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The development of efficient market hypothesis essay

Warren Buffett Introduction The movement of prices in the stock market are among a few phenomena that have cut across the boundaries of academic disciplines and have a cumulative research evidence spanning almost a century. Today the field of financial market research seems to be at the exciting stage of "crisis" to use Kuhn's analogy - past the development of efficient market hypothesis essay are being questioned, and new solutions are being proposed. There seems to be growing dissatisfaction among academic researchers with the body of literature developed on the assumption of market efficiency.

Keynesian ideologies on speculative market phenomena hitherto ignored are being resurrected to explain the volatile nature of the stock market. While only time will tell whether or not the present crisis will lead to a revolution in thought and development of a coherent theory of stock market behavior, it seems appropriate at this point to take stock of the current literature in the area of market efficiency and to identify the emerging lines of thought.

This essay is organized as follows: The first section provides a brief historical perspective on EMH. In this section it is observed that the initial euphoria about the EMH has waned and that conflicting opinions on market behavior have provided the impetus for the current debate.

The next section identifies some market anomalies and the resultant alternate theories for explaining market behavior. The third section provides Keynes' perspective on stock market behavior. A short summary followed by some directions for future research concludes the paper.

Efficient Market Hypothesis la. The simplest explanation would be that securities prices reflect information. Fama 1970 made a distinction between three forms of EMH: However, it is the semi-strong form of EMH that has formed the basis for most empirical research.

Critical Analysis of Efficiency Market Hypothesis Essay Paper

The strong form suggests that securities prices reflect all available information, even private information. Seyhun 1986, 1998 provides sufficient evidence that insiders profit from trading on information not already incorporated into prices.

Hence the strong form does not hold in a world with an uneven playing field. The semi-strong form of EMH asserts that security prices reflect all publicly available information. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. The availability of intraday data enabled tests which offer evidence of public information impacting stock prices within minutes Patell and Wolfson, 1984, Gosnell, Keown and Pinkerton, 1996.

The weak form of the hypothesis suggests that past prices or returns reflect future prices or returns.

  1. Interestingly, they find that snow and rain have no predictive power!
  2. While one cannot conclude that the market consists merely of speculators, it is plausible that they may form a substantial group, even with the enormous growth of institutional investors. Versions of the Efficiency Market Hypothesis and trials Following the construct of information.
  3. Shiller 1984 proposes an alternate model of stock prices that recognizes the influence of social psychology.
  4. If the time series of returns contains linear dependencies, the autocorrelation would yield approximately one. Fama used this model to describe the price development with.

The inconsistent performance of technical analysts suggests this form holds. However, Fama 1991 expanded the concept of the weak form to include predicting future returns with the use of accounting or macroeconomic variables. As discussed below, the evidence of predictability of returns provides an argument against the weak form. While the semi-strong form of EMH has formed the basis for most empirical research, recent research has expanded the tests of market efficiency to include the weak form of EMH.

There continues to be disagreement on the degree of market efficiency. This is exacerbated by the joint hypothesis problem. Tests of market efficiency must be based on an asset-pricing model. If the evidence is against market efficiency, it may be because the market is inefficient, or it may be that the model is incorrect. The literature documented below presents evidence of inefficiencies based on existing models and more recent research findings that cast doubt on these models.

The Initial Euphoria and Subsequent Discontentment The EMH has provided the theoretical basis for much of the financial market research during the seventies and the eighties. In the past, most of the evidence seems to have been consistent with the EMH.

While most of the studies in the seventies focused on predicting prices from past prices, studies in the eighties also looked at the possibility of forecasting based on variables such as dividend yield e.

Campbell and Shiller [1988]and term structure variables e. Studies in the nineties looked at inadequacies of current asset pricing models.

The maintained hypothesis of EMH also stimulated a plethora of studies that looked, among other things, at the reaction of the stock market to the announcement of various events such as earnings e. Fama, Fisher, Jensen and Roll [1969]capital expenditure e. McConnell and Muscarella, [1985]divestitures e. Klein [1986]and takeovers e. Jensen and Ruback [1983]. The usefulness or relevance of the information was judged based on the market activity associated with a particular event.

The development of efficient market hypothesis essay general, the typical results from event studies showed that security prices seemed to adjust to new information within a day of the event announcement, an inference that is consistent with the EMH. To this list of caveats, one could add the limitations of econometric procedures on which the empirical tests are based. The early euphoric research of the seventies was followed by a more cautioned and critical approach to the EMH in the eighties and nineties.

Researchers repeatedly challenged the studies based on EMH by raising critical questions such as: Can the movement in prices be fully attributed to the announcement of events?

  • Shares in open-end funds mutual funds can be bought at the prevaililng NAV plus any load charge and redeemed at the NAV minus any redemption fee;
  • Over a five year period starting from 1965, returns to investors correspond to the rankings given to firms;
  • This overpricing of OTM puts could only imply an expectation of a market crash or increased market volatility if the market fell;
  • Ratner [1992] "Turn-of-month and pre-holiday effects on stock returns:

Do public announcements affect prices at all? For example, Roll 1988 argues that most price movements for individual stocks cannot be traced to public announcements.

