The basic EMH conceives that no one can beat the market since it integrates all vital
determinative information into present share prices; hence, the market is deemed
efficient as a whole. By following the work of Roberts (1959) and taking the degree of information that is reflected in the prices into consideration, Fama formulates three different forms of market efficiency, namely the weak-form, semi-strong-form and strong-form. These forms of efficiency are varying degrees of the basic EMH. Although, the weak-form is the focus of the present study, other forms are described briefly for sake of clarity.
2.3.1 Weak-Form Hypothesis
Weak-form hypothesis implies that all previous data are already incorporated in the prevailing prices. It means that today’s stock prices already reflect all past information such as the previous price and volume of the trading (Urquhart, 2013). Based on the weak-form EMH, those who trade with the chart method, which relies on analysing price histories to beat the market cannot provide above normal profits because all information would have been instantaneously incorporated into the market price. By the way of illustration, since historical share price information is in the public domain and almost attracts no cost to acquire, if such information ever depicts reasonable signs regarding expected performance, all participants would have already learned to take advantage of the signs. In the end, the signals lose their value, as they become public knowledge.
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However, if fundamental analysis is applied in a market that is only weak-form efficient, overvalued and undervalued assets can be ascertained and traders can earn above-
average return by exploring a company’s financial report. A weak-form efficient market
denotes that security returns will follow the random walk (Abraham & Achma, 2013; Maximillian, 2015) and be free of technical anomalies (Ching et al., 2014). In other words, there is absence of successive dependence or serial correlation and exploitable patterns such as calendar anomaly in price changes.
2.3.2 Semi-Strong-Form Hypothesis
This type of efficiency holds that asset price incorporates all information made known to the public. In addition to the historical price data, most of the public information about the firm is made available in the financial statement and the market data, and are used in the calculation of the current security price. Therefore, analysts cannot rely on technical and fundamental methods to detect whether a security is undervalued or overvalued (Helena, 2009). Since these data are available in the public domain, the semi-strong-form hypothesis holds that the information is instantaneously incorporated into security prices as soon as the information gets to the investors (Abraham &Achma, 2013). Examples of public available information are fundamental information on the company’s product line, management quality, statement of affair composition, patents hold, earning projections and accounting policies (Maximillian, 2015) and economic situation (Fama, 1965). Therefore, no trading strategy, which relies on analysis of public information, will yield abnormal returns. The semi-strong-form implies that there is no learning lag in the distribution of public information. Therefore, relying on public information such as company’s sales, earnings and book-to-market ratios in selecting assets is also worthless. The advocate of this version of EMH, however, believes that above market average profits can be earned when investors have access to this information that is private or not publicly available. By implication, a semi-strong efficient market is a weak-form efficient market.
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A market is strong-form efficient where, in addition to past price information and all publicly available information, the price of security fully reflects even the insiders or private information (Fama, 1970). The private information, otherwise known as the insiders’ information is that only known to the managers regarding the firm’s prospects but which have not been made available to the public. In the face of this type of efficiency, the insider trading will fail to earn above-normal profit by relying on private information (Abraham & Achma, 2013). A market that is efficient in strong form is automatically efficient in semi-strong and weak forms. The supporters of this version of efficiency believe that investors cannot make above-normal market returns, irrespective of the types of information analysed. It is difficult to test this form of efficiency since the makeup of private information is difficult to determine.
Although, prices may fluctuate over time, EMH holds that it is not possible to identify the trend. A large number of empirical investigations accompanied EMH with many of the earlier tests confirming the efficient market hypothesis. Some of the earliest empirical studies in support the EMH include Fama and Blume (1966) who, estimating the path and extent of dependence in price changes, point out that serial correlation is probably as powerful as the Alexandrian (1961, 1964) filter rules. Similarly, Mandelbrot (1966) provided some of the first theorems revealing how, in competitive markets with rational risk-neutral investors, returns are unpredictable and security values and prices follow a martingale. In essence, if a market is efficient, available information will be incorporated in security prices and no amount of stock analysis will result in abnormal profits (Dyckman & Morse, 1986). Further, Fama, Fisher, Jensen and Roll (1969), who examined a sample of 940 stock split prices from 1927:1 to 1959:12, showed that all existing information is mirrored in prices on the day of announcement and that the knowledge of the occurrence cannot be exploited. Hence, Jensen (1978) proudly wrote that no existing proposition in economics, other than the EMH, had more solid empirical
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proof. According to him, “[a] market is efficient with respect to information9 set θt if it is
impossible to make economic profits by trading on the basis of information set θt.” (Jensen, 1978, p. 3) while Malkiel (1992) states that a stock market is efficient whenever the prices of stocks remain unchanged, despite information being revealed to each and every market participant.
Concluding on the role of Samuelson (1965) and Fama (1965, 1970) in the evolution of EMH, the two, irrespective of the difference in their approach, have a common ground for what they view as efficient market, which is “the more efficient the market, the more random the sequence of price changes in the market and the most efficient market of all is one in which price changes are completely random and unpredictable” (Lo, 2017, p. 38).
2.3.4 Early Aftermath of EMH
It was observed that most of the earliest (notably from 1960 to 1980) studies support EMH, while subsequent (1980-2004) findings cast doubt on its validity (Kim, Lim & Shamsuddin, 2011). Kemp and Reid (1971) observe that most of the earlier studies used only the U.S. stock market as a sample and by considering the UK setting, showed that changes in stock prices stray from the RWH and violate Fama’s (1965,1970) proposition. In an extensive survey of the literature, Ball (1978) submits that steady surplus returns follow the public broadcast of companies’ earnings, which obviously contradicts the EMH in its semi-strong form. Another violation of EMH was documented by Shiller (1979) who established that the observed volatility is higher than that expected under expectations models, meaning some degree of predictability of long-term interest rates. In reality, if markets were efficient, no one would analyse the stock or trade since no profit would arise, then the market would end up being inefficient (Grossman & Stiglitz, 1980). Hence, market efficiency has to do with market participants
9Information is defined as anything that influences prices in a way unknown in the present, appearing randomly in the future (Helena, 2009).
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who, being aware of inefficiency in the market, believe that buying and selling of securities will result in substantial gain (Shleifer, 2000). Thus, Grossman and Stiglitz (1980) became the most plausible piece of contradicting evidence against EMH.