Is Equity Market Efficient - Literature review Example

Student’s name) (Course code+name) (Professor’s name) (University name) Is equity market efficient? 1.0 Introduction Efficient market hypothesis has elicited mixed reactions from social scientists and economic financial researchers. Since its emergence around 1960’s efficient market hypothesis maintains that the available information in stock market is fully reflected in prices. While this is one side of the argument, researches on what constitute stock market and prices continue to evolve. This essay therefore builds on these hypotheses to discuss the available literature for and against EMH; giving anomalies involved in the hypotheses. Based on researches reviewed, there seems to be consensus that efficient market hypothesis has no common definition that binds (Worthington and Higgs 2004; Andrew 2007). In as much, definitions available have been made depending on the context and subject matter. On the one hand, Worthington and Higgs (2004) view the concept as the ability of the security prices in the market to instantly adjust to the new market information. On the other hand, the concept is understood to be a situation where stock prices are accurate and reflect the information available in the market (Fama, 1970 as cited in Andrew, 2007). Contemporary researchers however, delink the aspect of stock market in their definition by looking at the concept as a whole. Citing recent works, Jeff et al (2010) encompass the concept of market signals in defining market efficiency. While agreeing with other definitions, they add that market signals and feasibility help understand market efficiency since it is only through the two concepts that equity prices will signals market condition. 2.0 Arguments for markets efficiencies Just like its definition, arguments regarding market efficiencies are equally multifaceted. In so speaking, these arguments have not gone without criticisms. The first criticism that has since formed the basis of other arguments regards the theory of price and time (Samuelsion, 1978 as cited by Andrew, 2007). This theory posits that the price of stock fully reflects information which is fundamental to the investors. As a matter of fact, thought widely documented as a theory, it continues to be widely considered as one of the key pillars used to support the EMH. To underscore the statement, Bodie et al. (2008) argued that efficient market should be able to reflect all the available information in the market. What Bodie et al tries to bring forth is that more often than not, getting new information on the stock market has proven to be tricky. There is an exception to this though. According to Andrew (2007), one is still able to predict the movement of stock prices and the profit especially when the information is not directly included in stock price and players in the same stock market are not able to do so. How does the theory of price and time links with random walk hypothesis? First, it is distinguishable that random walk hypothesis gets much support from the protagonists of EMH. Secondly, theory of price and time and random walk hypothesis circles around market efficiency. Recent research that has tried to integrate the two theories with view to showing market efficiency is Burton and Malkiel (2003). This research uses historical data to support the EMH and concludes that stock prices reflect market information through its prices at the right time. Such conclusion brings one important factor; that when stock prices reflect market information through its prices at the right time equity markets are perfected. The second theory which supports EMH is Fama’s information/technical efficiency (Andrew, 2007). This theory posits that equity prices motivate the investors to trade in the stock market. Such trading activity can move the prices of the stock to present value of the future cash flow. Unlike the other theory, information/technical efficiency theory further believes that market efficiency is a continuum and the more the transaction cost used in obtaining the information becomes low, the more efficient the stock markets become. Citing relevant case of United States’ stock market, the information from Companies is cheap and easy to get and this might be as a result of the disclosure system within the country. This makes trading in equity cheaper and affordable thus the arguments that the United State equity market is efficient (Andrew, 2007). Another aspect regards return variances and RWH. This concept has been analysed by Worthington and Higgs (2004). In their presentation, they argue about variances linearly scale under the RWH. That is the variance of a return for two-week is twice the variance of a return for one week. In this case, the RWH holds. They further constructed a variance ratio test which rejects the RWH for weekly US stock returns indexes from the year 1962 to 1985. In particular, they found that variances normally grow faster than the linearly when the holding period increases---meaning positive serial correlation in weekly returns. To conceptualise these findings, Lo and MacKinlay (1986) also found that individual stocks do satisfy the RWH hence EMH. French and Roll (1986) as cited in Jeff et al (2010) discus random walk theory in a perspective that supports efficient market hypothesis. They state that stock return normally varies over weekends and the exchange holidays are usually considered to be lower than return variation over the same number of days when markets are open. This implies that the very activity of trading builds volatility. 