Evaluating of The Strong Form of The Efficient Market Hypothesis

In this essay I am going to be critically analyzing the validity of the strong form of the efficient market hypothesis whilst evaluating the Efficient Market Hypothesis, to determine the credibility of it today.

To be able to critically analyze the Strong Form of the Efficient Market Hypothesis, I will first define the hypothesis, its different forms and evaluate its credibility. A key supporter of EMH and one of the main economists who helped publicize it was Eugene Fama. Fama (1970) states that in an efficient market prices fully reflect all available information. The Efficient Market Hypothesis proposes that when new information arises, its spreads quickly and is then factored into the prices of investment securities with no delay. Investment securities are securities that are purchased to be held for investment. As all investors now have access to the same information, the changes in stock prices are no longer predictable and now respond immediately to new information. This implies that there is no amount of analysis that could give an investor an advantage over other investors, as all known information is already factored into the prices. Therefore, technical analysis, which is the idea that history repeats itself and therefore past stock prices can be used to predict future stock prices, cannot be used to aid investors in selecting undervalued stock.

The EMH is linked with the idea of a “random walk”. A random walk is a financial theory which claims that stock prices move in completely random ways (a random walk down wall street), and hence are unpredictable. The logic behind the theory is that if the flow of information is unrestricted and stock prices reflect all information with no delay, then tomorrow's stock prices will be based solely on tomorrow's information regardless of today’s price changes (a random walk down Wall Street). The news itself is unpredictable and therefore leads to random price changes. As a consequence, because investors now all have access to the same information, they will receive the same return on their individual investments.

There are three main forms of EMH, each one consecutively stronger in implication, these include weak form EMH, semi-strong form EMH and strong form EMH. The weak form is the least rigorous form, and proposes that all historical data is already factored into the prices of investment securities (the balance). Thus, implying that technical analysis does not work. Semi strong form EMH is a more rigorous form which suggests that new information is immediately factored into the prices of securities (the balance).

Strong form EMH is the most rigorous form of EMH. As mentioned earlier, in this essay I'm going to be going into depth on the strong form EMH and arguing the validity of it. Strong form efficiency is where stock prices are fully reflected by all available information, public, private and confidential (Nasdaq). What this means is that no group of investors should be able to consistently beat the market, so investors are unable to obtain a competitive advantage over one another. When analyzing strong form efficiency there are three different investor classes that are of significance: Corporate Insiders, Security Analysts and Professional Portfolio Managers.

Corporate insiders are either directors, an above 10% equity owner or a senior officer. It is mandatory that once someone is classed a corporate insider, they adhere to various strict rules and regulations set by the Securities and Exchange Commission (SEC) (TIP Ranks). Insider trading is the buying or selling of an investment security by an individual who has access to nonpublic information about said security (Investopedia). The legality of the trade depends on when the trade takes place, if the information is still nonpublic at the time of the trade, then it’s deemed as illegal insider trading. To help prevent this, the SEC have put some rules into place that all corporate insiders must follow. One of which being section 16a of the Securities and Exchange ACT 1934 that states that whenever an insider trades in shares of their own company, they must file a Section 16(a) report with the SEC detailing the acquisition of the stock. These reports can then be used by other investors to evaluate the profitability of the trade. This demonstrates exactly why corporate insiders are unable to make a profit because the more people that have access to insider information on a trade, the more it depreciates in value and seeing as all information is reflected in stock prices, the price of the stock would have already decreased before the investor gets the opportunity to make the trade.

After Corporate insiders, Security analysts have the next most amount of information when trading. Although they don't have access to insider information, brokerage firms spend vast amounts of time and money analyzing stocks for security analysts to give reliable and trustworthy investment advice to their clients Womack (1996). Their advice on which stock would be most profitable to buy and sell have a large impact on stock prices, showing that there are, indeed, returns on information search costs. This is proven by Womack (1996) who found, through testing, that the buy and sell recommendations provided by security analysts had a significant effect on stock prices immediately and over a short period of time. He also found that larger brokerage firms are more likely to give more credible recommendations and in turn, will charge more. Well-reputed security analysts have the highest influence on prices, as their advice is deemed more trustworthy.

