Prior to Fama’s EMH, no theory existed to explain why financial markets are so hard to beat, the recognition of such a possibility was non-existent (Bernstein, 2007). Eugene Fama is credited with the first use of the term ‘efficient market’(1965a) even though there is evidence that the concept was independently developed by Eugene Fama and Paul Samuelson (Samuelson, 1965) from two considerably unrelated research works which propelled both of them along two separate courses resulting in a number of other breakthroughs and achievements, all emerging from their related study, the EMH (Durlauf and Blume, 2008).
In Fama’s 1965 paper titled: “Random Walks in Stock Market Prices,” (Fama, 1965b), he cites, inter alia, his prior study of serial correlations in the daily price fluctuations of 30 stocks that made up the Dow Jones Industrial Average index (“The Behavior of Stock Market Prices”
(Fama, 1965a)). His conclusion was that the daily fluctuations had a very minimal positive correlation, approximating zero for all practical purposes. Fama (1965b, 56) defines efficient markets as:
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“…a market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.”
Figure 2.4 shows how in an efficient market, stock prices respond to new information plotting the response to prices of sampled firms targeted for takeover. The acquiring firms in majority of takeovers paid a substantial premium over the prevailing market prices, therefore any relevant information on an attempted takeover should trigger the stock price increase.
Figure 2.4: How Stock Prices Respond to New Information
Source: Adopted from Keown and Pinkerton (1981), cited in Bodie, Kane and Marcus (2014:
351)
The figure displays how stock prices increase spectacularly on the day the news is made public but there is no further movement in prices after the date of the announcement, implying that prices incorporate the new information, which by the end of the trading day, includes the probable enormity of the takeover premium.
Patell and Wolfson (1984) provide a more dramatic confirmation that swift reaction to new information may be found in intraday prices proving that majority of the stock price reaction to announcements of corporate dividends or earnings happens within ten minutes of the announcement. A study by Busse and Green (2002) provides a good demonstration of such
Page | 25 rapid assimilation. Busse and Green (2002) tracked minute-by-minute equity prices of companies that appeared on the “Morning” or “Midday Call” segment of business news television channel CNBC. Minute 0 in Figure 2.6 represents the time the equity is mentioned on the show at midday.
Figure 2.5: How Stock Price React on CNBC Report
Source: Adopted from Busse and Green (2002), cited in Bodie, Kane and Marcus (2014:352)
The line above represents the average price variation of equities that get positive reports, and the line below shows returns on equities that receive negative reports. From the above graph, it can be observed that the line on top levels off, demonstrating that the news has been fully incorporated by the market within five minutes of the news whiles within 12 minutes, the line below also levels off.
In the Swedish market, Hartman and Rodestedt (2010) find that adjustments to new information by the market as measured in volatility peaks within the first minute and within three minutes after the new information, more than half of the adjustments to normality is completed whiles full adjustment takes thirty-five minutes after the release of the information.
Kurov, Sancetta, Strasser and Wolfe (2015) studied the behaviour of the prices of equity index and the Treasury futures around the dissemination of macroeconomic announcements of the
Page | 26 United States and discovered that out of the eighteen market-moving announcements, seven exhibited evidence of informed trading prior to the official time of release with prices drifting towards the correct direction about thirty minutes before the announcement time.
Notable literature relating to the EMH though began earlier in 16th century with renowned Italian mathematician, Girolamo Cardano, in his book Liber de Ludo Aleae (The Book of Games of Chance) argued: “The most fundamental principle of all in gambling is simply equal conditions, e.g. of opponents, of bystanders, of money, of situation, of the dice box, and of the die itself. To the extent to which you depart from that equality, if it is in your opponents favour, you are a fool, and if in your own, you are unjust” (Cardano, c 1564).
In 1828, Robert Brown the Scottish botanist, discovered that viewed under a microscope, pollen grains suspended in water had a swift oscillatory movement (Brown, 1828). French stockbroker, Jules Regnault, noted that the longer one holds a security, the more likely it is to win or lose on its price fluctuations which is proportional directly to the square root of time (Regnault, 1863). Jules Regnault, an amateur mathematician and a broker on the Paris Bourse, was one of the earliest to make a formal expression on market efficiency in a book written in 1863. Regnault, by personal observation and by force of logic argues that the market price of an asset at any particular time reflects the ‘wisdom of the crowd’ and therefore speculators who trade on the imperfections of the market were being delusional. He asserts that one can only make a profit by trading on private information not available to other market participants. By using probability theory, he estimated the “gamblers ruin” problem - the number of times an uninformed trader has to trade before losing all his money. Regnault is also regarded as the first person to argue that market efficiency implies that security prices follow a random walk (Shamshir and Mustafa, 2014). Using data from both French and British bonds, Regnault tested this theory and therefore the first empirical researcher to verify a “random walk” in asset prices.
