Arguments For and Against the Efficient Market Hypothesis - Essay Example

Review the arguments and evidence for and against the efficient market hypothesis and discuss whether the recent financial crisis has caused the hypothesis irreparable damage. Contents Contents 2 Introduction 3 Discussion 3 Random Walk Hypothesis 4 Semi Strong Form of EMH 5 Asset Price Bubbles 6 Conclusion 7 References 8 Introduction The World financial crisis which occurred in 2008-2009 has resulted in severely damaging the economies of Europe and United States. During the time of world financial crisis, the Unemployment rates increased to high levels even reaching double digit levels. The world economic crisis left a damaging impact on US and Europe and they are still operating well below their economic capacity. Presence of high indebtedness of financial institutions, consumers and governments had made severe recession limit the effect of fiscal policy on economies throughout the world. The global financial crisis has made a huge impact on modern financial theory which was based on the hypothesis that the financial markets were more or less efficient. Many economists and writers were respected the efficient market hypothesis. Economists Robert Shiller touted EMH as the most important theory in the history of economics. This report will look at the implication of efficient market hypothesis in the functioning of the financial markets. It will focus the disadvantage of EMH and why some analyst wants to reject this hypothesis permanently. Discussion Efficient Market Hypothesis (EMH) is an investment theory in finance that states it is impossible to beat the market because the efficiency in the stock market leads to the reflection of all relevant information in the prices of shares. According to this theory, the trading of stocks always takes place at their fair values on every stock exchange. Hence it is impossible for investors to purchase stocks that are undervalued and also to sell stocks at a higher price than its fair market price. In this regard, it is not possible to outperform the return of the overall market through expert opinion on stock selection and also by timing the market. The theory also mentions that investors are left with only one way to obtain higher returns and it is through purchasing investments that are riskier in nature. The financial crisis of the year 2008-09 has left the economies of Europe and US vastly devastated. The rate of unemployment has reached very high and the economies in the US, Europe and also other countries are performing well below their economic capacity. The crisis has shaken the theory of efficient market hypothesis which assumes the existence of efficiency in every financial market. According to EMH, public information is reflected in the asset prices without any delay. It also suggests that the availability of any information which may affect the future price of any stock is already reflected in the current price of stock. In this regard, it could be stated that the impact of any new information may not be immediately felt by the participants of market. Random Walk Hypothesis EMH theory implies that the market prices cannot be forecasted. If the market prices revealed all the expectation and information of all market participants then the corresponding prices of hare must be random in nature. Stock prices will always change based on new information available in the market, but true news is mostly random in nature which cannot be forecasted from past events (Palan, 2007, p. 142). Hence in case of efficient market where information is readily available, price changes cannot be forecasted. A random price movement does not imply that stock price is capricious in nature. It basically implies that an efficient and well functioning market is random instead of being an irrational one. Many studies have been conducted in this respect and it was found that random walk model does not hold in the strict sense. There exists some pattern in the development of stock prices. Studies have shown that over a short period of holding there is presence of some momentum in the stock market and periods of long holdings reversion happens (Harder, 2010, p. 85). Thus it is clear that weak form of EMH is violated which states that unexploited trading opportunities must not be present in an efficient market. Semi Strong Form of EMH This form of EMH implies that any the current stock price reflects all the public information. Thus it implies that neither technical nor fundamental analysis will help in achieving superior gains. But majority of the investment managers are fundamental analyst and not technical analyst. It is important to know that any model which indicates that abnormal return in possible has some risk factor in it. Capital asset pricing model is one such example which is used to adjust for risk. Many researchers have been conducted to find out the speed of adjustment of new information in the market price. One example is share splits which does not provide any economic benefit and is usually followed by increase in dividend which conveys the information of management’s confidence about the growth of the company. Though it is quite evident that share slits results in higher market valuations, it is quite apparent