Is The Equity Market Efficient

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Introduction

This essay will provide a comprehensive discussion of whether the equity market is efficient by presenting arguments for and against. The arguments against efficiency include the consideration of various anomalies such as momentum and seasonality effects. However, many of these anomalies can be at least partly explained by questions on the methodology of identification.

There are three forms of efficiency under the efficient market hypothesis (EMH) originally developed by Fama in the 1970s, namely weak-form efficiency where stock prices are only reflected by historical performances, semi-strong where all public information is reflected in stock prices and strong form efficiency refers to where all available information is fully reflected in the security price. The market is deemed as efficient when all the available information is embodied into the share price. It is therefore not possible under this hypothesis to continually earn excess returns through knowledge of the market.

Empirical and Theoretical Evidence Against Equity Market Efficiency

One argument against the EMH is that there are times when the market seems to be massively over-valued (i.e. market bubbles). The stock market was overpriced in October 2007, just as it had been at the peak of the internet bubble in the late 1990s, and on the eve the stock market crash of October 1929 cited in Klein (2001). Market anomalies such as the January effect, the weekend effect and the momentum effect have also been widely quoted as evidence against the EMH. The question is thus posed: can the equity market still be considered as efficient after the challenges of these anomalies?

To consider the EMH, we need to consider an assumption of the fundamental analysis approach namely that securities have an intrinsic value other than their actual price. Efficient markets assume that investors always behave rationally, that they can access all the available information and that the actual price will adjust to the intrinsic value if it exists. However evidence shown by Kadir (2010) that if investors are rational as stated in the theory of expected utility and the efficient market hypothesis, they do not trade too much except when they need liquidity or have a desire to re-shape their portfolios. It is argued that there are minor investing activities if the rational investor is using only publicly available information only. However, we see millions of buy and sell orders in stock markets even when there are no apparent reasons. For example, the New York Stock Exchange (NYSE)’s total volume is approximately $5-6 Billion in a normal day when approximately 3,600 stocks are listed cited in (Thaler, 1999). In such a market environment, it is difficult to explain the exchange of 700 million IBM shares in a day as mentioned in Kadir (2010) if all information is fully observable in the market. If trading is being driven by non-public information, this raises the Moral Hazard question where there is asymmetrical information between the buyer and seller of stocks.

Kahneman and Tversky (1979) have demonstrated anomalies due to behavioral approaches. According to the behavioral approach, investors suffer from cognitive limitations when they make decisions. These cognitive limitations cause irrational investment decisions; these systematic erroneous investment decisions cause inefficient markets since they are impediments to arbitrage, which should in theory remove the inefficiencies. This evidence violates the assumption that all investor can assess to the all-available information and they will always behave rationally.

Momentum has been mention by Fama and French (1993) as the one major unexplained anomaly, although further studies by Fama and French (2012) claimed that the resulting anomalies are explained better with behavioral theory rather than CAPM model. Seasonality effects are another feature of momentum studies. High level of seasonality effect
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