Forms of Market Efficiency - Essay Example

Introduction

The securities markets are known to adjust to new information and changes immediately the said information is readily available as the trading happens. Nevertheless, if we consider the explanation from the behavioral finance, the aspects of efficient markets do not have an answer when we find the anomalies. Market anomalies are the strange occurrence that changes the smooth pattern of the stock exchange (Varvouzou, 2013). Many researchers have been able to show the existence of the anomalies while considering different equity markets in the world. However, the evidence presented on anomalies is debatable. The anomalies take a unique form that can be observed in the capital market regularities where they cannot be explained primarily by considering institutional practice or the use of theories. With many investors constantly trying to get the best percentage out the extra performance that the market can offer, it should be known that there is no easy way of beating the market. However, tradable anomalies are in existence where they have shown a certain persistence which remains to be a point of reference to many investors and scholars.

Efficient Market Hypothesis

The efficient market hypothesis is among the most important subjects when considering the theories in finance. Efficient market are markets with a large number of people who are actively trying to rationalize the maximum profit by engaging in activities of predicting the future value of the market mostly when they consider the individual securities. In this situation, the information is readily available to every investor. In this case, if the market is efficient, it has been proven that the stock markets have the effect of displaying the result of the new event (Chuvkhin, 2009).

Forms of Market Efficiency

In market efficiency, it is evident that the relevant information includes the publicly available information, the private information, and the past information. Relying on the aspects of the pertinent information will mean that the efficient market can be divided into three stages. The stages include the strong form, the weak form, and the semi-strong form which lies between the strong and weak form. Considering the weak form of the efficient market, all the past information, which includes the returns and the past prices, are reflected the current price of all the stocks (Bodie et al. 2007).

The assumptions that are based on the weak form of the efficient market have a direct link with the random walk hypothesis. In this situation, the stock markets are moving randomly where the changes in prices are an independent form. If the weak form of the efficient market were held, no one would be able to predict the future by depending on the relevant past information. Due to this, no person would be able to beat the direction of the market by earning abnormal profits. Therefore, the technical analysis in which traders use the chats on the price movements of the past to act as a prediction tool for the future is not the best strategy. However,a trader can be able to beat the trend of the market by depending on the private information or insider trading and the idea of the fundamental analysis (Zacks, 2011).

The current prices of the stock act as the current reflection of the public information when looking at the semi-strong form of the efficient market. Here, no one can make extra profit by fundamental analysis. However, in a normal situation one can only beat the market here if they had insider information. All the information that includes the past, public and private information are all reflected in the current prices of the stock considering the strong form of the stock market efficiency. Here, if the strong form of the market is persistent, no one can be able to go against the market by earning an abnormal profit even if there is use of insider information (Shleifer & Andrei, 2000).

Financial Market Anomalies

The literal understanding of the word anomaly is used to describe an unusual or strange occurrence about technological and scientific matters. One researcher defined it as the deviation or irregularity when thinking about the natural or universal order in a given condition (George & Elton, 2001). This is an interesting observation when thinking about the hypothesis, model, or theory.

Anomalies can be good indicators for inefficient markets where some of the anomalies may happen only once or in other cases happen many times which has its definition from the markets and the prices. Regarding the financial theory, the financial anomaly can be used to mean a particular situation where the performance of the stocks moves away from the known assumption that involves the market hypothesis of efficient markets. Since this anomaly cannot be explained using the market hypothesis, they are referred to as the market anomalies (Silver, 2011). To effectively gain convenience, anomalies are a group as technical, either seasonal, or fundamental anomalies.

Seasonal Anomalies

The calendar anomalies are related to a period where it gives consideration of the movement of the prices of stock on a day, monthly, or yearly period (Karz, 2011). A good example is the weekend effect where the stock prices are expected by the traders to fall on a Monday. Here, it primarily means that the closing price of the previous Friday is projected to be more than the coming Monday. In addition, the turn of the month effect where the stock prices are most likely to experience increases primarily on the last day of trading of the month that is coming and the next three days of that coming month (Michaud & Institute of Chartered Financial Analysts, 1999).

Fundamental Anomalies

These anomalies include the small cap effect and the value anomalies, low price to book, low price to sales, low price of earnings, and high dividend yield. Looking into the value anomaly, this type of anomaly primarily happens when the investors make a wrong prediction on the price of the market. Here, the traders overestimate the returns of the growth companies while at the same time; the traders underestimate the returns of the value businesses in the stock market. The other anomaly is based on the high dividend yield. Here, all the stocks that are associated with high dividend outperform most of the market by generating more returns for the traders (Keim & Ziemba, 2000).

Technical Anomalies

This refers to the number of technical analysis techniques that are utilized for forecasting the future stock prices by depending on the past prices and any information that is regarded as relevant from the past. In most cases, technical analysis uses some techniques that include resistant support strategies and the strategy of using the moving average. Many of the researchers have been able to point out that when the market holds the efficiency form that is weak, then the technical analysis and the all the past information are regarded as irrelevant. Here, the traders do not have the ability to earn abnormal profits by depending on the previous information and the technical analysis. The moving average, for example, is one of the most important technical analyses where the aspect of buying and all the selling signals in the stock market are generated by the issue of short period average and long period average. By using this strategy, there is the buying of the stocks primarily when on the short period averages are expected to rise over the idea of the long period average. In addition, the stocks can be sold when the short average falls primarily below the long period average (Posadas, 2006).

