STOCK MARKET

4 EFFICIENCY

LESSON 7
Stock Market Efficiency

Stock’s price is affectedby its intrinsic value, which is determined by the true level and riskiness

of the cash flows it is likely to provide, and investors’ perceptions about the stock’s intrinsic
value. In a well-functioning market, investors’ perceptions should be closely related to the

stock’s intrinsic value, in which case the stock price would be a reasonably accurate reflection
of its true value.

A body of theory called the efficient markets hypothesis (EMH) holds (1) that stocks are
always in equilibrium and (2) that it is impossible for an investor to consistently “beat the
market.” Essentially, those who believe in the EMH note that there are 100,000 or so full-time,
highly trained, professional analysts and traders operating in the market, while there are fewer

than 3,000 major stocks. Therefore, if each analyst followed 30 stocks (which is about right, as
analysts tend to specialize in the stocks in a specific industry), there would on average be 1,000
analysts following each stock. Further, these analysts work for organizations such as Goldman
Sachs, Merrill Lynch, Citigroup, Prudential, and the like, which have billions of dollars that can
be used to take advantage of bargains. In addition, as a result of SEC disclosure requirements
and electronic information networks, as new information about a stock becomes available,
these 1,000 analysts generally receive and evaluate it at about the same time. Therefore, the
price of a stock will adjust almost immediately to any new development. That makes it very
difficult for anyone to consistently pick stocks that will beat the market
Levels of Market Efficiency

If markets are truly efficient, then stock prices will rapidly adjust to all relevant information as it
becomes available. This raises an important question: What types of information are available
to investors and, therefore, incorporated into stock prices? Financial theorists have discussed
three forms, or levels, of market efficiency.

Weak-Form Efficiency

The weak form of the EMH states that all information contained in past stock price movements
is fully reflected in current market prices. If this were true, then information about recent trends
in stock prices would be of no use in selecting stocks—the fact that a stock has risen for the
past three days, for example, would give us no useful clues as to what it will do today or
tomorrow. People who believe that weak-form efficiency exists also believe that “tape watchers”
and “chartists” are wasting their time.13 For example, after studying the past history of the
stock market, a chartist might “discover” the following pattern: If a stock falls three consecutive
days, its price typically rises 10 percent the following day. The technician would then conclude
that investors could make money by purchasing a stock whose price has fallen for three
consecutive days. But if this pattern truly existed, wouldn’t other investors also discover it, and
then why would anyone be willing to sell a stock after it had fallen three consecutive days if he
or she knows the stock’s price would likely increase by 10 percent the next day? In other words,
if a stock were selling at $40 per share after falling three consecutive days, why would investors
sell the stock at $40 if they expect it to rise to $44 per share the next day? Those who believe
in weakform efficiency argue that if the stock were really likely to rise to $44 per share
tomorrow, its price would actually rise to somewhere near $44 per share immediately, thereby
eliminating the trading opportunity. Consequently, weak-form efficiency implies that any
information that comes from an examination of past stock prices cannot be used to make
money by predicting future stock prices.

Semistrong-Form Efficiency
The semistrong form of the EMH states that current market prices reflect all publicly available
information. Therefore, if semistrong-form efficiency exists, it would do no good to pore over
annual reports or yesterday’s Wall Street Journal looking at sales and earnings trends and
various types of ratios based on historical data because market prices would have adjusted to
any good or bad news contained in such reports back when the news first came out over the
Internet. With semistrongform efficiency, investors should not expect to earn above-average
returns except with good luck or information that is not publicly available.14 However, insiders
(for example, CEOs and CFOs) who have information that is not publicly available are able to
earn above-average returns even under semistrong-form efficiency. Another implication of
semistrong-form efficiency is that whenever information is released to the public, stock prices
will respond only if the information is different from what had been expected. If, for example, a
company announces a 30 percent increase in earnings, and if that increase is about what
analysts had been expecting, the announcement should have little or no effect on the
company’s stock price. On the other hand, the stock price would probably fall if analysts had
expected earnings to increase by 50 percent, but it probably would rise if they had expected a
10 percent increase.

