Strong form Efficiency of Market
To understand the efficient markets hypothesis as outlined in Roberts (1967) and Fama (1970), we first have to understand the efficient market. An efficient market refers to a market, which is composed of large proportions of rational, profit maximizers who are competing actively, with each trying to predict the future market values of individual securities and where current market information is available freely to all participants. In an efficient market, competition among the participating individuals creates a situation whereby the actual prices of individual securities reflect the effects of information based both on events that have already occurred and on events that the market expects to happen in the future (Kurth 2013). Hence, in an efficient market the actual price of a security will be a good estimate of its intrinsic value (Fama, 1970). There are three distinct levels at which a market can be efficient. These are strong, weak or semi-strong as outlined by Fama. The efficient market hypothesis (EMH) asserts that prices at all times fully reflect all available information that is present and relevant to their valuation (Fama, 1970). The EMH presents the argument that the competition between investors seeking major profits drives prices above their fair value.
Hence, it is critical that prices incorporate the information present in the market. Consequently, the ability of a stock market to incorporate information into prices portrays its levels of efficiency. The conditions for efficiency are; there are no transaction costs in trading securities, all information is costless and available to the market participants and all agree on the implication of current information for the current price and distribution of future prices of each security (Fama 1970). These are present but not necessary conditions of efficiency. The EMH can therefore be more precisely defined with respect to the information item present to the market participants (Fama 1970).
In its strongest form the EMH says a market is efficient if all the information relevant to the value of share is quickly available in an accurate form as reflected in the market prices. This is whether it is generally available to potential investors. Although it is difficult to confirm empirically as the necessary research would be unlikely in winning the cooperation of the relevant section of the financial community.
The financial points in the strong-form EMH are:
I. The Share prices reflect all information present in the market and no one can earn excess returns.
II. A market needs to exist where investors cannot earn excess returns over long periods. When the topic of inside trading is introduced, the idea of a strong form market seems impossible.
III. If there are fund managers who have consistently beaten the market then it fails to be recognized as strong form efficient. The available evidence suggests that stock markets are unlikely to be strong form efficient.
If the market price is lower than the value justified by some piece of privately held information the holders of the information will exploit this error by buying the shares. This will continue until the sustained demand for the shares has driven the prices to the level similar to that held by the piece of information they hold (Arouri et al., 2010). They will then have no incentive to buy at which point they will exit from the market and the price will stabilize to this new equilibrium level. This is called the strong form of the EMH.
The Strong Form Efficient Markets Hypothesis
As espoused earlier, the strong form efficiency of market relates to a situation when prices are reflective of all relevant information, both public and non-public. The endorsement of this type of efficiency shows, that neither investors who rely on readily available information, nor those who have access to the non-public information, are in a position to “beat the market” and attain abnormal rates of return. Intuitively, the strong form efficient market hypothesis appears to be false (Ho & Lee, 2004). This is due to the impossibility of public and non-public information to be captured in the price of a stock before it has reached the market and is yet to be discounted in the existing price. The available valuation criteria for the strong form efficient market is largely limited to undertaking an examination of the accomplishments of institutional investors, given that they were the subjects with unrestricted access to the non-public information as well as complex investment tools, which enabled comparison of these successes (often) to the weighted-capitalization market index (Arouri et al., 2010).
Until the 1960s, there was little research materials depicting outcomes of expert investment portfolios managers. To add to the explanation offered by Markowitz’s theory, researchers increasingly employed the CAPM model as a benchmark for paralleling the profitability of different investment fund performance (Elton, 2010). A pioneering publication assessing returns attained by investment funds was one by Jensen (1969) that involved an evaluation of 115 investment funds spanning from 1945-1964. The findings of this extensive study revealed that investment funds attain abnormal rates of return; nonetheless, taking into consideration the payment of fees together with expenses, the researcher made a conclusion that, averagely, the investment funds did not realize sufficient success in their trading activities to enable them recover at the very minimal their brokerage expenses. In this regard, therefore, the activities carried out using relevant information often do not guarantee generation of profits that exceed the average rate of return. Jensen’s conclusions are solid supporting evidence for the validity of the strong form of the efficient market hypothesis.
However, results from a research done by Jaffe (1974) contradicted Jensen’s findings as espoused above. Jaffe’s findings pointed to the probability of realizing profits greater than the market average where non-public information is utilized. This effectively challenged the validity of the strong form of the efficient market hypothesis. As relates to studies on the strong form efficiency, it therefore probable it is unrealistic to ignore such critique of the hypotheses, especially as concerns evaluation of investment fund results or other examination of profitability of recommendations provided by expert analysts (Elton, 2010). This further invites arguments for discussions relating to semi-strong efficiency theory and the strong form hypothesis, as a result of the discrepancies in conveying recommendations to sets of public and non-public information. In addition, it is highly challenging to establish which subset of information that is available to an analyst bears greater weight as relates to assets evaluation (Boatright, 2010).
