The Efficient Market Hypothesis (EMH) has been described as one of the cornerstones of modern financial economics. Fama first defined the term “efficient market” in financial literature in 1965 as one in which security prices fully reflect all available information. The market is efficient if the reaction of market prices to new information should be instant and impartial. Also, EMH is the idea that information is quickly and efficiently integrated into assets prices at any point in time, so that old information cannot be used to predict future price movements.

Consequently, three versions of EMH are being distinguished depending on the level of available information. The “Weak-form” (Predictability) asserts that all past market prices and data are fully reflected in securities prices, so technical analysis is of no use. The “Semi-strong” (Event studies) form asserts that all publicly available information is fully reflected in securities prices and fundamental analysis is of no use. The “Strong-form” (Private information) asserts that all information is fully reflected in securities prices.

In other words, even insider information is of no use. The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact “efficient” and if so to what degree. Investors have used price charts and price patterns as tools for predicting future price movements for as long as there have been financial markets. It is not surprising therefore, that the first studies of market efficiency focused on the relationship between price changes over time, to see if in fact such predictions were feasible.

As the studies of the time series properties of prices expanded, the evidence can be classified into two classes: studies that focus on short-term price behavior and research that examines long-term price movements. The greatest blend in academic circles has been created by the results of volatility tests. These tests are designed to test for rationality of market behavior by examining the volatility of share prices relative to the volatility of the fundamental variables that affect share prices.

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The empirical evidence provided by volatility tests suggest that movements in stock prices cannot be attributed only to the rational expectations of investors, but also involves an irrational component (The irrational behavior has been emphasized by Shleifer and Summers (1990) in their exposition of noise trading). Empirical tests to examine the “weak-form” efficiency of capital markets analyzed two kinds of problems. One group involved statistical tests, such as autocorrelation tests and runs tests.

The Random Walk Theory implies that consecutive price movements should be independent and that returns are identically distributed over time; so if the EMH was true, we would expect zero correlation. Consistent with this theory, Fama (1965) found that the serial correlation coefficients for a sample of 30 Dow Jones Industrial stocks were too small to cover transactions costs of trading1. Following studies have mostly found similar results, across other time periods and other countries.

The other group, tests the “weak-form” of market efficiency by examining the gains from technical analysis. While many early studies found technical analysis to be useless, recent evidence showed the opposite. They find that relatively simple technical trading rules would have been successful in predicting changes in the Dow Jones Industrial Average. However, subsequently research found that the gains from these strategies are inadequate to cover their transaction costs. Consequently, the findings are consistent with “weak-form” market efficiency.

The “semi-strong” form of the EMH is perhaps the most contentious, and thus, has attracted the most attention. Tests that analyze empirical data to prove or refute the “semi-strong” form EMH can be categorized as follows. One group of tests tries to predict future rates of return either in a time-series approach, or in a cross-sectional approach. The other group of tests examines how fast stock prices adjust to specific economic events. Time series studies have indicated that the long-term prediction of market returns, in contrast to short-term forecast, can be successful.

Studies have also shown that quarterly earning surprises and calendar patterns cause the market to be inefficient in the semi-strong sense. Cross-section studies have concluded that some variables, such as price-to-earnings ratios, size and book value-market ratios differentiated future return patterns. Share prices of neglected firms have also shown significant anomalies. The “semi-strong” form is wholly supported by event studies that examined the speed of price adjustment. The only mixed results can be found with stock exchange listing events.

A particularly significant study by Dann, Mayers and Raab (1977) concluded that at the New York Stock Exchange large block trades are reflected in the share price within 15 minutes. To test the “strong-form” EMH investors were categorized into four specific groups, which possibly had private information. Groups consisted of corporate insiders, stock exchange specialists, security analysts and professional money managers. Tests were also performed for pension plans and endowment funds. Each group was analyzed whether it consistently received above-average returns.


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