Question

What is an efficient market? Describes three forms of the efficient-market theory. Explain how technical analysts and fundamental analysts help keep the stock market efficient.

Answer 1

An efficient stock market is one in which the price for any given stock effectively represents the true intrinsic value or fair price of the stock. According to this-

----> security prices reflect all available information and

----> adjust rapidly to the new information.

Hence, any time is good time to but or sell and security price change only in case if inflow of new information. Since the inflow of new information is unpredictable, security price changes cannot be predicted. If the new information is good security price will adjust upward immediately and if it happens to be bad then the prices will adjust downward instantaneously.

The basic idea behind market efficiency is that investors are rational and demand and supply forces prevailing in capital market are such that market price happens to be the true worth or fair price of the security.

There are three forms of EMH:

• weak form
• semi-strong form and
• strong form

The forms of market efficiency and the use of  fundamental analysis and the technical analysis by analysts can be explained as under-

1) Weak Form of market efficiency: In this all past information is priced into securities. Accordingly one cannot predict tomorrow price on basis of past prices.

Fundamental analysis of securities can provide an investor with information to produce returns above market averages in the short term, but there are no "patterns" that exist. Therefore, fundamental analysis does not provide long-term advantage and technical analysis will not work.

2) Semi-Strong Form of market efficiency: In this form security prices reflect not only past information but also all publically available information. Any good or bad news once made to public will have immediate effect on stock prices. Only those traders can outperform the market who have insider information.

Neither fundamental analysis nor technical analysis can provide an advantage for an investor.

3) Strong Form of market efficiency: In this all information, both public and private, is priced into stocks and that no investor can gain advantage over the market as a whole. All the information about the security is already reflected in its prices. It is only inflow of new information that can change security prices.

Neither fundamental analysis nor technical analysis can provide an advantage for an investor.

One of the important implication of market efficiency is that No one can outperform the market on consistent basis over long term. This is because security price anytime reflect the true/fair value. However short term fluctuations or adjustments may provide some gains to some investors at time.But in long run no one can outperform the market.

Hope it clarifies!