Efficient Markets Hypothesis - Term Paper Example

Running head: Efficient Capital Markets Hypothesis: an explanation and Efficient Capital Markets Hypothesis: an explanation and critical assessment as applied to stock markets Name University Abstract A market is efficient if security prices fully reflect all relevant and available information about the fundamental value of the securities, and because a security is a claim on future cash flows, this fundamental value is the present value of the future cash flows that the owner of the security expects to receive. The efficient capital market hypothesis as applied to stock markets has affected the thinking of investment managers, corporate finance officers, and investors in the last three decades. This paper explains what the hypothesis is about based on a chapter in the textbook written by Elton, Gruber, Brown, and Goetzmann, and provides a critical assessment of its implications for the investor. . Efficient Capital Markets Hypothesis: an explanation and critical assessment as applied to stock markets Hypothesis being the Greek word for "assumption", the Efficient Markets Hypothesis therefore assumes that capital markets, of which the stock or equity market is one, is efficient. And what we mean when we say that a market is efficient is that buyers and sellers of stocks have all the relevant information they need to make an intelligent decision to either buy or sell stocks in companies at a certain price that reflects all available information. The first to propose the hypothesis is Eugene Fama of the University of Chicago in a paper (1970) where he presented a method of testing the efficiency of the New York Stock Exchange. Since then, hundreds of studies have been conducted to either prove or disprove the hypothesis. Since we know that in science, a scientific hypothesis that survives experimental testing becomes a scientific theory, the fact that the efficiency of markets remains a hypothesis begs the question: why Do test results thus far show that capital markets are inefficient because scientific investigation has not proven otherwise Or, if capital markets are efficient, and stock prices reflect all available information, then why is the trade on mere pieces of paper (called stocks) growing Is it a case of altruistic holders of stocks, seeing the potential for future earnings, selling these stocks to others in order to share the wealth Or are all sellers of stocks just looking for another fool to unload a worthless piece of paper And why do people still make (and lose) money in the stock market And if capital markets are efficient, are all investing decisions intelligent and based on complete information As we will show, capital market efficiency does not necessarily mean an increase in the intelligence quotient of all investors. Power of Information in Capital Markets Today Capital markets have the advantage of getting buyers and sellers to agree on a deal without the use of financial intermediaries like banks and insurance companies who direct the flow of resources from savers to borrowers. Capital market transactions are therefore deemed more efficient in the absence of intermediaries except for brokers who put buyers and sellers together and get a small commission for the effort, making the deal almost frictionless. This is one factor that leads to our hypothesis: the low transaction costs of capital markets enhance its efficiency. With transaction costs negligible, the only real factor that determines the current price of a stock should be the net present value of its future cash flows in the form of dividends and, assuming the company lasts long enough, capital gains when the stock is sold at a future date. After all, a stock is nothing else but a claim to a company's future cash flows. A company's cash flow is affected by several factors, among which are its business prospects, management quality and strategic plans, the economy's over-all performance, and the company's standing within the economy. If all these pieces of information are known, making a study of free cash flow looks relatively straightforward, and using a discount rate, the stock's present value can be easily calculated. If the market price is lower than the present value, the stock is bought. Otherwise, if one holds the stock, it is sold. Did the seller have a different set of information used in the calculation of net present value If he sold his stocks, this means that he calculated the current stock price to be higher than the net present value of cash flows. The decision to sell was in anticipation of a lower stock price in the future. If markets are efficient, why do buyer and seller have two sets of information Why does one decide to sell and the other decide to buy The answer is that both, deciding to go for future profits or cut losses, may have received different sets of information and acted on them accordingly. As we shall see, information comes in three distinct packages, each one resulting in a different definition of market efficiency. Sets of Available Information Makiel (1992) observed that: Formally, the market is said to be efficient with respect to some information setif security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set.implies that it is impossible to make economic profits by trading on the basis of [that information set]. Academics study market efficiency according to the extent, speed, and accuracy that the price of a stock is affected by available information. They identified three sets of available information that help in the valuation of a stock: the stock's price or return history, public information made available through disclosures, and private information not available to everyone. Three forms of market efficiency proceed from these three sets of information: weak (historical data), semi-strong (past data and public information), and strong (past data, public information, and private information), respectively. From Makiel's definition, if prices incorporate the stock's price or return history, investors cannot earn excess profits from trading based on any of the three sets of information. Those who move in first may earn windfall profits after a financial analyst recommends a stock based on a discovery in some just released public information. Having discovered a discrepancy that signifies an undervaluation or overvaluation of the stock, he can recommend clients to either buy (if undervalued) or sell (if overvalued) the stock, but as soon as this recommendation is made public, the market reacts quickly that soon, no profitable trading opportunities will exist. The third set is the availability of insider information not known to the public, which makes a buyer or seller privy to a piece of news that, once made public, will affect the stock price. Having inside information is not illegal, but using it to buy or sell stocks for a quick