Why the Capital Markets Are Expected to Be Efficient - Literature review Example

Why the Capital Markets Are Expected To Be Efficient Why the Capital Markets Are Expected To Be Efficient Introduction The capital markets are expected to be efficient, mainly based on efficient markets theory (EMT) of financial economics, which states that the price of an asset is a reflection of its available information, which should be pertinent and available regarding its key value when it comes to the asset. Since the capital markets efficiency involve the application of all types of financial securities, then it is important to discuss why they are expected to be efficient. This will be based on the efficient markets theory (EMT) that mainly focuses on shares of common stock in a company. It is important to note that another reason as to why capital markets are expected to be efficient is due to the fact that a financial security represents a claim on future cash flows, therefore the intrinsic value can be said to be the present value of the cash flows which will be received by the owner of the security (Clarke, Jandik & Mandelker, 2001). In the theory, the profit opportunity which is characterized by the presence of both the “undervalued” and “overvalued” stocks encourages investors to trade. It is this trading which inspires the movement of the prices of stocks aiming for the existing value of future cash flows. This is where investment analysts come in search for stocks which tend to be mispriced as well as their subsequent trading, hence causing the prices to be a reflection of intrinsic values, thus making the market efficient. This is where we come across “random walk” relative to stock prices since new data is arbitrarily great or unfavorable in connection to the predominating desires. Changes in stock costs in an effective business sector should be irregular. Therefore, when it comes to efficient markets where prices reflect intrinsic value, investors are prevented from earning risk-adjusted returns which are unusually high. It is important to understand that the increase of market efficiency is directly proportional to the decrease or lower transaction costs in a market, which also includes the expenses incurred by getting information and trading (Bakos, 1998). Literature Review There has been evidence that it is indeed possible for investors to find trends in the past stock price thus be at a position to beat the market. Historically there is proof of this efficient market hypothesis being favorable to investors. Over recent time, there has been elaborate analysis of the evidence suggesting that this hypothesis although it may not be entirely accurate is very feasible. In this section of my paper I will start by looking at previous facts favoring this hypothesis and then look into a few of the more recent proof that sheds more light on this notion (Richard, Pillemer, & Light, 2009). There is proof favoring market efficiency which examines the working of investment mutual funds as well as financial analysts and whether there can be information which gives public reflection of stock prices. This is where we have the random-walk behavior of stock prices as well as the accomplishment which has been brought about by technical analysis. Here I am going explain the tests which are used in the analysis of the relation between the past performance and stock returns (Working, 1962). Performance of Investment Analysts and Mutual Funds Random-Walk Behavior of Stock Prices We have mentioned that capital markets are expected to be efficient due to the fact the hypothesis which quantifies that one cannot expect to earn an unusually high return resulting from a purchase of a security. There has to be a state of equilibrium thus proving that it is practically impossible to beat the market. Taking buy and sell recommendations from a group of advisers or mutual funds then comparing the proceeding of the subsequent selection of stocks with the market as a whole is one common test that has been performed. There have been comparisons of the choices of advisers to a group of stocks selected just by rolling dice at a copy of the financial page of the newspaper. A good example of this randomness perhaps can be cited by the Wall Street Journal, where there had been a regular article by the name “Investment Dartboard” which likened how well stocks picked by investment advisers performed in relation to stocks selected just by throwing darts. It is surprising as well as embarrassing to find that the advisers were beaten hands down by the dartboard just as often as they beat it the dartboard (Lehman, 2010). Since they are consistent with the hypothesis of the markets, mutual funds rarely beat the market forces or dynamics. Mutual funds are always categorized into groups on the basis whether they had the highest or lowest profits within a selected period. We clearly see that if the mutual funds performed well in the first period, in the second period it is the market that wins. From this test on efficient market hypothesis it was concluded that if an investor performed well in the past this is no indication that neither an investment adviser nor a mutual fund will replicate the same results in the future. There is a lot of luck involved since it is impossible and no one has the ability to beat the market. Now I am going to build my discussion on the two sets of tests that examines this hypothesis that fundamental analysis enables investors to earn abnormal profits. According to efficient market hypothesis, stock prices reflect all information that is publicly available. Therefore, since the information is already public, a positive statement regarding a company on average, cannot raise the price of its stock since there was already a reflection of the information in the stock price (Enke & Thawornwong, 2005). Technical Analysis This is the second type of test which examines the data to find out whether publicly available information other than past stock prices can be used in the prediction of changes. These are more strict tests since extra information such as money supply growth; government spending and interest rates are likely to be used in forecasting stock returns. Technical analysis is a technique which is well known when it comes to predicting stock prices. It involves the study of previous data of a stock price while looking for a pattern or trends and assessing its recurrence or its cycle. This is where we now come up with rules for trading stocks which are solely on the basis of the emergent patterns. Efficient market hypothesis presumes technical analysis to be a waste of time. One can easily comprehend this by incorporating the random-walk result we derived from the efficient market hypothesis which clearly shows that that past stock price data cannot help when it comes to predicting changes and since technical analysis relies on such data in coming up with its forecasts, then its only logical to assume that technical analysis cannot predict changes in stock prices successfully (Shleifer, 2000). Fundamental analysis Does fundamental analysis enable investors to earn abnormal profits? Below is a buildup of my discussion on the two sets of tests examining this hypothesis? From here I am going to define strong-form efficient market hypothesis (EMH) as well as discuss the results of a study that tests strong-form EMH. In strong-form efficiency: An investor cannot be able to earn