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Versions of the Efficient Market

Hypothesis It is common to distinguish among three versions of the EMH: the weak, semistrong, and strong forms of the hypothesis. These versions differ by their notions of what is meant by the term “all available information.” The     w e a k - f o r m    hypothesis asserts that stock prices already reflect all information that canbe derived by examining market trading data such as the history of past prices, trading volume, or short interest. This version of the hypothesis implies that trend analysis is fruitless. Past stock price data are publicly available and virtually costless to obtain. The weak-form hypothesis holds that if such data ever conveyed reliable signals about future performance, all investors already would have learned to exploit the signals. Ultimately, the signals lose their value as they become widely known because a buy signal, for instance, would result in an immediate price increase. The     semistrong-form    hypothesis states that all publicly available information regarding the prospects of a firm already must be reflected in the stock price. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Again, if investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices. Finally, the    strong-form   version of the efficient market hypothesis states that stock prices reflect all information relevant to the firm, even including information available only to com-pany insiders. This version of the hypothesis is quite extreme. Few would argue with the proposition that corporate officers have access to pertinent information long enough before public release to enable them to profit from trading on that information. Indeed, much of the activity of the Securities and Exchange Commission is directed toward preventing insiders from profiting by exploiting their privileged situation. Rule 10b-5 of the Security Exchange Act of 1934 sets limits on trading by corporate officers, directors, and substantial owners, requiring them to report trades to the SEC. These insiders, their relatives, and any associates who trade on information supplied by insiders are considered in violation of the law. Defining insider trading is not always easy, however. After all, stock analysts are in the business of uncovering information not already widely known to market participants. As we saw in Chapter 3 and in the nearby box, the distinction between private and inside informa-tion is sometimes murky. Notice one thing that all versions of the EMH have in common: They all assert that prices should reflect available information. We do not expect traders to be superhuman or market prices to never turn out to be wrong. We will always like more information about a company’s prospects than will be available. Sometimes market prices will turn out in retrospect to have been outrageously high; at other times, absurdly low. The EMH asserts only that at the given time, using current information, we cannot be sure if today’s prices will ultimately prove themselves to have been too high or too low. If markets are rational, however, we can expect them to be correct on average.

T e c h n i c a l    a n a l y s i s   

is essentially the search for recurrent and predictable patterns in stock prices. Although technicians recognize the value of information regarding future economic prospects of the firm, they believe that such information is not necessary for a successful trading strategy. This is because whatever the fundamental reason for a change in stock price, if the stock price responds slowly enough, the analyst will be able to identify a trend that can be exploited during the adjustment period. The key to successful technical analysis is a sluggish response of stock prices to fundamental supply-and-demand factors. This prerequisite, of course, is diametrically opposed to the notion of an efficient market. Te c h n i c a l a n a l y s t s a r e s o m e t i m e s c a l l e d   chartists because they study records or charts of past stock prices, hoping to find patterns they can exploit to make a profit. As an example of technical analysis, consider the relative strength approach. The chartist compares stock performance over a recent period to performance of the market or other stocks in the same industry. A simple version of relative strength takes the ratio of the stock price to a market indicator such as the S&P 500 Index. If the ratio increases over time, the stock is said to exhibit relative strength because its price performance is better than that of the broad market. Such strength presumably may continue for a long enough period of time to offer profit opportunities. One of the most commonly heard components of technical analysis is the notion of   r e s i s t a n c e   l e v e l s    or    s u p p o r t   l e v e l s .    These values are said to be price levels above which it is difficult for stock prices to rise or below which it is unlikely for them to fall, and they are believed to be levels determined by market psychology. The efficient market hypothesis implies that technical analysis is without merit. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any infor-mation that was ever available from analyzing past prices has already been reflected in stock prices. As investors compete to exploit their common knowledge of a stock’s price history, they necessarily drive stock prices to levels where expected rates of return are exactly commensurate with risk. At those levels one cannot expect abnormal returns. As an example of how this process works, consider what would happen if the market believed that a level of $72 truly were a resistance level for stock XYZ in Example8.2 . No one would be willing to purchase the stock at a price of $71.50, because it would have almost no room to increase in price but ample room to fall. However, if no one would buy it at $71.50, then $71.50 would become a resistance level. But then, using a similar analysis, no one would buy it at $71, or $70, and so on. The notion of a resistance level is a logical conundrum. Its simple resolution is the recognition that if the stock is ever to sell at $71.50, investors   mustbelieve that the price can as easily increase as fall. The fact that investors are willing to purchase (or even hold) the stock at $71.50 is evidence of their belief that they can earn a fair expected rate of return at that price.

Fundamental Analysis

uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. Ultimately, it represents an attempt to determine the present discounted value of all the payments a stock-holder will receive from each share of stock. If that value exceeds the stock price, the funda-mental analyst would recommend purchasing the stock. Fundamental analysts usually start with a study of past earnings and an examination of company financial statements. They supplement this analysis with further detailed economic analysis, ordinarily including an evaluation of the quality of the firm’s management, the firm’s standing within its industry, and the prospects for the industry as a whole. The hope is to attain insight into future performance of the firm that is not yet recognized by the rest of the market. Chapters 12 through 14 provide a detailed discussion of the types of analyses that underlie fundamental analysis. Once again, the efficient market hypothesis predicts that most fundamental analysis also is doomed to failure. If the analyst relies on publicly available earnings and industry information, his or her evaluation of the firm’s prospects is not likely to be significantly more accurate than those of rival analysts. There are many well-informed, well-financed firms conducting such market research, and in the face of such competition it will be difficult to uncover data not also available to other analysts. Only analysts with a unique insight will be rewarded. Fundamental analysis is much more difficult than merely identifying well-run firms with good prospects. Discovery of good firms does an investor no good in and of itself if the rest of the market also knows those firms are good. If the knowledge is already public, the investor will be forced to pay a high price for those firms and will not realize a superior rate of return. The trick is not to identify firms that are good but to find firms that are better than everyone else’s estimate. Similarly, poorly run firms can be great bargains if they are not quite as bad as their stock prices suggest. This is why fundamental analysis is difficult. It is not enough to do a good analysis of a firm; you can make money only if your analysis is better than that of your competitors because the market price will already reflect all commonly available information.

Answer 1

This paragraph is about the weak Efficient form of market hypothesis which emphasizes upon that all the available information have already been discounted into the price of the company but it is not properly reflected as excessive return cannot be made out with the use of technical Analysis and fundamental analysis.

it asserts that technical analysis is a combination of various kinds of technical strategies which are a combination of supports and resistance so that it is highly dependent upon the past price performance and it would result into an inappropriate study of technical trends in the past because the past informations are already discounted but they are not still reflected so the excessive rate of return cannot be made through other fundamental analysis or technical analysis.

it asserts that if fundamental analysis would have made excessive return, then the competitors would have also adopted it and made excessive return beating the market rate of return, what it is not easy to beat the rate of return of the market into a weak Efficient market form ,because the prices are unpredictable in nature and they already reflects all the informations which have been announced in the past.

it also asserts that technical analysis is just a belief of various support and resistance which could be different according to the perspective of various investors and it is not uniform in nature so that excessive return cannot be made in a weak efficient form of market using technical analysis and fundamental analysis is not futuristic in nature , So it would also not be able to beat the market rate of return.