The Efficient market hypothesis states that market prices rapidly incorporate all available information. The implications of this simple idea are far-reaching and often surprising to the non-academic public.
The first major implication is that price movements cannot be predicted and are, therefore, completely random. No analysis of any kind, whether “fundamental” or “technical” is of any value to investors, since security prices already reflect all relevant information.
Another surprising implication: no one can consistently beat the market. Unless you are familiar with the way modern academic theories are “tested,” you will be amazed to learn that this theory is widely accepted in academia. Needless to say all security analysts and investment advisors (like this author) reject this interpretation of market efficiency – or else they might as well give up their jobs.
The fact that 75% of all money managers underperform the market in any given year supports the theory. But how does it explain the fact that some managers consistently beat the market? According to the theory, their favorable results can be explained by chance or luck. The results of world-renowned investors like Warren Buffet or Peter Lynch explained by luck? How degrading!
The first mistake involved in the theory is the implicit assumption that information finds its way into security prices automatically and effortlessly. Not so. It is precisely the diligent work of analysts that determines the effect of particular data on the price of a security. More often than not the effect on the price is not straightforward or unanimously agreed upon. Whether in regard to a particular security or to the entire market, arriving news requires analytical reasoning and those with the superior interpretation “beat the market!”
The fact that people trade securities is an indication of investors’ disagreement concerning the prices. Even if everyone followed “fundamental analysis” there would still be argument as to the correct price. For example, should one discount earnings of the next five years, ten years or more? When market uncertainty is high, investors tend to be more short-sighted. Such issues illustrate that the notion of “prices reflecting all available information” is problematic.
All this said, there is still value in the theory of efficient markets. It forces one to compare one’s analysis of a security with all other market participants. For example, when you spot a stock with a low Price-Earnings ratio you cannot assume that the stock is undervalued. Remember that numerous other investors are looking at the same numbers, and the current market price reflects the sum of their judgments. Is your judgment better? Do you know something that escaped the attention of other traders (inside information excluded)? Perhaps you have specialized knowledge not likely to be possessed by other Wall Street analysts? If so your judgment concerning a particular stock may be superior and you will beat the market.
“Technical analysis” searches (mainly) for pattern in stock prices. According to the Efficient Markets hypothesis this is without merit. As soon as a pattern is found, the information about that trading rule itself will be incorporated into the security’s price, thereby rendering the rule useless. That much is true: simple patterns in market prices cannot persist. But that does not mean that there are no hidden relationships that can be exploited. Our forecasts are based on the discovery and exploitation of such obscured causal connections.