excess returns by using any information, be it public or private information. In strong-form efficiency it is implied that there be a full reflection of all information in the asset price. Strong-form efficiency is seen to be very strong as it implies that corporate insiders don’t stand a chance of profiting by use of private information. A good example can be in the case that we have information that our firm has made a big technological breakthrough be it in the field of science and technology or mathematics with regards to financial matters. According to strong-form efficiency prices will have already adjusted thus no one can profit before having the opportunity to trade in based on the impending news (Easterbrook & Fischel, 1981). When it comes to strong form efficiency, the efficient market hypothesis dictates that not even individuals or investors who hold privileged information can use the information in order to come up with investing strategies which are profitable. However it does not come as a surprise that there is insufficient support for this hypothesis. This is because management insiders possess additional awareness into their company’s dealings and future. There is also proof that specialists in stock exchange are capable of causing irregular patterns pertaining to the fractional price movements (Godfrey, 2003). Importance of the findings Based on the above given evidence, the only accurate description of the stock market is that it’s a “nearly efficient” marketplace. It is with no doubt that, in the market place if a chance for what can be termed as inordinate profit presents itself, it clearly doesn’t stand a chance of going unnoticed. One would not expect prices to deviate by a large margin in such a marketplace, or either deviates for long, from what is regarded to as being “fair” price by the countless market participants. Hence we can conclude that the market is “reasonably efficient” since this way we will understand these two reasons as to this conclusion. In the first place if the market was not efficient (i.e., existence of feasible strategies in attaining constantly above-average performances) then the study of modern portfolio theory (MPT) would be unnecessary. But, it can be considered as naivety in assuming that the meticulous quest of traditional forms of analysis could somehow provide above-average returns because of the fact that the market is very efficient in a reasonable way. Secondly, we can also come to the conclusion that a “reasonably efficient” market is a prerequisite for the incorporation of modern portfolio theory (MPT). Devoid of such a high level of efficiency, there would be no existence of MPT since it is its theoretical foundation upon which it rests (Bolter, McConnaughey, & Kelsey, 1990). Conclusion The main goal of this paper is the expansion of knowledge in capital markets as well as the logical implications of the EMH when it comes to accounting for some of the fundamental factors of behavior which have an effect on stock prices. This paper contains reference materials which can serve as very good reference material when it comes to the study of capital markets. It could be verified that the efficient market hypothesis (EMH) is relevant and applicable as implied in this paper. However, it is important to note that any study of the efficient market hypothesis (EMH) cannot generalized the whole market, not at any given moment since EMH is manifested differently according the difference in circumstances. As mentioned in this paper, stocks which are more risky can tend to go through more volatility when it comes to price at a certain level of information than is seen with less risky stocks. Investor expectations will affect stock prices in a different way than during a boom when there is a crisis. However, on the other hand, it is also not easy to refute the EMH since most of its informational content is tacit. Investor expectations about a firm’s next move can ultimately cause price change even when there is no news announcement. Also capital markets are expected to be further more efficient since it can be shown that factors not within the category of new information can have direct effect on stock prices. These are the basic factors that can have adverse effect on individual investors at a personal level and may not have anything to do with the qualitative information available on the particular stock. In this paper I have used efficient market hypothesis (EMH) as a medium for elaborating on efficiency in capital markets which has its basis on news sensitivity of stocks so as to determine if there is any variance when it comes to the way which underperforming as well as over performing stocks act in response to new information. Therefore I hypothesize that matters pertaining capital markets are very versatile and are very dependable on fundamentals more than technical, on whether there is good or bad news. An investor holding a stock which is not performing well will tend to be more panicked regarding their holdings and thus the more their assets get mentioned in the news. This is because the panicked state induces sales of the asset, thus bringing down the price of the said asset. While on the other hand, the response of the investors who are holding well-performing stocks, will not be aggressive to the arrival of new information, thus prices will be stable even if there is an increase in news frequency. As an overview of the proof on the efficient market hypothesis and as to why capital markets are expected to be efficient, you can see in this paper that the debate on the efficient market hypothesis is quite far from being over. The research on diverse content pertaining to this seems to only indicate that the efficient market hypothesis may be a rational basis for the evaluation of behavior in capital markets. Nonetheless, there do seem to be major violations of market efficiency that imply that the efficient market hypothesis is just part of the piece of puzzle and not the whole piece and therefore it cannot be generalized to all behavior in capital markets. References Bakos, Y., 1998. The emerging role of electronic marketplaces on the Internet. Communications of the ACM, 41 (8), 35-42. Bolter, W. G., McConnaughey, J. W., & Kelsey, F. J., 1990. Telecommunications Policy for the 1990s and Beyond. New York: ME Sharpe. Clarke, J., Jandik, T., & Mandelker, G., 2001. The efficient markets hypothesis. Expert Financial Planning: Advice from Industry Leaders, 126-141. Easterbrook, F. H., & Fischel, D. R., 1981. The proper role of a targets management in responding to a tender offer. Harvard Law Review, 1161-1204. Enke, D., & Thawornwong, S., 2005. The use of data mining and neural networks for forecasting stock market returns. Expert Systems with applications, 29 (4), 927-940. Godfrey, M., 2003. Employment dimensions of decent work: Trade-offs and complementarities. Geneva: International Labor Organization. Lehman, R., 2010. Far from Random: Using Investor Behavior and Trend Analysis to Forecast Market Movement. New York: John Wiley and Sons. Richard, J., Pillemer, D. B., & Light, R. J., 2009. Summing up: the science of reviewing research. Harvard: Harvard University Press. Shleifer, A., 2000. Inefficient markets: An introduction to behavioral finance. Oxford: Oxford university press. Working, H., 1962. New concepts concerning futures markets and prices. The American Economic Review, 431-459. Read More