Markets Can Be So Efficient That They Add Up To Nothing

Should they wait with a new rights issue or borrow short term and bet on falling interest rates? Is it a good idea to acquire companies because they appear undervalued?

The criterion for real investments applies also to financial transactions: look at the net present value (NPV). The NPV of a bond issue is simply the proceeds of the issue minus the present value of all expected future repayments of principal and interest.

The NPV of purchasing a share is the value of the share (the present value of future dividends) minus its price.

Markets are efficient if the NPVs of all these transactions are zero. If transaction costs are zero and all investors have access to the same information, then competition will eliminate opportunities for earning positive NPVs. All available information would be incorporated into prices.

 

Since these ideal conditions do not prevail, it is practical and customary to distinguish different degrees of market efficiency, depending on the amount of information reflected in prices. These are traditionally labelled as weak-form, semi-strong form and strong form market-efficiency.

Weak-form efficient markets

A market is said to be weak-form efficient if current prices reflect all information contained in past prices. This form of efficiency is weak because it requires only a small amount of information to be incorporated into prices. Its implication is nonetheless very powerful. If markets are weak-form efficient, then past prices cannot predict price movements in the future, i.e. it rules out trends, cycles or any other predictable pattern of price movements.

It is instructive to understand why this is so. Assume, for example, that an agricultural stock moves in an annual cycle, booming in the autumn and declining in the spring. All investors expect that the regular drop in the spring will be reversed in the autumn, hence the stock becomes a one-way bet and everybody who knows the cyclical pattern will buy. Conversely, in the autumn, there will be strong sales pressure as all investors anticipate the seasonal decline. However, a situation in which everybody has an opportunity to make profitable transactions is not sustainable. The autumn sales will drive prices down, whereas the spring purchases of the stock will move prices up. As a result, the cycle will self-destruct.

A similar argument can be made for any regular pattern in prices: once many investors discover such a regular pattern, their trades will adjust prices and the pattern will disappear.

If markets are weak-form efficient there is no scope for profitable technical trading rules since they are based on information that is already reflected in market prices. In fact, a very simple forecasting rule applies: the best predictor of tomorrows stock price is todays price. More formally, this result is known as the random walk hypothesis. Tomorrows price Pt+1 can be expressed as todays price, Pt plus a random expectation error Et+1 which has an expected value of zero.

Pt+1 = Pt+Et+1 E(Et+1) = 0

This implication is empirically testable and countless studies have been performed to show that financial markets are, indeed, weak-form efficient.

Semi-strong-form efficient

A market is said to be semi-strong-form efficient if all publicly available information is reflected in market prices. This requires that no investor can consistently improve his or her forecast of future price movements simply by analysing macroeconomic news such as earnings statements, annual reports or other publicly available sources.

The empirically testable implication in this case is that financial markets react to relevant news fast and on average appropriately. This excludes systematic over- or under-reactions for the same reasons as stated before: if all investors knew that the market overreacts (or underreacts) after the announcement of a dividend rise, then all investors who realise this would sell (or buy) immediately after the announcement.

Numerous studies have been conducted to test stock price reactions after the announcements of news (dividend and earnings, stock splits, changes in accounting rules, macroeconomic indicators, rights issues and so on) and have generally confirmed that the markets incorporate public information efficiently and quickly.

The implication of this finding is as powerful as the previous one. If stock markets are semi-strong-form efficient, then fundamental analysis cannot lead to profitable stock-picking.

There is one exception to the last conclusion. If a very smart analyst has a proprietary model for processing public information and one which builds on relationships between variables nobody else has so far discovered, then he or she effectively produces original information in its own right. As long as the research results were not public, trading on this information might still be profitable in semi-strong-form efficient markets.

Strong-form efficient

A market is strong-form efficient if all relevant information (public or private) is reflected in market prices. This definition is the most stringent one, since it implies that nobody can ever profit from any information, not even inside information or the information produced by the highly original analyst mentioned above.

In a strong-form efficient market prices adjust instantaneously to orders based on private information. Studies have generally found that analysts and fund managers cannot consistently beat the market, whereas trades by corporate insiders are usually very profitable. Hence markets are generally not strong-form efficient.

More recently, studies more critical of stock market efficiency have documented anomalies or effects which appear to be inconsistent with market efficiency. Usually, these studies test a particular model of asset prices, so that a rejection of the test can indicate a failure of the particular pricing model as much as a failure of markets to be efficient. These studies are too lengthy and detailed to be discussed here.

The overall message of this discussion is fairly clear. In efficient markets there are no gains from trend spotting and timing the market for rights issues, security repurchases or for speculating on interest rate movements when considering whether to borrow at long or short maturities.

Similarly, accounting changes are just as valueless as acquisitions of supposedly undervalued companies. Corporations can add value through their operations. Financial transactions are usually zero-NPV activities, i.e. those that do not add value.

Summary

Markets are efficient if the net present value (NPV) of financial transactions is equal to zero. It is customary, though, to distinguish different degrees of market efficiency. A market is said to be weak-form efficient if current prices reflect all information contained in past prices; it is semi-strong-form efficient if all publicly available information is reflected in market prices; and it is strong-form efficient if all relevant information (public and private) is reflected in those prices.

Books Suggested further reading

Dimson, Elroy, 1988 Stock market anomalies,

Cambridge University Press, Cambridge

Fama, Eugene F., 1970

Efficient Capital Markets: a Review of Theory and Empirical Work,

Journal of Finance 25, 383-417.

Fama, Eugene F., 1991

Efficient Capital Markets: II, Journal of Finance 46, 1575-1617.