Why Efficient Market Hypothesis dictates Stocks “are” Random…

...and does this mean it's not possible to make consistent returns?

5 minute read

Efficient Market Hypothesis is a concept many traders don’t like the idea of since its premise centers around the fact that charting information, publicly available information, and even insider knowledge cannot be used to outsmart the markets. There are three varying weight levels to this hypothesis, all with the underlying characteristic that the price of a stock always trades at its fair market value, implying that all the information available surrounding it has already been 'factored in' to the price. The reason why this doesn’t sit comfortably with traders and investors is that it means that a stock can never be purchased at an undervalued price, or sold at an over inflated value. This entail, means that it is not only impossible to predict what the market will do next, but also means technical and fundamental analysis are effectively, futile endeavors.

Efficient Market Hypothesis
Efficient Market Hypothesis has three strength levels which, to varying degrees, state that the current price level in a market represents fair value given all available information. Random Walk Theory has similar principles, alluding to the fact that price moves are impossible to predict.

The three weight levels which make up Efficient Market Hypothesis are Weak, Semi-Strong and Strong; and these levels directly reflect the types of information which are already present in a stock’s current price. The strongest form suggests that even insider trading information is ‘priced in’ to a stock, and so even by acquiring this knowledge, there is no advantage to be gained. Once an individual holds this viewpoint, then they are succumbing to the idea that future price movements are impossible to predict, and that the movements in stocks are completely random (which is how I personally see the market also). This is where the hypothesis has strong ties to Random Walk Theory - a theory that market movements are totally unsystematic, and akin to taking a random walk.


This model states that all historic price levels and volumes are already incorporated into the current price. It implies that technical practitioners cannot predict price moves by simply looking at a stock’s previous trading levels, and dismisses the relevance of any chart formations such as Elliot Waves, Head and Shoulders, Candlestick Formations, Trend lines, or any other charting techniques. In its weak form, this hypothesis does not state that prices are trading at an equilibrium, and therefore, an advantage can still be gained by means of using fundamental analysis or having access to insider trading information.


A semi-strong form of Efficient-Market Hypothesis takes the weak model into account, but in addition states that all the publicly available information concerning a stock, ie. fundamental analysis, is already reflected in the stock’s current value. This in-turn, deems any analysis undertaken which focuses on profit to earnings ratios, share prices, or historic public statements a non-advantageous strategy in the markets. This form of the hypothesis still allows for an ‘edge’ in the markets by means of insider information, but also leaves a little room for traders who can trade on the latest fundamentals ahead of anyone else.


Many financial institutions trading in today’s markets widely accept that fundamentals are the overriding factor which make up a stock’s price, and whilst previous information has already been accounted for, getting in first whenever any new information is released is their best shot at gaining an edge over competing market participants. This is the reason they invest so heavily in developing computer algorithms that can scan the internet in such a way that allows them to make moves in the markets, based on the latest information, before anybody else.


The strongest form of this market hypothesis says that even insider trading information has already been accounted for in a stock’s current price level, and if this is to be believed, then it means that there is no possible advantage which can be gained in the markets. It would also make it impossible for fund managers to be able to outperform the markets on a consistent basis, bar from any lucky runs, which there are always likely to be a handful of when you have millions of individuals trading in the markets. In fact, Burton Malkiel produced a study which showed that prior to 1996, more than two thirds of professional portfolio managers were outperformed by the S&P500 Index, and moreover, that the correlation between those that outperform in one year versus the next, is weak. Whether market dynamics have evolved since that time, especially with the rise of computerized algorithmic trading, is something that still remains to be seen.

"There are of course, strongly opposed views towards Efficient Market Hypothesis, and many leading economists believe that the fact that bubbles exist in markets is enough on its own to negate the theory in its entirety."

The concept is that stocks must indeed be overvalued, something that EMH does not accept, in order to produce a stock market bubble and result in the ‘pop’ that inevitably follows. The 2008 financial collapse, which came about from what is widely considered to be an asset bubble in the property market adds strength to this argument. Moreover, it demonstrates that even individuals ‘on the inside’ did not have trading positions which were anywhere close to the equilibrium value, thus resulting in an accelerated, sharp and prolonged down move.


In addition, there was also, what these same economists would describes as the ‘Bit-coin bubble’ in 2017. Opposing economists might argue that the price of this stock collapsed so dramatically for other reasons that are more consistent with their EMH model. The argument would be that when the price was at a high level, it was trading there because that represented a fair market value at the time, and when it fell more than 70% in 2018, it was simply reacting to technical, fundamental, and insider information in real time.


Efficient Market Hypothesis is one which many traders struggle to give any credence to, because by doing so, submits them to the idea that it might not be possible to form any kind of system that gives them an edge in the markets. Whilst it is certainly unpopular amongst traders, it has gained its notability due to the fact that a large number of economists believe that a semi-strong form efficiency is at minimum, a fair reflection of current market dynamics. And if you were to ask Joe public their views on the markets, then the over riding majority would likely congregate toward this view point. EMH is a theory that certainly needs careful, and non-subjective consideration by anyone considering trading professionally.


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