is combined with risk neutrality. According to him a large number of studies in the finance literature have confirmed that stock returns can be predicted to some degree by means of ‘interest rates’, ‘dividend yields’ and a ‘variety of macroeconomic variables’ exhibiting clear business cycle variations. But EMH suggest market to be at a random movement and that stock price is non predictable. So the factors with which asset price can be predicted violates Efficient market hypothesis. EMH has wide applications in the financial markets, since it is easily extended to the valuation of companies, market failures, or performance analysis of the mutual funds. The traditional analysis of the market efficiency is based on the analysis of the anomalies such as Peso Effect in the foreign exchange market or devoted to the predictability of the stock returns. CONCLUSION: The random walk theory asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements. The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact "efficient" and if so to what degree. Many novice investors are surprised to learn that a tremendous amount of evidence supports the efficient market hypothesis. Early tests of the EMH focused on technical analysis and it is chartists whose very existence seems most challenged by the EMH. And in fact, the vast majority of studies of technical theories have found the strategies to be completely useless in predicting securities prices. However, researchers have documented some technical anomalies that may offer some hope for technicians, although transactions costs may reduce or eliminate any advantage. According to some researcher stock market returns will be non-predictable only if market efficiency is combined with risk neutrality. According to him a large number of studies in the finance literature have confirmed that stock returns can be predicted to some degree by means of ‘interest rates’, ‘dividend yields’ and a ‘variety of macroeconomic variables’ exhibiting clear business cycle variations. But EMH suggests market to be at a random movement and that stock price is non predictable. So the factors with which asset price can be predicted violates Efficient market hypothesis. 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