profit is illegal, a crime for which Martha Stewart was punished in the U.S. and for which she was imprisoned for some months in 2004. These three sets of information are what affect the stock price and contribute to market efficiency. Bits and pieces of these information flow from insiders to analysts who interpret them, before passing them on to buyers and sellers of stocks, adjusting the price of the stock upward or downward reflecting all available information until, with time, it settles at a price close to its fundamental value. Thousands of individual decisions and perceptions meet in the marketplace resulting in buy and sell decisions. That stock prices react quickly to the flow of information has been proven empirically by tests of the efficient market hypothesis (Elton, Gruber, Brown & Goetzmann, 2003, pp. 402-443). What it all means to investors If capital markets are efficient and stock prices reflect all available information, then the only way for people and investment portfolios to make money in the stock market is to move fast enough before the information flow is completed. Otherwise, getting in at the peak will penalize the latecomers, resulting in lower profits or, if the market crashes, ending up with overvalued stocks. Is this efficiency Yes. This is how an efficient and free market is supposed to behave. The first one to reach the market gets the choicest cuts of beef, the largest fishes, and the freshest vegetables. The same holds true for capital markets, which reward the first to act on available information and dives in with funds to invest. Those late in the game will have to be satisfied with smaller profits but are more certain to buy the stock at a price closer to its true value. So does this mean that the stock market is just a timing game As the well-known American investor Warren Buffett has often shown, one need not be the first in line to make profits. Often, it pays to wait until investor euphoria dies down before sinking one's teeth. During the dot.com boom of the late 1990s, Buffett did not bite and was castigated for it, but he ended having the last laugh. By deciding not to rush in early, he was able to get in after the price has settled down in order to reap the reward from the stock's upward price potential. Does the experience of booms and busts in the stock market prove that capital markets are not efficient On the contrary. The hypothesis says that market prices reflect all available information, which does not necessarily mean that the information need be true. An astute investor armed with inside information about a company's profits can artificially depress the price of a stock by circulating false information, knowing that the market will react by bringing down the stock price, allowing him to buy when the stock hits the bottom and wait until the company announces the good news. Aside from proving that markets are efficient, this also proves that foolish investors rush in where wise ones fear to tread. The efficient market hypothesis merely shows how all the available information is reflected in a stock price. If not all the information is true it is equally possible that the stock price does not reflect its true value, the amount that best approximates the net present value of all future cash flows. A wrong interpretation of the hypothesis is to think that market efficiency means one has to believe that the stock price is always the same as the stock's underlying value. Market anomalies persist to this day like the calendar, weather, and small firm effects that create abnormally high returns caused by information based on unfounded expectations, tempting inexperienced investors into thinking they know something many others don't. Many investors who saw their stock portfolios wiped out everytime the market crashed were guilty of committing these mistakes. Remember, one still needs to discern prudently whether the available information is true. This is the work of thousands of analysts who help push down or pull up the stock price. Seeing the price of a stock going sky-high, analysts pore through reams of news and reports to discover if the rise is supported by so-called fundamentals: cash flow, future plans, and so on. Depending on what the analyst discovers as a basis for the stock's valuation, s/he recommends a buy, sell, or hold on the stock. This is their job, but the final decision falls on the investor. Lessons We can learn some basic lessons from the studies surrounding the efficient capital markets hypothesis. First, trust your instincts. Stock prices reflect all the available information, but investors should never think that all the information is true. Just because an analyst recommended a buy on Reuters, Bloomberg, or the BBC Business News does not mean investors should jump right in. Investors should trust their instincts: if someone says something that seems too good to be true, then most probably it is. Second, trust the market. The competition in capital markets taking place daily among millions of greedy investors looking for the best returns for the risks they are taking is what makes the market efficient. It is possible that half of them (buyers) think the stock is undervalued, while the other half (sellers) think the stock is overvalued. Unfortunately, only one half will be correct all the time, but the ongoing interactions between these two groups allow a stock's market price to reach, with time, a level that is close to its true value. Third, do the homework. The efficient capital markets hypothesis is just a tool for analysing the behavior of stock market prices. Studies show the market is efficient, but in the end, every investor should always remember what any buyer in any market, free or not, efficient or not, must keep in mind: caveat emptor. Fourth, timing is important. In this age of fast communications, equally fast information exchange takes place and stock price adjustments are almost as quick. Investors should not be misled by fast rising stock prices and market anomalies. Getting into the market early is not necessarily a profitable proposition. Sometimes, it pays to be late. Fifth, anyone who makes a bundle in the stock market usually did so either because that person possessed information not available publicly or he moved faster than everyone else: the first is illegal, the second is luck, timing, and certainly, not wisdom. References Elton, E.J., Gruber, M.J., Brown, S. J. and Goetzmann, W. N. (2003). Modern Portfolio Theory and Investment Analysis (6th ed.). New York: Wiley and Sons, pp. 402-443. Fama, E. (1970). Efficient Capital Markets: A review of theory and empirical work. Journal of Finance, 25, 383-417. Makiel, B. (1992). Efficient Market Hypothesis. In P. Newman, M. Milgate, and J. Eatwell (Eds.). The New Palgrave Dictionary of Money and Finance. (Vol. 1, pp. 739-744; Vol. 3, pp. 787- 789). London: Macmillan. Read More