Just how efficient are capital markets?

Efficiency of the markets is a topic continually discussed, debated and researched with no real conclusion. Nothing proves this more than the fact that two economists with contradicting theories were both awarded the Nobel memorial prize for Economics in 2013. Eugene Farma and Robert Shiller were both commended for their work on market theories but what exactly is “efficiency”?

Market efficiency is simply how well the current price reflects information, be it public or not, and how quickly the market responds to new information. The red line on the diagram above shows a perfectly efficient market where on the announcement date the price reflects the news instantly. However, sometimes markets can react before the official announcement, for example there may be a leak or people with insider information may react and Line 2 shows this change in price before the event. Sometimes markets can overreact to news and Line 3 shows this with a period of deflation afterwards as the market moves back towards efficiency. On some announcements there may be a slow reaction in the market, this is shown by Line 4 and sometimes the market is continually inefficient, as shown by Line 1.

The most widely accepted theory thus far is that of Fama’s (1970) weak-form efficiency which claims that prices reflect all past movements and future movements cannot be predicted by looking at the past. So does this mean that all those city analysts are a waste of money if the markets can’t be predicted? One man who would disagree with is Warren Buffet who has become one of the most successful traders of all time; surely it can’t all just be good luck?

Fama also described stock market efficiency as semi-strong and strong:

Semi-strong efficiency will not just reflect all historic information but the publicly available information as well and the market will react quickly and rationally to new information. This theory also supports that abnormal returns cannot be made by studying information publicly available because the market has already taken into account this information. This hypothesis was supported by earlier evidence in the 60’s and 70’s.

Finally, strong market efficiency would reflect all information, whether it was available to the public or not, so that even ‘insider dealers’ cannot make abnormal returns. This is a “theoretical” ideal but is not often seen in the market.

One of the main themes of Shiller’s theory is that of “rationality”. This is particularly interesting as it considers investor’s decisions when they react to particular news, be it good or bad. For example, bad news to one person may not be bad news to another and this is how market can either overreact or underreact. Shiller compared share price to earnings over a long period of time and found that there were sharp peaks in 1929, just prior to the Wall Street crash and in the late 1990’s before the technical bubble burst. It’s hard not to ask why these irrational ratios weren’t spotted at the time, but as Shiller explains, in a boom so many people are benefitting from higher prices and earnings that nobody is going to burst that bubble.

Kendal (1953) came up with the “random walk” theory, this states that price movements are independent of each other and they will always reflect known information, only changing when new information is released.

So considering all these theories what does efficiency mean for the average investor? If the market is efficient then no abnormal returns will be made unless by chance or if you have access to information that has not been made public. There are also consistent patterns that contradict the efficient market theory such as the effects of the time of day and month.

An interesting example for looking at market efficiency is Tesco, on 22^nd September 2014 news came out about how they had overstated profits by £250m.

We can see here that the major change in price happened before the markets even opened on the Monday, therefore before the majority of people will have even heard the news. This would point to the market being semi-strong efficient as for those seeing the news on Monday morning; the price already reflected this, pointing to an early leak in information.

Overall, I believe it is hard to come to a definite answer to this question. I believe human behaviour can affect the markets and we can never 100% say how people are going to react to certain information. Therefore, I believe markets will never truly be efficient based on the fact people don’t always react in a rational way.