3.0 Arguments against market efficiency The critics of the EMH maintain that the perfect market efficiency hypothesis is not valid as market efficiency cannot be realized under any situations (Bodie et al., 2008). Another school of thought from financial behaviorists believes that the efficient stock market hypothesis does not hold. Instead, it assumes rational behavioral model arguments (Worthington and Higgs, 2004). Financial behaviorists further argue that there are certain financial phenomenal which can better be understood using mathematical models. These models too are dependent on rational people---insinuating that not all market participants are rational. In most cases, the market participant may not correctly decode and interprets the information as explained by Fama. There is where Basu (1999) arguing that though the information might be correct, its correctness still needs suboptimal choices. Under efficient stock market hypothesis, all investors are able to obtain high profits more than others. However, investors might have the same invested capital fund---neoclassical theory of maximization. But in reality if investors have the same information and the same invested fund, then it is logical to argue that they should get equal returns. Therefore EMH is not valid if the trend above is not respected (Burton, 2003). What happens in most markets across the world is that every investor has an advantage over the other; different in returns from equity markets proves that there are several inefficiencies in market. Because of the differential returns among stock market players, it is true to conclude that there is no efficient equity market. Some antagonists of EMH such as Bodie et al (2008) present argument where they discredit the hypothesis based on the information processing. Other issues they raise are forecasting error, representativeness of information processing biasness and overconfidence conservatism that could actually lead to an irrational behavior and inefficiencies in the market. This biasness on the other hand, could be the reason for anomalies seen in the market. The biasness of the market efficiencies are as a result of mental accounting, prospect theory and regret avoidance. This biasness is also better placed to explain the market anomalies. The hypothesis of efficient stock market also states that there is no investor who is able to beat the market (Jeff et al., 2010). This means that the annual average return that all equity investors are able to achieve using their ability and efforts. The anomalies of beating the market in its actual sense does not apply because none had managed to do so rather, advantages over others are continuous hence there is no perfect market efficiency. Going by Grossman and Stiglitz (1980) as cited in Jeff et al (2010), informational perfect efficient market is a dream which shall not be easily realized. The point here is, if markets are ever efficient there would be no profit in information gathering hence no reason for trading in security market. This phenomenon eventually leads to market collapse. The degree of inefficiency in the market is determined by the efforts of individual investors who are willing to spend and gather information. The market equilibrium will only arise when there are adequate profit opportunities---recipe for inefficiencies to compensate investors for the costs of trading and information gathering. 4.0 Anomalies Anomalies are other major challenges to efficient market hypothesis. This is a regular pattern in the asset returns described as known, reliable and inexplicable. The idea that the asset returns patterns are regular and reliable means that there is a degree of predictability and it being known implies that many investors are able to take advantage over it (Andrew, 2007). Size effect is one of the anomalies where expected excess in returns accrue to stocks of small capitalization companies. Roll (1983) as cited by Jeff et al (2010) noted a related anomaly. They stated that small capital based stock outperform companies with large capital stocks by a wider margin over years. It has been difficult to reconcile this effect with the EMH though. Conclusion In conclusion, the empirical evidence which supports the market efficiency hypothesis is strong and dispersible. It is argued that there is no other hypothesis in social sciences that has been tested as the one for efficient market hypothesis. There is also much evidence which has strongly opposed the efficient market hypothesis in equal measure. The evidence of anomalies which are inconsistent with the efficient market hypothesis has been recorded in several literatures. To review some instances in the essay, equity with low price earnings is associated with high risk adjustment while one with high price earnings is associated with low price adjustment. Efficient market is normally associated with asymmetric information flow and efficient market hypothesis do undermine itself as it do allow random occurrence of eventualities of the environment. In short, whether equity market is efficient or not, what is important is that; Equity markets no to achieve perfect efficiency any time near and that there is need for universal advance price analysis to be met and lastly, the willingness of all the investors to accept their returns and losses more humbly. Therefore the current equity market is not efficient as there are disparities in the returns among the fund investors if it were efficient. The debate over EMH is still there to continue. However, despite the lack of consensus in academia and industry, the ongoing dialogue has brought new insights into the economic structure of financial markets. References Andrew W. Lo (2007) efficient markets hypothesis The New Palgrave: A Dictionary of Economics, Second Edition,. New York: Palgrave McMillan. Basu, S (1999). “The Relationship between Earnings’ Yield, Market Value and the Returns for NYSE Common Stocks: Further Evidence.” Journal of Financial Economics. June, 12:1, pp. 129–56. Bodie, Werner and Richard T. (2008). “Financial Decision-Making in Markets and Firms: A Behavioral Perspective,” in Handbook OR & MS, Volume 9. R. Jarrow et al., eds. New York: Elsevier Science, Chapter 13. Burton G. Malkiel (2003) Critics of EMH: Perspectives of Economic Journal—Volume 17, Number 1—Winter 2003—Pages 59 – 82 Jeff Castura, Robert Litzenberger, Richard Gorelick, Yogesh Dwivedi RGM Advisors, ( 2010) Market Effciency and Microstructure Evolution in U.S. Equity Markets: A High- Frequency Perspective Worthington K and Higgs J. (2004). The Incredible January Effect. Homewood: Dow Jones- Irwin. Read More