The notion of efficient market can be traced back to Bachelier(1900) in his dissertation. According to his research, the expected return for each investor can be seen as an independent event, and the samples are close to normal distribution. That means, therefore, the expected return for the security is zero and the stock prices are unpredictable. As he stated, "past, present and even discounted future events are reflected in market price, but often show no apparent relation to price changes" The newly rising concept challenged the former economic theory which focus on estimating the future security prices, but unfortunately, his contribution was not valued until the later scholars had came up empirical evidence and developed to "random walk theory", which is seen as the origin of market efficiency.
With further understanding of random walk model, in which assuming the stock price is not predictable, Samuelson(1965) then carried out resembling researches in stock markets. He found that if there was a technical indicator implying that the stock price would rise, it would have already been raised by the coming investors. (cited in )Thus, the increased price led the indicator disappear and the stock price reset to the random position. "Arguments like this are used to deduce that competitive prices must display price changesâ€¦that perform a random walk with no predictable bias. "
Basing on previous approaches, Fama(1969) concluded those literatures reviews and produced market efficiency hypothesis with relevant evidence. In his paper, he defined market efficiency hypothesis, in the meaning that the stock prices have fully reflected the related information in capital market. Therefore, it is unreasonable to earn abnormal profits by using the public news. In other words, those excess returns gained by speculators are merely occasional chances and may disappear through frequent operation.(Fama 1991)
2.2 The Problem of Hypothesis Assumptions
Although it is important to establish a theory upon controlled assumptions, the background of those has also to be suspected if it is alive in reality. As Fama(1969) stated, the market hypothesis have to build up on four assumptions, which will be described as below. Nevertheless, a volume of researchers have proposed opposition to challenge the theory. The major criticism will then be presented.
To begin with the first assumption, the hypothesis assumes there is no transaction cost, taxation, and other expense in capital market. Ruling out the cost, the stock prices are close to random walk theory and there are no opportunities to make profits because of the unpredictability. However, it is impossible to exist such pure economic surroundings as Fama(1969) state. Thus, The hypothesis have face the challenges of whether it is applicable in financial markets.
The continuous point of control variable has been stated that the relevant information is spread to every investor at the same time for free, so all of them have the same expectations for the security return. Those are other challenges in which not only how can the information be delivered to everyone simultaneously, but the different levels of risk taking for various revenue expectations. Although the development of technology has help reduced asymmetric information, there are difficulties to say the resource is fully shared and even without considering the delivery cost. Besides, the limitation of investors' rationalities has to be discussed. Criticisms argue that the evidence here to support the points is too powerless.
Moreover, the method supposes that people are all rational to share the same thoughts and regard the maximum return as major aims. Through analyzing, evaluating, and operating the assets, they participate on the market frequently and actively. However, in the hypothesis, the various considerations of investors are ignored. As the financial market is tend to be more complex recently, it is impossible to say profit is the major factor to affect decision makers. For instance, financial managers may use stocks to hedge risk and does not pursue the profitable return. Consequently, oppositions propose it is seem to be sustainable in favor of the hypothesis under this position.
Last but not least, as Fama(1969) presumed, individual transactions would not affect the security prices and participators are price takers. That means investors are independent enough not to be influenced by others. However, Criticisms may say the supply of security quantities is limited, and if the stock exchanges have no impact on the prices, how can stock market be adjusted. This point is considered as a contrary side of the principle of stock exchange operation.
Types of Market efficiency
In section 2, the stock prices are defined to react to all relevant information. Actually, different information may influence the share prices at different speeds. The common categories are sorted information into historical price information, publicly available information, and all information which includes public and private resources. ( Hillier et al,2010) The three types of efficiency will be described and discussed in the next sections.
In Engle and Morris(1991) studies, the price reaction is believed to be an indicator of future dividend market value , which comes from the profitability of companies. Thus, it can be said that the price changes reflect the company performance. For example, if there is a new technology patent received, investors may suppose the possibility of profitable income in the future and then buy in the securities. That implies the increasing strike amounts grow the stock price up.
2.3.1 Weak Form Market Efficiency
In the weak form of market efficiency, the current security prices are asserted to fully contain the historical price changes. That means, therefore, that investors cannot get any help from past stock trend when choosing securities. Under the weak market efficiency, technical analysis cannot assist investors to find those stocks which are underestimated or overestimated in order to earn excess returns. Several research have conclude that most economic environment in the world belong to this type.
2.3.2 Semi-Strong Form Market Efficiency
A market is defined as semi-strong form efficiency if current security prices have incorporated all publicly available information. In the semi- strong market efficiency, fundamental analysis cannot suggest investors any advance decisions. That is, investors are unable to gain excess returns even analyzing the published accounting statements and historical price information thoroughly, since the stock prices adjust to new information immediately.
2.3.3 Strong Form Market Efficiency
A market is defined as strong form efficiency if current security price have reflected all kinds of information, including public and private. Once, new information appears the stock prices will modify to appropriate level rapidly. Thus, any investors, even insiders, cannot predict market performance.
Empirical Test for Various Types of Efficiency
To support the hypothesis, the evidence for Market efficiency hypothesis is also brought up. Because of the comprehensive ways of examining the method, just the major tests are explained below. With various intensities of efficiency, there are the empirical measurements here:
Test for Weak Form Efficiency
The weak form efficiency contains the notion that investors cannot earn any abnormal return from past price information, which have highly relationship with random walk theory. Fama(1965) suggested further evidence that security prices follow the random walk model. The test for weak efficiency has been developed extensively; however, two common methods are discussed.
