Question

How do you think about this argument? I think the EMH does hold in the stock market in the long run. However, in the short run I am not sure how much the EMH holds up. I believe that mispricing can occur in the short run. The EMH can be challenged with the ideas of momentum investing, behavioral finance, and fundamental analysis. In a truly efficient market, there should be no serial correlation among stock prices, but momentum investors would argue that there are examples of short-term serial correlations that are not zero. With respect to behavioral finance, investors may overreact or underreact to events in the short term and these abnormal returns can continue post event. With respect to fundamental analysis, PE ratios and dividend yields do not consistently predict stock performance in all time periods (Malkiel 2003). In addition, an equity with a small market cap and low trading volume can be easily manipulated by an entity with large amounts of capital, which can also lead to sustained mispricing. However, for the most part I think that in the long run, markets do tend to allocate capital efficiently as long as there is enough liquidity in the markets because investors will always take trades that provide adequate rewards for their risk.

Answer 1

This arguement can broadly be divided in two parts; firstly, effectiveness of EMH in the short term and secondly, effectiveness of EMH in the long term.

As far as short term results are concerned, its highly dependent on investors' psychology. Traders indulged in intra day trading and option trading react on technical charts. And they do trade more on momentary patterns than correlations. The impact of things like momentum investing and behavioral finance in the short run is pivotal. However, fundamental analyses are mostly done with long term perspectives as far as my knowledge of investor sentiment is concerned. Again the total value of intra day trades and option trades consume major portion of the market. Consequentially, in the short term, market will be highly volatile beyond correlation. Hence, I do agree with the fact that substantially EMH does not hold in the short run and impact of patterns on the stock prices are more than the actual correlations.

Now coming to the latter part of the arguement, i.e., effectiveness of EMH in the long run; we need to understand how the market reacts in the long term. There is broad expectation of perfection from the market in the long run. The entire industry of fundamental analysis is based on that assumption of perfect efficiency. But we need to understand that there is no concept of perfectly efficient market. Market will keep on reacting to investors' momentary impulses. Alongside, investors may choose to overreact or underreact to fundamentals even in long run and it is also factual that an equity in small cap and low trade volume is highly prone to manipulaton by the big bulls.

However, it can never be ignored that in the long term investor decision is highly dependent on fundamental analysis. Therefore, market moves towards pattern that is highly expected by analysts and researchers. Since human behaviour can never be perfectly anticipated; market will never result into an absolute anticipated correlation. Absolute perfection can not be expected. But market usually tends towards anticipations and correlations in the long term but not in an absolute term.

Hence, we can conclude the EMH can substantially or reasonably hold in the long run, but not absolutely. Short term boosts on investors' sentiments can never be ignored. So we can expect efficiency from market persuasively, but not conclusively.