Strong-form market efficiency
Strong-form market efficiency- The strong form of the EMH (Efficient Market Hypothesis) states that prices fully reflect all information from both private as well as public sources. The strong form pf EHM includes all sorts of information: public, market information, past security and insider (private) information. This translates into the fact that no group of investors is entitled monopolistic access to information that is relevant to the formation of prices, and none should be able to achieve positive abnormal returns consistently.
Given the restriction on insider trading in most markets, it would be unreliable to expect markets to reflect all the private information. The evidence supports the fact that markets are not strong-form efficient. In strong form market efficiency, the profit exceeding normal returns cannot be made regardless of the number of information investors have access to.
As the strong-form market efficiency reflects all information, both public and private, the tests for the strong-form revolves around groups of investors with excess information. These investors are as follows:
- Insiders – These are people, such as senior managers who have access to unpublished price sensitive information about the Company.
- Exchange Specialists – An exchange specialist can attain above-average returns with this specific order information.
- Analysts – The equity analyst analyzes and forms the opinion that can help an investor achieve above-average returns.
- Institutional money managers – Institutional money managers, working for mutual funds, pensions funds, etc. have been found to have typically not performed above the overall market benchmark consistently.
Factors that affect a market’s efficiency.
Markets are commonly neither completely inefficient nor perfectly efficient. The degree of informational efficiency differs across time, countries, and market types. The following factors affect the degree of market efficiency in general.
- The number of market participants – There is a direct relationship between the number of market participants and the market price. The larger the number of analysts, investors, and traders who follow the market, the more efficient is the market. For example, many countries do not allow foreigners to trade in their markets, to reduce market efficiency.
- Availability of information- The more information is available to investors; the more efficient is the market. In developed markets, markets are quite efficient, and information is plentiful. In emerging markets, however, the availability of information is much less, and consequently, market prices are relatively less efficient.
- Access to available public information- Everyone in the market should have access to publicly available information, and there should not be any biases about sharing of information. Traders with the material inside information about a firm are prohibited from trading on that information.
- Impediments to trading- Arbitrage refers to buying a security in one market and simultaneously selling it at a higher price in a separate market to make a riskless profit. This buying and selling of assets would continue until the prices in the two markets are equal. The barrier to arbitrage, such as high transactions costs or lack of information, will limit arbitrage activity, and the market will not be efficient.
- Short selling improves market efficiency- The sales pressure from short selling prevents assets from becoming overvalued. Restrictions on short selling, like a restriction to borrow stock at alower price, can reduce market efficiency.
- Transaction and information costs- It is generally accepted that markets are efficient if, after decreasing costs, there are no risk-adjusted returns which have to be made from trading based on publicly available information.
Semi-strong form market efficiency
The semi-strong form of the market efficiency holds that security prices adjust rapidly without bias to the arrival of all new public information. This means the current security prices fully showcase all publicly available information. The semi-strong form of the EMH says security prices include all non-market information and past security market information available to the public. This means that an investor cannot achieve positive returns on average by using fundamental analysis. Semi-strong-form efficiency implies that neither technical analysis nor fundamental analysis techniques will be able to reliably achieve excess risk-adjusted returns. To check for semi-strong-form efficiency, the adjustments to previously unknown news must be instantaneous and of a reasonable size. To test for this, constantly downward or upward adjustments after the initial change must be checked for. If there are any such adjustments are found, it would mean that investors had interpreted the information in a biased manner and hence in an inefficient manner.
As a semi-strong form of EVH indicates that the market is reflective of all publicly available information, the tests of the same are as follows:
- Event Tests – One of the main events in the corporate world is the announcement of earnings. The concept behind the event test is that an investor will not be able to generate a good return by trading on an event.
- . Regression/Time Series Tests – Time series forecasts return that is based on historical data. The investor should not achieve an above average return using this method.
Weak-form market efficiency in efficient markets hypothesis
The weak form of the EMH efficient markets hypothesis states that current security prices fully reflect all currently available security market data. All past price and volume (market) information will have no predictive power about the future trend of security prices because the price changes will be independent of one period to another period. In a weak-form efficient market, the investor cannot achieve positive returns on average by using technical analysis. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements. All the technical analysis techniques will not be able to time after time produce excess returns. Although some forms of fundamental analysis may still offer some excess returns. Share prices reflect no serial dependencies, meaning that there are no “patterns” to asset prices. This means that all the future price movements are determined by information not contained in the price series.