that stock market adjusts itself to such announcements immediately and fully. Thus though substantial returns can be earned by the shareholders of the company before the announcement of the stock split but they don’t earn abnormal returns after public announcement (Cooper, 2008, p. 115). Similar case happens in case of mergers. Such an announcement raises the market price of a share substantially in case when premiums are paid to the shareholder of the acquired company. But it can be seen that the stock market adjusts itself to such public announcements. Many studies have shown that there is no evidence of abnormal price changes after the news of mergers is made public. Wolfson and Patell (1984) studied the intraday speed of adjustment to dividend and earnings announcements. They found that the stock market quickly absorbs publicly available information very quickly. Their key findings were that stock price change in response to public disclosures in the first 5 to 15 minutes. But there were studies which indicated that abnormal returns can be earned even in period after the announcement date. Researchers found that in some cases unexpected earnings announcement did not reflected in the stock price and that abnormal returns can be earned if one purchases shares of companies which generates positive earnings surprises. Thus EMH hypothesis does not hold true in all circumstances. Asset Price Bubbles The asset price bubbles could be explained as the soaring prices of the assets due to the spectacular bubbles in the economy. The asset price bubble provides the strongest evidence against the theory of efficient market hypothesis. The efficient market hypothesis suggests that the movement of the share prices are supported by the information available in the market (Malkiel, 2003, p.74). Any change in the share prices also lead to the flow of information to the market based on which the decisions on the investment is taken. However, asset price bubbles resemble the rise in the prices of the assets above the average asset performance. This was observed in the bubble that developed in the housing and mortgage securities market in the US. This led to the flow of information in the market that the housing and real estate is very lucrative for investment as the investors were able to realize higher returns in a short span of time (Bruetsch, 2009, p.48). The rising investments in the real estate led to the soaring prices of the real estate stocks. The loans for purchasing the real estate properties were granted by the banks in US by taking the real estate properties as the mortgage securities. The aggressive lending by the banks in order to realize higher returns led to the inflow of borrowers who were not creditworthy. The subsequent non-repayment of loans led to the increase in the bad debts of the financial institutions. The non-repayment of the loans led to fall of the share prices of the real estate stocks of the companies. This led to the decline in the valuation of the companies and the prices of the real estate mortgage properties also declined. As the real estate mortgage securities were the underlying assets, the loans of the banks transformed to bad debts and big players like Lehmann Brothers went bankrupt. The asset price bubble which finally burst in the US gave rise to the global financial crisis. It could, therefore, be said that the flow of information to the market due to the asset price bubble did not appropriately reflect the performance of assets (Courtois, 2009, p.18). Hence, the asset price bubble served as the evidence for opposing the theory of efficient market hypothesis. Conclusion The efficient market hypothesis explains that any change in the prices of the shares and stocks of the companies lead to the flow of information in the market. Conversely, the information on the market events that have occurred in the past and present leads to changes in the share price of the companies. There are various forms of efficiency of the market which may be termed as weak, semi-strong and strongly efficient markets. However, the occurrence of the global financial crisis has provided strong evidence for opposing the efficient market hypothesis. The asset price bubble which led to the rising investments in the real estate sector and the increasing finances of the financial institutions in anticipation of the rising performance of assets turned into a debacle as the bubble finally burst resulting into global financial crisis. The big corporate houses with investments in real estate went bankrupt and the share prices declined leading to devaluation of companies and stock index. References Courtois. 2009. The Price Is Right?. Region Focus, Federal Reserve Bank of Richmond. 1(1), pp.16-19. Malkiel, B. G. 2003. The efficient market hypothesis and its critics. Journal of Economic Perspectives. 17(1), pp.73–76. Bruetsch, M. 2009. From Capital Market Efficiency to Behavioral Finance. Berlin: GRIN Verlag. Palan, S. 2007. The Efficient Market Hypothesis and Its Validity in Todays Markets. Berlin: GRIN Verla. Harder, S. 2010. The Efficient Market Hypothesis and Its Application to Stock Markets. Berlin: GRIN Verla. Cooper, G. 2008. The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy. London: Harriman House Limited Read More