Since the weak efficiency is close to random walk theory, it is measured whether the stock prices are random. Serial correlation has been widely used to test for it. This method inspects the correlation between the past and the present return on one security. While Calculating the series of this period, if the coefficients are low and the expected return is close to zero, this market can be seen as Weak form efficiency. ( Hillier et al,2010)
There is, in addition, filter rules is an alternative tool to examine weak form efficiency. As Fama and Blume(1966) defined, the principle states that setting a standard of buying and selling points and operating the stocks once the prices reach the level, if the sum of the security returns is higher than the long-term strategy, we can say that price changes are related, and analysis can help investors to earn abnormal returns. That means, the market is not in weak efficiency form. For instance, Investigating 30 securities in U.S. stock market, Fama and Blume(1966) explored the effect of technical analysis and efficient market by using different levels of filter rules. As a result, although 15 of them achieved higher return on performance, the abnormal profits still vanished after considering transaction cost. Namely, technical analysis cannot be in favor of earning excess return in weak market efficiency.
3.2 Test for Semi-Strong Form Efficiency
The major test for semi-strong efficiency is to measure the speed of adjusting security prices to new public information. The frequent used principle here is event study. Measuring the stock price changes over news announced period, the performance is used to judge whether the market is semi-strong efficient.
According to Fama, Fisher, Jensen and Roll(1969) paper, they observed the security price adjustment for stock splits and earnings announcements. As a result, stock prices were surprisingly found that most reaction have completed before the news were released to market. Once the information announced, the changes continued rapidly.
Actual events, which can be seen as applications of empirical evidence, are such announcements of dividends, earnings, mergers, initial public offerings, stock splits, or block trading. In these examples, security prices would carter to the appearance of new information. Thus, speculators cannot gain any abnormal profits even from fundamental analysis.
3.3 Test for Strong Form Efficiency
The method of strong form efficiency is based on the position that security prices have already reflected all public and private information. Namely, no one can earn extra return in this market. Therefore, to test the market efficiency, many studies have been developed to investigate whether insiders can gain profit in long term. If they do, it can be seen as a symbol of inefficient strong market. For instance, mutual fund which managed by financial experts is an alternative examination for strong form efficiency, because those experts are seen to have close relationship with insiders and able to use private to control the fund in order to reap profits. According to the analysis of mutual fund performance published by Jensen (1968), the return of portfolio might have been offset by fees and expense. In other words, "on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses."
Furthermore, some studies also point out that the sustainable evidence are not strong enough to hold the hypothesis. In fact, as general identification, traders who have private information are easily to earn excess returns.
There are, of course, critical studies with applied evidence showing the unusual phenomenon in reality. The next section will provide discussion of market anomalies.
4.1 Stock Return Anomalies
Arguments about the predictability of stock return are still continued discussed. It is important to note that challengers controvert to market efficiency hypothesis by presenting exceptional appearance in real world. The first suspicions are drawn in return anomalies which violate the semi-strong hypothesis. Based on Fama(1969) in his paper, fundamental analysis do not provide stock prediction for investors, therefore, the seasonal anomalies such as January effect, weekend effect, and monthly effect are an indicator which debate the hypothesis and provide the opportunities to obtain the excess return.
January effect is defined as a position that there is unusual price decreasing in every December, but the capital would have flowed back in January. That leads the stock returns in the first month of every year are normally greater than other months.
Examining seasonal phenomenon between seventeen nations from 1959 to 1979, Mustafa and Gultekin(1983) discovered that most of them consist with the January effect.
The notion of weekend effect illustrates that the stock prices are frequently lower on Mondays. The reason for the anomalies is believed that most companies and government usually announce unfavorable news on Fridays and the stock prices all react to the information on Mondays. As the similar idea of weekend effect, monthly effect illustrates the higher return before every 15th than the following days.
4.1 Overreaction and Underreaction
Famous literature published by De Bondt and Thaler(1985) brought up the notion of "overreaction phenomenon". They looked at a long-term stock price changes and discovered those which had overreacted in the past would have rebounded back to former levels, and vice versa. De Bondt and Thaler explained this price reversal can be seen as strong evidence to prove the usefulness of fundamental analysis in predicting returns and suggested investors to use the constrain strategy of price overreaction to gain extra return.
However, sharing a consensus with Fama and French(1988), Poterba and Summers(1988) stated "Noise trading, trading by investors whose demand for shares is determined by factors other than their expected return, provides a plausible explanation for the transitory components in stock prices. "
Samuelson, Paul (1965). "Proof That Properly Anticipated Prices Fluctuate Randomly",Industrial Management Review, 6, pp. 41-49.
Fama, Eugene (1965). "The Behavior of Stock Market Prices", Journal of Business, 38, pp. 34-105.
Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work", Journal of Finance, 25, pp. 383-417.
Fama, Eugene (1991). "Efficient Capital Markets II", Journal of Finance, 46, pp. 1575-617.
Engel, C., & Morris, C. S. (1991). Challenges to Stock Market efficiency:
Evidence from Mean Reversion Studies. Economic Review, Federal Reserve
Bank of Kansas City , pp.21-35.
( Hillier et al,2010)
De Bondt and Thaler(1985)
Fama and Blume(1966)
Fama, Fisher, Jensen and Roll(1969)
Mustafa and Gultekin(1983)
Fama and French(1988)