In their analysis of the aggregate stock market, Cutler, Poterba and Summers 1989 reach similar conclusions. They report that there is little, if any, correlation between the greatest aggregate market movement and public release of important information.

More recently, Haugen and Baker 1996 in their analysis of determinants of returns in five countries conclude that "none of the factors related to sensitivities to macroeconomic variables seem to be important determinants of expected stock returns". The Current Debate The accumulating evidence suggests that stock prices can be predicted with a fair degree of reliability. Two competing explanations have been offered for such behavior.

Proponents of EMH e. Fama and French [1995] maintain that such predictability results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken. Critics of EMH e. La Porta, Lakonishok, Shliefer, and Vishny [1997] argue that the predictability of stock returns reflects the psychological factors, social movements, noise trading, and fashions or "fads" of irrational investors in a speculative market.

The question about whether predictability of returns represents rational variations in expected returns or arises due to irrational speculative the development of efficient market hypothesis essay from theoretical values has provided the impetus for fervent intellectual inquiries in the recent years. The remainder of this paper is motivated largely by this issue, and places greater emphasis on the speculative aspect.

Market Anomalies The EMH became controversial especially after the detection of certain anomalies in the capital markets. Some of the main anomalies that have been identified are as follows: Rozeff and Kinney 1976 were the first to document evidence of higher mean returns in January as compared to other months. Using NYSE stocks for the period 1904-1974, they find that the average return for the month of January was 3.

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Later studies document the effect persists in more recent years: Bhardwaj and Brooks 1992 for 1977-1986 and Eleswarapu and Reinganum 1993 for 1961-1990. The effect has been found to be present in other countries as well Gultekin and Gultekin, 1983.

The January effect has also been documented for bonds by Chang and Pinegar 1986. Maxwell 1998 shows that the bond market effect is strong for non-investment grade bonds, but not for investment grade bonds. They also find that the January effect is stronger since 1986.

Taken together, their results support a tax-loss selling explanation of the effect. The Weekend Effect or Monday Effect: French 1980 analyzes daily returns of stocks for the period 1953-1977 and finds that there is a tendency for returns to be negative on Mondays whereas they are positive on the other days of the week.

He notes that these negative returns are "caused only by the weekend effect and not by a general closed-market effect". A trading strategy, which would be profitable in this case, would be to buy stocks on Monday and sell them on Friday. Internationally, Agrawal and Tandon 1994 find significantly negative returns on Monday in nine countries and on Tuesday in eight countries, yet large and positive returns on Friday in 17 of the 18 countries studied.

However their data do not extend beyond 1987. Steeley 2001 finds that the weekend effect in the UK has disappeared in the 1990s. Holiday and turn of the month effects have been well documented over time and across countries. Lakonishok and Smidt 1988 show that US stock returns are significantly higher at the turn of the month, defined as the last and first three trading days of the month.

  1. Abnormal returns can be assumed, if the variance from the return time series shows unsteady movements.
  2. Directions for Future Research It is likely that the quest for a coherent theory of the stock market will continue to stimulate the intellect of academic researchers.
  3. The maintained hypothesis of EMH also stimulated a plethora of studies that looked, among other things, at the reaction of the stock market to the announcement of various events such as earnings e.

Ariel 1987 shows that returns tend to be higher on the last day of the month. Cadsby and Ratner 1992 find similar turn of month effects in some countries and not in others. Ziemba 1991 finds evidence of a turn of month effect for Japan when turn of month is defined as the last five and first two trading days of the month. Hensel and Ziemba 1996 and Kunkel and Compton 1998 show how abnormal returns can be earned by exploiting this anomaly.

Lakonishok and Smidt 1988Ariel 1990and Cadsby and Ratner 1992 all provide evidence to show that returns are, on average, higher the day before a holiday, than on other trading days. The latter paper shows this for countries other than the U.

The Uses And Concept Of Efficient Market Hypothesis Finance Essay

Brockman and Michayluk 1998 describe the pre-holiday effect as one of the oldest and most consistent of all seasonal regularities. Banz 1981 published one of the earliest articles on the 'small-firm effect' which is also known as the 'size-effect'. His analysis of the 1936-1975 period reveals that excess returns would have been earned by holding stocks of low capitalization companies. Supporting evidence is provided by Reinganum 1981 who reports that the risk adjusted annual return of small firms was greater than 20 percent.

If the market were efficient, one would expect the prices of stocks of these companies to go up to a level where the risk adjusted returns to future investors would be normal.

But this did not happen.

Critical Analysis of Efficiency Market Hypothesis Essay

These results also contradict the EMH. Fama and French 1995 find that market and size factors in earnings help explain market and size factors in returns. Dechow, Hutton, Meulbroek and Sloan 2001 document that short-sellers position themselves in stocks of firms with low earnings to price ratios since they are known to have lower future returns. The Value-Line organization divides the firm into five groups and ranks them according to their estimated performance based on publicly available information.

Over a five year period starting from 1965, returns to investors correspond to the rankings given to firms. That is, higher ranking firms earned higher returns.