Why Is Market Efficiency Interesting? - Essay Example

The Efficient Market Hypothesis (EMH) states that stock markets are efficient enough to incorporate and reflect all relevant information within the pricing of its securities, making it impossible to ‘beat the market’. The fundamental theory of EMH is that securities always trade at their fair value on the stock market, making it impossible for an investor to find and purchase a bargain. EMH states that it is practically impossible for an investor to outperform the overall market through publically available information, expert stock selection or market timing.

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The only way an investor can possibly obtain higher returns is by exposing their capital to a greater amount of risk. Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed topic. Supporters such as Fama (1970) claim that undervalued stocks cannot exist in an efficient market and that trends cannot be predicted ether by fundamental or technical analysis such as market movements and charting.

Although the Efficient Market Hypothesis is a widely supported theory among academics it has also attracted an equal amount altercation, some of the main critiques include Pasour (1989), Shoustak (1997), Howden (2008) and O’Neil (2000). O’Neil for example suggests several theories on predicting the movement of ‘undervalued’ shares based on charting. Some of the techniques demonstrated by O’Neil are ‘cup with handle’ and ‘double bottom’ chart patterns.

It could also be said that EMH does not consider market anomalies such as speculative bubbles; calendar effects, Brusa et al (2005); company size, Dimson & Marsh (1986); and events outside a company’s control such as ‘Black Monday’ which occurred on 19th October 1987. On this day global stock markets crashed causing the values of company securities to severely diminish over a short space of time. By the end of October 1987 the UK’s FTSE 100 index had fallen by 26. 45%. Showing evidence that stock prices can seriously deviate from their fair values.

Recent Relevant Studies Fama’s (1970) theory on Efficient Market Hypothesis states that for a market to be truly efficient a security price must fully reflect all available information at any point in time. Although Fama points out that this type of ideal is an extremity and cannot be ‘literally true’. Within his paper ‘Efficient Capital Markets: a Review of Theory and Empirical Work’ Fama identifies and tests three feasible market models: strong form efficiency; semi-strong form efficiency; and weak form efficiency.

A study conducted by Kahnerman & Tversky (1973) on the physiology of prediction gave the opinion that individuals in revising there beliefs, tend to over-weigh recent information and under-weigh past data. This research set the way for studies on behavioral finance, in particular investor over-and under-reactions within the stock market. A seminal study of long-term stock market over and under reaction was conducted by DeBont & Thaler (1985), they found that individual investors do have the tendency to over-react to unexpected news and events whilst studying stocks listed on the Centre for Research Security Prices.

They also concluded that based on market over-reactions there were elements of weak form efficiency within the tested stock market. In the context of short term stock market over-reactions, two similar studies were conducted by Brown & Harlow (1988) and Howe (1986) both found strong evidence that an over-reaction hypothesis can occur over short periods of time. A more recent study undertaken by Schnusenberge (2006) argues that there is more to market efficiency than the long accepted weak form and semi-strong form market models.

Schnusenberge tested short term stock market over-and under-reactions in relation to DJIA and S&P indexes in an attempt to understand the psychology of investors and their effect on financial markets. The published article focuses on the stock market’s reaction to events before and after stock market highs. The research suggests that investors are cautious prior to stock market highs, but are overly optimistic following a stock market high.

Schnusenberge also points out that once investors discover an overreaction their previous assessment is revised leading to a ‘stock price reversal’. Schnusenberge suggests that investors over-and under-reactions render stock markets inefficient. Similarly a study on behavioral finance conducted by Basu et al (2008) presents compelling evidence supporting the idea that irrational investment behavior is a wide spread phenomenon and has serious implications on the global financial markets.

Testing Market Efficiency This section will test three fundamental theories in relation to market efficiency in the case of the share price movement of GKP. The Author acknowledges that external events outside the control of GKP have had a dramatic effect on the company’s share price, such as civil and political unrest in the Middle East and Africa and the fluctuating price of oil. These events will not be considered within testing as it would be infeasible to consider all variables.

Theory 1, Investors Are Overly Optimistic Upon The Prospect Of Good News. This section of theory will be tested in conjunction with Schnusenberge’s (2006) paper The Stock Market Behavior Prior and Subsequent to New Highs. Schnusenberge describes an overreaction as ‘a reaction than one that is considered normal in light of a simultaneous release. ‘ For the purposes of testing both RNS statements released by GKP are considered ‘new highs’. It can be seen that the results from diagram 1 are similar to Schnusenberge’s findings.

In which he states ‘it is reasonable to believe that stock market precipitants are cautious prior to new stock market highs but are overly optimistic following such a new high’. It can be seen from diagrams 1 and 2 that on the 17th of March trading activity was minimal, suggesting that investors and potential investors were ‘cautious’. After the release of the initial RNS statement on the 18th the close price increased from the previous day by 28%, this was followed by a second consecutive increase in the close price of 10% on the 21st, suggesting investors were ‘overly optimistic’.

After the successive RNS was released on the 22nd a ‘stock price reversal’ occurred, Schnusenberge states that this occurs when an investor upon discovering their overreaction, reconsiders their initial assessment. This caused the share price to eventually decrease settling at 158p on the 24th March. Hart, D (2011) speaking on behalf of Thompson Reuters also pointed out that the GKP’s oil find ‘is very much a qualitative thing at this point where people are probably leaning towards the higher estimates more so than the lower estimates’.