Renowned English economist John Maynard Keynes opined that investors are rewarded for bearing risk rather than not for knowing better than the market, this assertion is a consequence of the EMH.
Fama (1970) defines three kinds of market efficiency – weak-form, semi-strong-form and strong-form efficiency - each based on a differing conception of what kind of information set is construed to be pertinent in the statement: “a market in which prices ‘fully reflect’ all available information is called ‘efficient’”.
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• Weak-form Efficient Market
In weak-form efficient market, analysing information relating to past prices cannot be used to predict future prices. Therefore, in the long-run, one cannot earn excess returns by applying investment strategies that are based on historical data or the historical share prices. In a weak- form efficient market, technical analysts will be unable to consistently deliver excess returns, even though some kinds of fundamental analysis could still be able to deliver excess returns.
Share prices do not exhibit any serial dependencies therefore future price fluctuations are defined solely by information that is not contained in the time series of price. The implication is that the time series of prices follow a random walk. In a weak-form efficiency it is not necessary for prices to be at or near equilibrium, however, investors will still not be able to persistently profit from market 'inefficiencies' (Drake and Fabozzi, 2010).
Many findings have shown a noticeable inclination for stock markets to ‘trend’ for weeks or longer (Saad, Prokhorov and Wunsch, 1998; Hamori, 2012; Pring, 2014). Furthermore, there is evidence of a positive correlation between the time period and the degree of trending (Granger and Morgenstern, 2001) although the EMH asserts that barring any changes in fundamental information, all price movements are random.
In academic finance, there exist an extensive literature dealing with the momentum effect first identified by Jegadeesh and Titman (1993,2001) who discovered that equities that have performed well over a period of 3 to 12 months, maintain such performance over the next 3 to 12 months and vice versa. The momentum effect, based simply on historical stock returns, provides a strong evidence against the weak-form efficient market, and has been detected in the stock returns of many countries (Garg and Varshney, 2015, Birru, 2015, Choi and Kim, 2014, Asness et al., 2013, Fama and French, 2012).
Jefferis and Smith (2005) using weekly data starting from the third week of January 1990 to the last week of June 2001, applied a GARCH approach with parameters that vary with time, implemented a test of evolving efficiency (TEE) and reported changes in weak form efficiency through time on selected stock exchanges in Africa. The TEE showed that the JSE exhibited weak form efficiency over the period of the study whereas three stock exchanges namely the Casablanca Finance Group (CFG) 25 of Morocco, the EFG Price Index of Egypt and, the S&P/IFC Global Index for Nigeria exhibited weak form efficiency towards the end of the period of the study (1999 for Morocco and Egypt and from early 2001 for Nigeria.). However,
Page | 28 the Nairobi Stock Exchange of Kenya and Zimbabwe Stock Exchange showed no movement towards weak form efficiency whereas the SEMDEX of Mauritius displays a slow drift towards eliminating inefficiency.
• Semi-strong-form Efficient Market
In a semi-strong-form efficient market, prices of securities adjust rapidly to information that is publicly available in an unbiased fashion, therefore investors cannot persistently earn excess by trading on such information. The implications for a semi-strong form efficient market is that one cannot rely on fundamental analysis or technical analysis techniques to consistently produce excess returns (Drake and Fabozzi, 2010).
• Strong-form Efficient Market
In strong-form efficient market, prices of securities incorporate all information, both public and private, and therefore no investor can earn excess returns. It implies that even corporate insiders cannot profit from using private information. Strong-form efficient market builds and incorporates the weak-form efficient market and the semi-strong form efficient market. Given that there are legal barriers that may prevent private information from becoming public, for example insider trading laws, strong-form efficiency may be impossible, except in the situation where these laws are collectively ignored (Drake and Fabozzi, 2010).
The semi-strong efficient market differs from the strong efficient market, in a strong form efficient market, market participants cannot even profit from inside information (Harder, 2010). This implies that in a strong form efficient market the management of a company who are regard as insiders cannot benefit from inside information if they chose to trade the shares of their company even after they decide without making the information public, to carry out what they perceive to be a profitable takeover. A strong form efficient market will foresee future event and such information would have been incorporated in security prices in an objective and unbiased way before even those considered insiders make any trading decision (Clarke et al. 2001).