ISSUE

The issue of this question is concerned with the Efficient Market Theory (EMT). EMT theory states that (i) the market is efficient, i.e. investors cannot earn more than the average market yield, and (ii) economic agents in the market are rational actors.

WEAK FORM EMT

Future price cannot be predicted. Excess earning is not possible in the long run. The past prices of stock reflect all information available at that time frame. Stock prices occur as a random walk.

However, it is a common fact that when prices are plotted over a long period, a pattern begins to emerge. If there is a pattern, it cannot be said that it is truly random and, therefore, not predictable. Another error of the assumption of weak form EMT is that all investors are of the “same type.” This assumption is flawed. Some investors may be risk affine and others may be risk averse. These differences may influence their behavior in the market, i.e. information interpretation.

For the sake of argument, assume that weak EMT exists and that human behavior resulted from cognitive bias is a “nuisance variable” then it could be said that weak EMT still is a valid argument. This position is still untenable. If the market is comprised of human conduct. Human conduct is a culmination of human thinking. Each thinker may think differently from his peers, then economic agents would act in a non-uniform patterns, i.e. when presented with the same set of fact, each agent may interpreted the information different and act according in different diction. Each thinker may act according to his rationalism. Without this differences in perception there will not be buying and selling in the stock market. Therefore, at least we can say that despite individual differences, at least two patterns will emerge. Thus, weak form is not a true random walk.

SEMI-STRONG FORM EMT

Share prices adjust to publicly available information very rapid in such a way that there is no decision made as a result of information lag. As the result, there cannot be excess earning from the market. This implies that fundamental analysis and technical analysis are not useful as decision tools. This form of efficiency argument is an improvement from weak form EMT because it takes into consideration that people (agents) adjust their conduct in the market in accordance with the available information.

In order for this theory to work, it is necessary that all agents in the market must have access to the same information. Secondly, all agents must act under the same standard of “rational thinking.” Assuming that there is no insider information and information is available freely to the public, the first assumption may be possible. However, in reality, for practical reason information is not free. Even if it is “free”, there may be a question of “accessibility.” So the assumption may contraindicate practical facts. As for the second assumption: “rational thinker” requires the honmogeneity of investors to exist. However, economic agents or investors are not homogeneous. If all agents are rational thinker in the same manner and sees the world in the same light, there will not be “buying” and “selling” of stocks in the market. Assumes that A is a seller and B is a buyer. A and B have the same information. A thinks that the price will go down and thus decides to sell. B thinks that the price will go up, and thus decides to buy. This simple experiment tells us that even the agents have the same information, they differ in interpretation of that piece of information. Who will decide if A is rational or B is rational? This is another flaw of EMT.

STRONG-FORM EMT

Share prices reflects all available information both public and private. No excess earning beyond average market yield is possible. This is to say that no one can perform consistently higher than the market average earning. The problem here is the definition of “market.” We must understand the context of EMT. The theory grew out of a Ph.D. thesis in 1900 on the “The Theory of Speculation” by Louis Bachellier. This work was later confirm be researchers in the late 1930s and 1940s after the Great depression that no fund managers can out perform the market in the long run. This 20th Century theory was born in a time where the market was confined within a well defined national border. There was no transnational transaction and capital movement across border. Today’s market is completely different. A money manager can move his funds across border and park his money at the other side of the globe and earn higher interest rate than what the market offers at home. Thus, there are two flaws in strong-form EMT: (i) information availability is not equal and not all time accessible by everyone, and (ii) market is not confined within one national market.

WEAKNESS OF THE THEORY

Much criticism against the theory is based on the argument that EMT heavily relies on rational expectation theory, i.e. economic agents act rationally in the market. However, as the financial crisis of 2009 shows, this is not the case. Economic agents in the financial markets are non-rational: (i) over confidence, (ii) over reactive, (iii) representative bias, (iv) information bias, and (v) displaying cognitive bias. For these reasons, EMT is considered to be flawed because it assumes that the market is efficient and that “humans” are rational.

CONDUCT FURTHER RESEARCH

It is still logical to conduct further research on EMT because it is still alive; the theory is not completely dead even though it received many criticisms. We still look for the last nail to close the coffin. In light of transnational and inter-regional capital movement, a new theory may emerge from EMT: What would be EMT for the current global market look like? Can EMT have a unified statement without creating 3 exceptions as it now has?

LINK

For 30 years patterns, see link below:

http://en.wikipedia.org/wiki/File:Price-Earnings_Ratios_as_a_Predictor_of_Twenty-Year_Returns_(Shiller_Data).png

I strongly feel that there is no area where it can be said that it cannot incorporate more research. So do it

As above, there is still a lot of work to do with respect to EMH and developed markets. Whether this be to do with fine tuning and improving econometric tests, or the theory itself, as more data becomes available (notably intraday values) this offers the opportunity to attain a more concrete understanding of movements of prices and jumps with respect to news and information. Also I think research is now moving away from stock markets and stocks specifically and into sectors and co-movements of sectors, so there is a lot of work to do there.