Financial and capital market efficiency is the ability of the market to reflect the available information through the company valuation. Listed companies are valued through the share prices, hence the market efficiency means that all share prices reflect the true value of the company.
The Market Efficiency Proposes That:
- In an efficient market, all current share prices reflect the available information
- The concept of available information means that shares reflect the information quickly
- The market information is shared publically and in an unbiased way
The market efficiency theory is defined as the Efficient Market Hypothesis (EMH). The Efficient Market Hypothesis (EMH) defines the ability of the market as a whole to reflect the information.
If the theory holds true, then investors trying to buy the shares cannot outperform the market. The moment any information changes (company performance or macroeconomics) occurs, the market reflects the change in the share prices. Hence the investors will not be able to beat the market. The assumptions hold only in theory though, otherwise, the existing trade on the stock markets would only happen through speculations.
Important Consideration
The EMH primarily proposes the market efficiency to reflect the available information as a whole for the stock markets. An important implication of the EMH theory comes into play with business valuation methods. If the market is efficient then all current share prices reflect the true market capitalization of the company. Practically, the current market cap presents the starting point in the company valuations.
The Efficient Market Hypothesis categorizes information availability and the market’s ability to reflect that information into three forms. These are Strong, Weak, and Semi-Strong efficient market forms.
3 Levels of Market Efficiency
Strong Form Efficient Market
It states an ideal market state where all the information is available in an unbiased manner. The market reflects that available information instantaneously too. It proposes a state that a company’s share prices reflect both the public and private information.
The public information about a company or the economy includes the company’s performance, economic conditions, and other macroeconomic factors that affect the share prices. Private information includes the company’s insider information. The EMH proposes that the market also reflects the insider’s information, which may not be true practically.
If the Strong form of Efficient Market Exists then:
- There will be no change in the share prices with news about the company performance (when announced) as the shares already reflected that information.
- The market on a macroeconomic level will not perform irrationally
- There will be nor stock market crashes and bubbles
- There will be no insider trading as all the information will be available publically
The strongest form of the efficient market may exist in theory only. In a practical world, we have all seen market bubbles and crashes. Insider trading still happens despite strict legislation and code of conduct in apparatus by stock markets around the world.
Weak Form Efficient Market
The weak form of efficiency states that the share prices only reflect the historic information available. In other words, the share prices reflect on the company’s achievements and performance only.
The study of historic data through fundamental analysis can provide future predictions on the share price movements. It also proposes that as the historic data is fully reflected in the share prices, the trends or technical analyses do not exist.
If the weak form of efficient market exists then:
- The share prices will not follow any trends or patterns, hence no modern tools like the technical analyses
- Investors cannot predict future prices based on past share prices
- The future share prices will only change with newly available information i.e. when the information becomes publically known or historic
- If the weak form holds, then investors cannot beat the market with the help of modern trend and technical analytical tools
Semi-Strong Form Efficient Market
It states that the share prices reflect all the historic information and all publically available information. It proposes that investors cannot beat the market with past performance or technical analyses.
Practically, the semi-strong efficient market hypothesis reflects the most realistic approach. As it proposes that markets follow the publically available information, we can observe that phenomenon with stock markets reflecting the share price movements.
If the semi-strong form of efficient market exists then:
- Share prices will incorporate all the new information made public instantaneously
- No amount of historic data analyses will help investors to beat the market
- Only the investors trading within the time frame of new information adjustment can occasionally beat the share prices
- This also leads us to the privately held information or insiders information, as it means only insiders information can help beat the stock prices
- The investors cannot beat the market with technical analyses repeatedly
Problems with Market Efficiency Hypothesis
If the market is efficient to at least the semi-strong form, there should be no market crashes and bubbles in the practical world. Also, there must not exist any insider trading. Yet we see all of such occurrences happen in the real world.
For the weak form of market efficiency to prevail, the share prices of some companies will be undervalued and for others overvalued. It proposes that investors with access to the information can gain more and investors without access to information will lose more.
Which Form Of Efficient Market Exists In Practice?
Practically, the existence of a strong form efficient market is not possible. If it was, there would have been no undervalued or overvalued share prices. Hence stock trading wouldn’t exist.
The weak form of efficient market exists in most parts of the world as the markets rely on the published information only. Insider’s dealings and private information play crucial roles in such markets.
The semi-strong form of efficient market proposes the most realistic theory of the modern world. As we see the stock market analysts these days utilize both fundamental and technical analyses. The investors can then use these strategies to make profits by investing rationally. However, theoretically, the semi-strong efficiency also proposes that investors cannot make abnormal gains by beating the market.
