Efficiency Market Crash
Discuss Efficiency Market Hypothesis in the context of the “crash of 1987” and the “Internet bubble”
The theory of efficient market hypothesis (EMH) has been of great debate among investors about its existence. The EMH is an economic concept which describes how an efficient market will impound new information into prices quickly without bias, meaning the price of a stock will fully reflect the information available. In the past the notion of the EMH was very strong and was widely accepted as the underlying force behind the movement of market prices (Fama 1965), neither fundamental or technical analysis enabled greater returns for a portfolio over a randomly selected portfolio of shares. However, if we fast forward to the present day many investors will dismiss any relevance of the EMH and its power in effectively and efficiently reflecting new information into prices. So, why has there been a change of perception amongst investors about the efficient market hypothesis? Because there are reasons to expect that the general investors will always underestimate the level of efficiency in the market and some may say that the point where the perception may have changed is during the crash of 1987 which resulted in a 22% drop in stock prices in a single day without any real economic factors changing and further the internet bubble burst of the late 1990s. We will further explore this point on whether the EMH does exist, and if it does how can it explain these crashes?
Efficient market hypothesis assumes that all financial markets are efficiently priced, therefore the price of a stock includes all the public knowledge and is reflecting the collective opinion of all investors about future prospects. The hypothesis goes on to say that it is not possible to outperform the market on a consistent basis by using any information that the market is already aware of. Any information that may affect the stock that is presently unknown will be represented in the price of the stock in the future, this results in tomorrow's price being determined by today's price plus a random shock.
Efficient market hypothesis applies the theory of rational expectations to pricing of securities. The EMH comes in three versions; the weak form, the semi strong form and the strong form. The three versions of EMH have been distinguished depending on the level of available information.
The weak-form efficiency of the EMH asserts that prices fully reflect the information contained in the historical sequence of prices. Thus, investors cannot devise an investment strategy to yield additional profits on the basis of analysing past price patterns. But, fundamental analysis (the study of financial statements) might be able to earn excess returns.
Semi-strong efficiency states that current stock prices reflect not only historical price information but also all publicly available information relevant to a company's securities. There are no undervalued or overvalued stocks and thus, investors trading will be unable to generate excessive returns. When new information available, it is fully incorporated into the stock price rather speedily. This form of the EMH has formed the basis for most empirical research.
Strong-form efficiency asserts that all information that is known to any market participant about a company is fully reflected in market prices. Hence, not even insider information is of any real use.
The theory of the EMH under the semi-strong form of efficiency states that bubbles are impossible because markets are efficient that is prices reflect all available information about a stock. Followers of the EMH tend to deny a connection between excessive speculation and following economic crises. However, the necessary assumptions underlying the EMH must be jointly held. Thus it is necessary to examine the extent to which they do hold.
The crash of 1987 should make one question the validity of an efficient market hypothesis and rational expectations. EMH critics do not believe that rational market place could have produced such a massive decline in share prices. So, if we reflect on the implications of the EMH what can be said about the crash of 1987 can this situation be described by the EMH or does it go against the theory? We will briefly explain the crash of 1987 and then further its validation with the EMH.
On Monday 19th October 1987 a day which became ‘black Monday' most international stock markets crashed, there was a sudden dramatic fall in share prices which was triggered off worldwide, for no apparent economic reason. The shockwave started in Tokyo, followed by Hong Kong and then not to further London. However, in America the Dow Jones industrial average dropped by 508 points which accounted for billions of dollars and a third of its original value. At the time no new information was able to explain what had occurred. This lead to the question how if markets are efficient, could an event such as this occur, where shares in even the leading stock market companies can plummet for no apparent reason? The leading answer came from behaviourists who dictated that such a dramatic fall in stock prices cannot have been decided by rational investors but were caused by psychological issues since the main economic foundations were unchanged. The values of the EMH seemed unsustainable after the crash and the EMH must therefore be invalid, or so the arguments ran at the time.