Research findings conducted by Ambachtsheer (1972, 1974) in the American market as well as another by Fitzgerald (1975) in the British market, provide further reasons for the rejection of the validity of the strong form of efficient market hypothesis in a given capital market. The researches argue for the prospect of “beating the market”. Nonetheless, Gruber (1998) challenge the reliability of these two papers, taking issue with the selection of data procedure that the researchers employed to reach their findings. Gruber raised a suspicion that the data selection process that provided the recommending institutions with access to the reports may have contributed to manipulation of a section of ex post data.
Interestingly, Dimson and Marsh (1984) refuted the aforementioned allegation, basing their research on a relatively larger set of information retrieved from investment fund doing business in the British market. The researchers analyzed data collected from 35 brokerage houses and referred to up to 200 companies registered on the British stock exchange. Basing on the a set of about 4000 forecasts, the researchers showed poor dependence between the forecast returns on the one hand and those actually realized on the other. This indicates that expert analysts are by no means in a position to make accurate forecasts on movement of firms’ asset prices. At the same time, transactions concluded on the foundation of such recommendations enables investors to attain better results in a certain period relative to what they would achieve using a benchmark interest rate (Boatright, 2010). In this regard, therefore, one can reach the supposition that non-public recommendation together with forecasts produced by expert analysts serve the purpose of enable investors to “beat the market”. This effectively refutes the validity of the strong form efficient market.
Keown and Pinkerton (1981), provided strong evidence for attaining abnormal return rates by insiders prior to the public proclamation of planned mergers. The study, conducted between 1975 and 1978, sample a total of 194 companies. The analyzed return rates enables us to form a postulation to the effect that trade and utilization of non-public information is indeed a common practice by managers and organizations. According to the researchers, using non-public information inside a period of 12 days prior to its public announcement, makes it possible for investors to attain abnormal rates of return (Correia, 2007). In this regard, the results reject the existence of the strong form of efficient market hypothesis.
Results by Morse (1980) as well as Penman (1982) demonstrated the inefficiency of the American stock market. In Morse’s study, there were notable increase in sales volume along with the potential of attaining abnormal return rates a day before publication of the merger report of financial statements of a firm. Also, Penman utilized data gathered by U.S. Security and Exchange Commission, after which he was able to prove the possibility of insiders achieving premium profits from purchasing assets in the lead up to the public declaration of the information followed by their sale immediately after the announcement. This implies that insiders in possession of non-public information, not reflected in the offered share price, can successfully “beat the market” during the short run (Ogilvie, 2008). This is in support of the hypothesis previously espoused by other researchers whose evidence demonstrated the prospect of realizing abnormal return rates via the use of non-public information, thereby rejecting the validity of the strong form efficient markets.
Other researchers such as Kara and Denning (1998) have addressed this topical area. In their study, they analyzed about 370,000 transactions performed by insiders between the periods of 1979-1980, building on information from the U.S. SEC. The study rejected the the strong form of efficient market hypothesis in the financial instruments’ market (N.Y.S.E. and Amex) on the basis of gathered data on both purchases and sales by insiders. The authors further found the average return on analyzed funds to be averagely 3 percent higher than the benchmark rate of return, notwithstanding the fact that circa 40 percent of the concluded transactions were judged as unprofitable.
However, Brown et al. (2003) confirmed the existence of strong form efficiency in the Canadian stock market. The researchers analyzed projections of stock prices as given by analysts of brokerage companies, to which it was ascertained that the analysts working in the Canadian market had access to non-public information. The author showed that the choice between ATP and CAPM models does not impact on the outcomes of the analysis, which in turns adds weight to the argument that the analysts who have access to pertinent non-public information are able to accurately project the movements of prices. These results suggest that projections made by analysts are indeed accurate estimators of the future market situation, thus contradicting Toronto’s strong form of efficient stock market.
Conclusion
To this end, it is clear that the bulk of empirical research on the topical area suggest indicate that timely identification and use of new information can lead to considerable profits for a firm. Insiders who conduct trade transactions relying on non-public information can therefore achieve abnormal return, which in effect disputes the hypothesis of the strong form of efficient market. Generally, in light of the existing evidence, managers and firms must seek to increase their portfolio efficiency through an astute selection of stocks founded on both public and non-public information as well as choose the right time for modifying the quantity of risky assets in the portfolio. It is also clear that the information prepared by analysts on the basis of ratios of portfolio evaluation and used by investment fund managers renders them unable to attain abnormal return rates even after a careful selection of assets and accurate projections of the future economic situation of the market. This paper has presented empirical evidence from several studies arguing to the effect that the existence of a strong form of efficient market hypothesis is not valid.
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