Is The Efficient Market Hypothesis Still Valid?

The Efficient Market Hypothesis (or EMH, as it's known) suggests that investors cannot make returns above the average of the market on a consistent basis. This is because under normal circumstances all available information about asset values and prices is rapidly disseminated throughout the market, bringing prices quickly to an equilibrium value.

The hypothesis was developed in the 1960s by University of Chicago economics professors Harry Roberts and Eugene Fama. The latter then formalised the hypothesis in his 1970 paper, "Efficient Capital Markets: A Review of Theory and Empirical Work."^[1]

"A market in which prices always fully reflect available information is called efficient, Fama wrote. "For the purposes of most investors, the efficient markets model seems a good first (and second) approximation to reality. In short, the evidence in support of the efficient markets model is extensive and contradictory evidence is sparse."^[2]

Fair Game, Random Walk

The hypothesis is rooted in earlier ideas such as the Fair Game Model and the Random Walk Theory, and it was first elaborated with a focus on equities markets. Over the years, however, it has been applied to other areas of investment.

The EMH has traditionally been examined in three forms:

• The "Weak Form" stipulates that no investor can earn excess returns using historical prices.
• The "Semi-Strong Form" stipulates no investor can earn excess returns using historical prices and all publicly available information.
• The "Strong Form" stipulates no investor can earn excess returns using any information, including historical prices, publicly available information, and private or insider information.^[3]

Investor Speculation And Doubt

Since the EMH came into prominence in the 1970s, it has come under question from several researchers and market participants who point to situations where market pricing does not appear to be "efficient."

Famed investor Warren Buffett, for example, has questioned not just whether the EMH is still valid, but whether it ever was in the first place. He is a proponent of the Value Investing approach outlined by Columbia Business School professors Benjamin Graham and David Dodd in their 1934 book Security Analysis. And in a 1984 talk on their method, Buffett said he was "convinced that there is much inefficiency in the market."^[4]

"When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally," Buffett continued. "In fact, market prices are frequently nonsensical."^[4]

Technical Analysis: Spotting Exceptions To The Efficiency Rule?

Technical analysis techniques are the examination of past price trends for their predictive capacity.

The use of technical analysis dates at least to the 1700s in Japanese commodities markets and was first methodically applied to U.S. equities markets by investor and publisher Charles Dow in the late 1800s. The technique has enjoyed a strong surge of popularity among traders since the 1980s, and its successful employment to spot profitable price movements has caused some to suggest that it can be used to defy the EMH, particularly in its "weak form."^[5]

Some theorists have suggested this could be because of market inefficiencies that can lead to abnormal profits, which are enhanced during "swing" period transitions of prices to differing ranges that can be detected in technical analysis.^[5]

Researchers have also suggested that the successful use of technical analysis to consistently take profits will depend on keeping transaction costs at low levels, of 0.5% or less of overall transaction values.^[6]

A Market Evolution: Distortions Caused By High-Frequency Trading

Among other recent developments that have brought the EMH into question is the emergence of high-frequency trading, which is the execution of automated high-speed trades with computers using pre-established algorithms.

Some researchers argue that as high-frequency trading has progressed it has brought technology-led inefficiency into the market. This is because not all traders have equally fast access to news, prices and trade execution, and those with better technology will be able to better exploit pricing discrepancies.^[7]

In this scenario, some in the market are left playing a perennial game of catch-up to those with the most advanced techniques and technologies. Those who are not involved with high-frequency trading would appear to be at the greatest disadvantage. The flip side of this argument, however, is that as more traders acquire new technologies, the average "abnormal" profit for market participants over the long-term should move back toward the mean predicted by the hypothesis: zero.^[7]

If high-frequency traders become the majority of market participants, then the EMH will once again hold. Some other studies have further suggested that at times when high frequency trading enhances market pricing inefficiencies, it can lead to price discrepancies that can produce opportunities for all in the market, even those who are not involved in high-frequency trading.^[7]

More Participants, Greater Efficiency

The fast-paced, unpredictable nature of price movements in today's highly automated market environment has further had repercussions for government policy making and its impact on market opportunities. There are moments, particularly in the forex market, when conditions for optimum efficiency can be challenged.

Researchers have found that during moments of global financial crises, the increased intervention of central banks in currency markets has prompted many speculative traders to drop out of the market, thus reducing the efficiency of price discovery. Likewise, under static market conditions where there is low volume and liquidity, price equilibrium may not be achieved as quickly whereby momentary opportunities for large gains may arise. However, it is important to note that during these times traders may also be subject to greater risk..^[3]

A Theoretical Debate

The debate over the continued validity of the EMH has produced some distinct conclusions in the theoretical and practical spheres of the investment world. High-profile investors routinely exploit inefficiencies in market pricing to take significant profits. They note that if prices were perfectly efficient, that would be impossible.^[8]

Evidence has mounted over the years that the EMH can be routinely violated by the existence of inefficiencies. However, theorists maintain that, discounting for new circumstances that can introduce these inefficiencies, the theory tends to hold and be reaffirmed. It is certainly possible to make profits by trading on the market, they argue, but it is impossible to make abnormal profits (above-average or low-risk profits) consistently in violation of the hypothesis.

Summary

With ever-expanding volumes of market data to be processed and an increasingly speedy execution of trades, opportunities have arisen for asymmetry of information where the efficient markets model does not hold. However, proponents of the EMH argue that it continues to be valid under theoretical conditions where markets maintain fluid information and transmission of prices. This evolving reality presents both a challenge and opportunities for traders.

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