However, the months leading up to the crash of 1987 for the US economy may give us a different approach to the situation. Firstly, yields on long-term treasury bonds increased from about 9% to 10.5% this would have implied that markets are becoming bearish two months prior to the crash. In early October the US congress wanted to impose a ‘merger tax' which would have made mergers very expensive this could have threatened to end the merger boom. The risk that merger activity might be curtailed increased risks throughout the stock market by weakening the control over corporate management that potential takeovers provide. During this time the secretary of the treasury decided to further reduce the exchange value of the dollar. This had increased the risk of foreign investors and may have even halted home investors. These series of events small in effect, but together could have explained the investors view about the underlying value of the stock market in mid October 1987.
As these factors are logical paths leading to the dramatic occurrence can we now state that the EMH is in a fact a true theory of market on goings, but before we go any further we must recall our EMH definition which states that markets react quickly and efficiently to any new change in information, but clearly the factors leading up to the crash occurred weeks before and were not effectively implemented as price changes in the market. This may give suggest that the EMH is incorrect. However, when we consider a market which is said to be efficient what we mean to say it has a great degree of efficiency about it and for the most part no markets are said to be purely efficient. There is a paradox surrounding the efficient markets hypothesis that is if every investor believed the stock market was efficient, then the market would not be efficient because no one would analyse securities. In other words, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market.
Whilst the efficient market hypothesis dictates that bubbles or crashes are unable to occur in the market and that the 1987 crash may be treated as a one off occurrence or an anomaly to the hypothesis. How may this statement apply during the occurrence of another crash the internet bubble of the late 1990s. This bubble was caused by the internet, this was viewed as a new frontier with this new technology the capabilities of it were endless, the market overreacted to this and phenomenally high valuations of these companies were being reported and tremendous amount of pressure was being put on companies to become dot com. This enthusiasm was being advocated not just by investors but major players in the market including Alan Greenspan claiming the dawn of a new economy, this would have altered the view of even the most sceptical of investors in becoming caught up in the hype.
As was expected this euphoria burst and the stock market crashed this further dampened the views of behaviourists whom believed the market was irrational and that dot.com companies valuations were a bit too farfetched for a rational investor. This gave doubt towards the existence of EMH in time were a crashed occurred.
Although there were errors made, there were certainly no arbitrage opportunities available to rational investors before the bubble burst. Stock valuations depend on future cash flows. If all market participants rationally valued their stock using the future cash flow, still some excess may develop. In perspective the claims that were being made about the growth of the internet and the companies involved were unsupportable. But remember it was the praise of the analysts that backed these views and were recommending the dot com stocks to potential investors, in view of all that has taken place the justification for these analysts claims were not based on previous models because of the doubling of growth every several months this combined with the short-run gains that were available, thus making stock valuations impossible.
We have stated that the internet bubble did not bring in any opportunity for an arbitrage possibility. When the stock prices finally adjusted towards a more plausible value which meant that stock values were being priced at a level which corresponded with the a better future cash flow, thus resulting in a better growth prediction. However, all this occurred after the bubble burst which gives reservations about the market may have been inefficient in allocating the stock and violating the EMH.
The two periods that we considered have given different views about whether the EMH has been dismissed or acted as the underlying market force. We firstly examined the EMH in the context of the stock market crash of 1987 from this we concluded that EMH may have been in effect because the weeks leading up to the crash were able to explain the change in the investors view about the true value of the market. However, the market did not appreciate the information as quick as the EMH states this may have damaged the EMH but not dismissed it. On the other hand the late 1990s saw the burst of the internet bubble which to our knowledge failed to adhere to the EMH, there was a lot of irrational exuberance from investors which bought about inefficiency in the market. The EMH is a theory which has had a lot evidence to suggest it exists however, the theory is not able to explain the entire on goings in the market and sometimes it may not hold at all.
Bibliography
Fama, Eugene. "Random Walks in Stock Market Prices," Financial Analysts Journal (1965).
Malkiel, Burton. "The Efficient Market Hypothesis and Its Critics." CEPS Working Paper No. 91 (2003). 12 Nov. 2007 <http://www.princeton.edu/~ceps/workingpapers/91malkiel.pdf>.
"Efficient Market Hypothesis on Trial." Westga. 12 Nov. 2007 <http://www.westga.edu/~bquest/2002/market.htm>.
Bowman, Robert, and John Buchanan. "The Efficient Market Hypothesis: a Discussion of Institutional, Agency and Behavioural Issues." Australian Journal of Management (1995).
Toporowski, Jan. The Economics of Financial Markets and the 1987 Crash. Aldershot, 1993
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