A professional portfolio manager is a person or a group of people who are responsible for investing a mutual, close end or exchange traded funds assets, implementing its investment strategy and overseeing day to day portfolio trading (Investopedia). They are usually experienced traders, brokers or investors and generally have direct impact on the overall returns of the fund. However according to Elton, Gruber, Das and Hlavka (1993), test results found that a funds expenses were proven to be negatively related to the funds’ performance. Fund expenses include investment advisory fees, so if it’s been determined through testing that the funds expenses are adversely related to the returns on the fund, its showing that the investment advice isn’t particularly necessary. Therefore, showing that apparently, professional portfolio managers don’t have much influence over stock price after all.

According to the strong form EMH, it should be impossible for an investor to profit from investor trading. However, in an article published by Nejat Seyhun (2000) there is information on all reported insider trading in all publicly held US companies over duration of 21 years, this produced over one million transactions in total. Adding to the fact that recommendations made by security analysts have a large impact on stock prices, showing that there are returns to information search costs, this contradicts the main idea behind the strong form efficiency. It is claimed that stock prices are fully reflected by all available information, and therefore no group of investors should be able to make a profit, however evidence found by Seyhun and Womack refute that claim. This is further disproven by Stickel (1995) whose findings are similar to that of Womack whereby the abnormal returns following the security analysts’ buy and sell recommendations were in the direction predicted. It also found that, as mentioned earlier, recommendations of more reputable security analysts have the biggest influence on prices. These findings could lead to higher acquisitions of profitable stocks, which in turn produces higher returns for the investor. As a result, seeing as these findings go against the main concept of strong form EMH it can be refuted.

The efficient market hypothesis is one of the most controversial theories in social science and many people continuously dispute its legitimacy. It can be argued that investors referred to in the previous paragraph, who “beat the market” don’t disprove strong form efficiency as they are unable to do so over a long period. This is the case for many EMH supporters. One of the key advocates of EMH, Burton G. Malkiel, argued in his book “a random walk down Walls Street” that there is no one who can reliably beat the market over time (macat analysis). Stating that even if individuals do manage to beat the market once or twice, it’s only sustainable to a certain extent and even if they can consistently beat the market it’s only by chance. For that reason the success of long term investors such as Warren Buffet or George Soros () can be explained away as anomalies, supporting the validity of EMH.

However there are still some arguments that can be used to discredit the EMH. One of which relating to the fact an obvious condition of EMH is that all new information, public or private, must be disclosed to all investors with no delay. Insider information is usually difficult to come across and, due to the rules put in place by the SEC, can easily become accessible to all investors in a short amount of time, quickly decreasing the value of the stock. This, as mentioned earlier, can leave investors frustrated and hence generates an understandable distaste to the sharing of insider information as they are unable to make profit. There is evidence that shows that valuable information is likely to be kept hidden by investors to get the maximum return on their investment. EMH states that as new information arises, its spread quickly and is immediately factored into stock prices, so it can be argued that how can the market be able to quickly and efficiently alter its prices when there is so much hostility when it comes to sharing insider information. Although there are rules put in place by the SEC to try to ensure that all trading is legal and fair for all investors, and there are regulations that require investors to report all new stock acquisition, there is still some uncertainty on whether the speed in which this information is factored into prices is as quick or efficient as its claimed to be.

There are various issues related to the testing of EMH, the main one being the Joint Hypothesis Problem. This states that market efficiency isn’t truly testable, but must be accompanied by some form of pricing model in to give an accurate result. Fama (1970) states that in order to accurately test whether information is properly factored into prices it must be within the context of a pricing model. The problem with this is that if its used and the outcome is false, it’s impossible to find out what exactly is the cause of the problem.

In this essay I have analyzed the Efficient Market Hypothesis and gone into detail on the strong form efficiency. I have argued the legitimacy of both with arguments both supporting and refuting the hypothesis. I have come to the conclusion that there is not much substantial evidence supporting the strong form efficiency mainly due to the fact that there are several examples of strong form EMH being disproven. For example corporate insiders consistently profiting from insider trading. As a result it is tough to argue that the strong form EMH is valid. However seeing as it’s also the least tested form out of the three it’s difficult to fully oppose it until further research emerges either supporting or refuting it.