Strong-Form Efficiency
The strong form of the EMH states that current market prices reflect all pertinent
information, whether publicly available or privately held. If this form holds, even insiders would
find it impossible to earn abnormally high returns in the stock market. Many empirical studies
have been conducted to test for the three forms of market efficiency. Most of these studies
suggest that the stock market is indeed highly efficient in the weak form, reasonably efficient in
the semistrong form (at least for the larger and more widely followed stocks), but not true for
the strong form because abnormally large profits are often earned by those with inside
information.

Implications of Market Efficiency

If the EMH were correct, it would be a waste of time for most of us to seek bargains by
analyzing stocks. That follows because, if stock prices already reflect all publicly available
information and hence are fairly priced, we can “beat the market” only by luck or with inside
information, making it difficult, if not impossible, for most investors to consistently outperform
the market averages. To support this viewpoint, efficient market proponents often point out
that even the professionals who manage mutual fund portfolios do not, on average, outperform
the overall stock market as measured by an index like the S&P 500.16 Indeed, the relatively
poor performance of actively managed mutual funds helps explain the growing popularity of
indexed funds, where administrative costs are relatively low. Rather than spending time and
money trying to find undervalued stocks, index funds try instead to match overall market
returns by buying the basket of stocks that makes up a particular index, such as the S&P 500. It
is important to understand that market efficiency does not imply that all stocks are always
priced correctly. With hindsight, it is apparent that at any point in time the situation shown in
Figure 1-1 back in Chapter 1 tends to hold true, with some stocks overvalued and others
undervalued. However, as the efficient markets hypothesis implies, it is hard to identify ahead
of time the stocks in each category. To beat the market, you must have above-average
information, above-average analytical skills, or above-average luck. Finally, it is important to
understand that even if markets are efficient and all stocks are fairly priced, an investor should
still be careful when selecting stocks for his or her portfolio. To earn the greatest expected
return with the least amount of risk, the portfolio should be diversified, with a mix of stocks
from various industries.

Is the Stock Market Efficient?

During the past 25 years, many empirical studies have been conducted to test the validity of
the three forms of market efficiency. Until 10 years ago, most of these studies suggested that
the stock market was highly efficient in the weak form and reasonably efficient in the
semistrong form, at least for the larger and more widely followed stocks. However, the
evidence also suggested that the strong form EMH did not hold, because those who possessed
inside information could and did (illegally) make abnormal profits. More recently, the empirical
support for the EMH has been somewhat diminished. As we indicate in the behavioral finance
box, skeptics point to the recent stock market bubble and suggest that at the height of the
boom the prices of the stocks of many companies, particularly in the technology sector, vastly
exceeded their intrinsic values. These skeptics suggest that investors are not simply machines
that rationally process all available information—rather, a variety of psychological and perhaps
irrational factors also come into play. Indeed, researchers have begun to incorporate elements
of cognitive psychology in an effort to better understand how individuals and entire markets
respond to different circumstances. Keep in mind that the EMH does not assume that all
investors are rational. Rather, it assumes that whenever stock prices deviate from their intrinsic
values due to the availability of new information, investors will quickly take advantage of these
mispricings by buying undervalued stocks and selling overvalued stocks. Thus, investors’ actions
work to drive prices to their equilibrium level. Critics of the EMH stress, however, that the stock
market is inherently risky and that rational investors trading in an irrational market can lose a
lot of money even if they are ultimately proven to be correct. For example, a “rational” investor
in mid-1999 might have concluded that the Nasdaq was overvalued when it was trading at
3,000. If that investor had acted on that assumption, he or she would have lost a lot of money
the following year when the Nasdaq soared to over 5,000 as “irrational exuberance” pushed the
prices of already overvalued stocks to even higher levels. Ultimately, if our “rational investor”
had the courage and patience to hold on, he or she would have been vindicated, because the
Nasdaq subsequently fell to about 1,300. The events of recent years, and the new ideas
developed by researchers in behavioral finance, suggest that the stock market is not always
efficient. Still, the logic behind the EMH is compelling, and most researchers believe that
markets are generally efficient in the long run.