Market Efficiency (Efficient Market Hypothesis)

Efficient Market Hypothesis (EMH) is the hypothesis that securities trade at their fair value i.e. their prices reflect all currently known information.

So, how do we know whether a market is efficient or not?

Basically, it’s a matter of how fast does trading activity reflect new information in the securities’ prices.

In an inefficient market, there would be arbitrage opportunities everywhere.

Arbitrage Example

Let’s say you live in an informationally poor country with a currency called XXX.

The bank close to your home changed the XXX/USD exchange rate from 10 to 11. That means that you can buy more XXX per USD, or in other words: your home currency lost value.

You ride to the bank at the other side of the city and turns out that they didn’t reflect this information yet.

So you call your sister and tell her to immediately buy USD50k worth of XXX, amounting to XXX55m, while at the same time you sell XXX55m at the other bank and get USD55k.

That’s 5000$ of risk-free profit. Congratulations!

This is an extreme and hypothetical example of a dysfunctional country, but even the slightest lags, and I’m talking seconds here, are opportunities to generate superior returns.

Contributors to Market Efficiency

In an efficient market, new information is quickly reflected in the prices of the securities. There are many factors that contribute to the market efficiency and here are the biggest ones:

Number of market participants – the larger the number of traders, the more efficient the market is. Markets with high barriers of entry or those in countries that prohibit foreign investments are less efficient.
Availability of information – the more information, the higher the efficiency. In developed world markets, all data is publicly available and easily accessible, making it reflected immediately in securities’ prices.
Liquidity – ease of trading, short selling, speculation, etc… They all contribute to market efficiency because they push the prices to their fair value. Implicitly, transaction and information costs affect the liquidity as well.

If markets are inefficient, one could use technical analysis to predict the movement of an asset or asset class. However, it’s important to note that these techniques are only based on trading activity, not on external information. Basically, it’s forecasting price movements by looking at charts – price data, volume data, etc.

However, there are rarely markets that are inefficient, so let’s explain the three types of market efficiency.

Weak Form Efficiency

A weak form efficient market is the one in which securities’ prices reflect all currently known market data.

In other words, past market or trade data (such as price information, volume information, or any type of market information) will have no predictive power of the price movements of the asset. That means that an investor would not be able to consistently beat the market using technical analysis.

As mentioned above, technical analysis is used with the goal of achieving superior returns based on historical price and volume information.

In general, technical analysis is not shown to produce superior returns, although survivorship bias can lead many to a different conclusion. It’s fun to recognize the patterns anyway.

However, one can use fundamental analysis to beat a weak form efficient market. Although all trade data is already priced in, traders can generate superior returns by trading based on the public information regarding the securities, by determining if they’re overvalued or undervalued.

Semi-Strong Form Efficiency

A semi-strong form efficient market is the one in which current securities’ prices fully, quickly, and rationally reflect all public information available at that moment.

If you think about it, this means that, regardless of the type of analysis, an investor can’t find undervalued or overvalued securities based on public information, as all information is already priced in. In a semi-strong efficient market, the securities’ prices already reflect all public market information, but also all public non-market information. Basically everything publicly known is reflected in the prices.

A sentence that should come to your head at this moment is: you can’t beat the market.

At least not consistently.

And especially not by using fundamental analysis, as it uses publicly available data, such as price, earnings, and other accounting ratios and estimates, to value a security. But because semi-strong markets already reflect all this information in the securities’ prices, investors utilizing fundamental analysis shouldn’t be able to beat the market (consistently, because getting lucky doesn’t count).

However, if you’re indulging in the illegal habit of insider trading, i.e. using knowledge that’s still not available publicly, you’d be able to overperform the market. This is true because in semi-strong efficient markets, private information is not reflected in securities’ prices.

A market has to be weak form efficient in order to be semi strong form efficient.

Strong Form Efficiency

A strong form efficient market is the one in which the current prices of securities fully, quickly, and rationally reflect all information available at that moment, public and private.

If you think about it, this means that there is no way how an investor can value a security, since regardless of how he analyzes it, all information is already priced in. In other words: there are no undervalued and overvalued securities – any security’s market value is equal to its “intrinsic value”.

And this is a market you can’t beat. A market in which index investing is the one and only way of investing that makes sense.

A market has to be weak form efficient and semi strong efficient in order to be strong form efficient.

What About the Stock Market?

There are debates regarding how efficient is the stock market.

My first instinct was to assume that it’s semi-strong form efficient. But let’s think about it…

The reason I think it’s not strong form efficient is because insider trading can generate superior returns. This is supported by the fact that it’s punishable under law and the rapid changes in stocks’ prices after a release of new public information (publishing quarterly earnings, beating expectations etc.).

On the other hand, in order for a market to be semi-strong form efficient, all publicly available information need to be reflected in securities’ prices. This means total absence of human emotions (hype, fear, etc.), which is not always the case. However, the market is still efficient enough that all these discrepancies are quickly fixed. It’s also believed that a handful of investors generated superior returns continuously using fundamental analysis, although some can be attributed to and explained as factor investing.

So I’m not sure if fully, but the stock market still seems closest to semi-strong efficient. At least to the extent that allocating extra time in order to beat it won’t be worth it. In other words: any private investor should adopt a passive investing strategy rather than an active one.

That’s why even the most-successful-and-above-mentioned “handful of investors” also recommend, and some even utilize, index investing. And even when stock picking, many are more focused on the macro-perspective (read: the point in the business cycle we’re in) and are diversified enough so that the portfolios are correlated with the market to an extent. Maybe not as much as a total market index, but it’s shown that a diversified portfolio of 30 large-cap companies will have a pretty similar performance as one with 500 large-cap companies. I won’t link a study, but I’ll mention two indices representing my statement. Yup, you guessed it, DJIA and S&P 500.

World-class investors aside, professional traders and smaller fund managers also fail to continuously outperform the market. So, as for most people, the best route is to avoid extra fees and buy the market yourself. That’s the smartest and only investment decision most people need to make in their lifetimes, as everything else is most probably inferior. And if you need help starting, check out The Ultimate Guide to Long-Term Investing for Absolute Beginners.