Evidence Supporting Different Types of Anomalies

Calendar Anomalies

The time and calendar anomalies contradict the weak market efficiency. This is because the weak form postulates the idea that the market should be as efficient in the past prices of the stock. Moreover, this cannot function as the basis for the prediction of the future prices of the stock. However, the existence of monthly and seasonal effect acts as a contradiction to the efficiency of the market. Due of this fact, the investors have the ability to earn abnormal profits (Shleifer & Andrei).

Seasonal effect

This type of influence can be found at the international market. Some of these markets include the Tokyo, Italian, and the Australian stock exchange. A research states that there are ten Asian countries that have the seasonal effect primarily from the period of between the years 2000 to March of 2005 (Yakob et al. 2005).

This case was considered to the ideal case reviewing these markets were not influenced or affected by the financial crisis that rocked the late nineties. It is evident that the Chinese market primarily does well during the New Year season and not entirely in January (Zhang & Wei, 2010).

Monday Effect

Many researchers to show the effect of the weekend, particularly in the United States markets, have presented many studies. The average returns on Monday are usually small or negative (Zacks, 2011).

Day of the Weak Effect

Here, it entails the difference that is expected in the returns of a given day in that week. The findings have been able to point out that the returns are more on Friday where on Monday they are expected to be very low. However, there have been findings particularly in Canada and Hong Kong, which seems to suggest that the returns are lower at the beginning of the week, which does not mean that it has to be a Monday. In addition, consideration should be given to other countries where the returns on Tuesday are lowered that the returns on Monday. A good example is in India where the returns on Tuesday are negative while the returns expected on Monday are higher than the other days of the week. This is based on the settlement period in India. Most of the studies have been able to show that the weekend effect shows the elements of negative returns primarily on Monday due to the idea of the non-trading period that cuts across Friday to Monday and that the returns of Monday are positive in the real sense (Keloharju, Linnainmaa, Nyberg, & National Bureau of Economic Research, 2014).

Evidence of Technical Anomalies

Momentum Effect

The momentum effect trading strategies were studied primarily in the stock market of the U.S, and it was discovered that the momentum strategies were present primarily between the year 1977 to 1996 (Hons & Tonks, 2003). According to this study, traders can be able to gain a considerable advantage if there is use of the momentum strategy. Nevertheless, all the stocks that have been rated top will be labeled as losers’ portfolio while the stocks that are ranked low will be labeled as winners’ portfolio. However, the strategy is a profit generator when the prices of the assets show the elements of over-reaction. The studies show that the benefits of the winners’ portfolio are greater than when comparing it to the losers’ portfolio since the winners’ portfolio carries more risk when compared to the losers’ portfolio (Subramaniam, 2014).

How the Issues on Anomalies should be viewed

The anomalies that are considered to be large should be resolved since they have the effect of causing hindrance, however if they are deemed to be small, they should be left alone. In a situation where we are dealing with science, one has to have a paradigm to replace primarily the one that is in existence (List & National Bureau of Economic Research, 2011).

Behavioral Explanation of Existence of Anomalies

Failure of Different Forms of Models

Various models are being invented particularly in different times, but they all fail to give a statement on some of the causes of the anomalies being witnessed primarily on the asset behavior. The three-factor models do not conclusively give a clear answer when it comes to the long-term effect and the some of the momentum returns for all the assets. The non-linear model fails when it comes to the reproduction of momentum and the contrarian effect (Wouters, 2006). Other models have failed to give a clear explanation of the anomalies.

Over-reaction and Under Reaction of the Financial Market

Based on Wouters (2006), he views that the overreaction and under-reaction of the market can only be linked to the psychological reasoning of the traders. Other scholars have been able to argue that the aspect of under reaction is due to conservatism primarily from the traders, as they tend to react to the information that they get but fails to do so. This can be based on the slow reaction of the traders which causing this aspect of under reaction.

Behavioral Cause of Contrarian and Momentum Effect

Some researchers were able to divide based on their investment styles, and they argued the fact that all the traders and the investors have exhibited the art of investing based on their different styles. Their basis of style depends on the momentum effect cause, end of the price bubble, herd behavior, and the past performance. Researchers have been able to explain the presence of the autocorrelation. Here, the price will be at the equilibrium primarily when in the end but it is anticipated that the price will cause an autocorrelation, especially in the short term (Shi & Chaoqiong, 2011).

Critics of Efficient Market Hypothesis

Many critics have come to present different arguments that are against it. One view is that the assumption that holds the investors and traders to be rational and therefore is expected to be rational regarding their value of investment. This is based on the idea of calculating the future cash flows net present values, which are discounted for all the risk in an appropriate manner. According to the critics has no supporting evidence where it shows that the investors are all affected by the idea either on the herd instincts, their behavior to over-react or in other times under react to the release of the particular news, and judge according to the causes of loss or profit from previous events (Piard, 2013).

Conclusion

Many types of research have been done to cover the aspect of abnormalities in the market primarily covering the returns of the stocks. It is evident that for the efficient market hypothesis, the investors do not have the ability to make huge or abnormal profits based on the facts or information that is stale. It is not a difficult task when it comes to the definition of the obsolete information. Here, they are considered excess primarily depending on an assessment that is accurate especially on matters that touch on the risk that is associated with the idea of holding a particular share of the stock. Despite all the researches done since the early 1960s up to now, no measure has been accepted as objective and verifiable when it comes to the measurement of the risks.