Market efficiency: the predictability of share price developments
In 1953, Kendall analyzed the price development of securities and was surprised to discover that share price movements did not follow cyclical patterns, but rather a "random walk" - a random development over time.
"... appears to be a 'wandering' one, almost as if once a week the Demon of Chance drew a random number ... and added it to the current price to determine next week's price."
Price changes in a random walk model are completely independent of each other, which is why the current price is the best forecast for the future price. This independence can be observed in the lack of correlation between successive prices (t/t+1).
Why do security prices follow a random walk?
Let us imagine that it was generally known that the price of Microsoft shares would rise by 100 % in the coming weeks. This would immediately generate strong buying demand and quickly raise the price to a level where no further profit could be expected. The price would therefore rise to the discounted value of the expected future price. Such an expectation is therefore directly "priced in" as soon as new information becomes available.
When information is quickly reflected in security prices, we speak of information efficiency.
In this context, Fama wrote in 1970:
"Security prices always fully reflect all available information."
This means that no systematically profitable investments are possible on efficient markets. Securities can neither be bought "cheaply" nor sold "expensively".
Why is this the case?
"Buying cheaply" would mean that positive information about a security is not yet fully reflected in the price and only leads to price increases later.
The three forms of the efficient market hypothesis (EMH)
Also in 1970, Fama presented three different forms of market efficiency:
- Weak efficiency: All historical price data is already included in the price. Profits can therefore not be made by analyzing past prices.
- Medium efficiency: All publicly available information - such as annual reports or market announcements - is already priced in. No profits can be made on this basis either.
- High efficiency: Even insider information is priced in, so even insiders cannot make above-average profits.
In practice, medium efficiency is often considered particularly plausible.
Market anomalies
According to the theory of market efficiency, financial markets offer no opportunities for systematic excess returns, as the price of a security always reflects the present value of all future cash flows, discounted by the risk-adjusted opportunity costs. However, empirical studies repeatedly reveal market anomalies that enable profits to be made.
Examples of such anomalies are the January effect and the Monday effect. These phenomena can often be explained by a "wrong" risk-return model. However, speculative bubbles such as the Japanese real estate bubble of the 1980s, the dotcom bubble or the real estate bubble of the 2000s also contradict the EMH. They illustrate how difficult it is to determine the absolute value of securities. Even small changes in growth assumptions can trigger strong price movements.
Summary
- A random walk in the price movement implies unpredictability.
- The EMH implies that all available information is directly reflected in security prices.
- The three forms of the EMH differ in the amount of information taken into account.
- Many empirical findings support the EMH; nevertheless, there are market anomalies that seem to contradict the theory.
Source: Brealey, R., S. Myers, F. Allen, A. Edmans (2022): Principles of Corporate Finance, 14th edition, McGraw Hill, ISBN 1260013901, and lecture notes.