In 1953 Kendall reported that no patterns could be fit to price movement and that all prices moved randomly. There was little or no statistical correlation to be found. His idea is that there is no hope of being able to predict movements on the exchange for a week ahead without extraneous information.
By extraneous information he is referring to ‘insider trading’ by which someone knows information about a certain security that has not yet been made public. This type of activity is illegal, usually conducted by people within the industry or institution that have a better chance of finding this information out earlier. Samuelson (1965) supports statements by Kendall and even criticized that he found only the slightest serial correlation. In his work he describes market prices as a ‘random walk’. His theory is that in a competitive market there is one buyer for every seller. Everyone has the same information and therefore if someone is certain a price is to go up it would have already happened.
Can you make a profit in the markets?
Samuelson believes there is no way of making an expected profit using probability theories, charts, and other mathematical formulas. He does explain (for the corn market) that prices vary with macroeconomic supply and demand factors such as taste changes, income and crop yields. But news or information on these aspects themselves can be randomly good or bad, hence even if price is reactant to information they will still be random.
Ball & Brown (1968, p.160) conducted further studies on the concept of information determining prices. In their report is quoted … “capital markets are both efficient and unbiased in that if information is useful in forming of capital asset prices, then the market will adjust asset pricing to that information quickly and without leaving further opportunity for further abnormal gain”. An experiment they conducted was to see how market prices of particular shares with certain abnormal behaviour reacted on the release day of its quarterly annual report shown in Figure 1
At point zero on the bottom axis is the release date. Across the side is % price movement. Before the release date bits of information are given as to whether the report is expected to be good or bad. For example, news reports on how sales have been for a certain company or if it has opened new stores. As can be observed this information is digested and taken into account by the market and interpreted into the price before the actual figures have been released. When they are released prices level out again. This supports that the market is efficient in discounting information into the price quickly and efficiently whether it be bad or good.
Source <Ball & Brown (1969)>
An event study shown in Opong (1996) again supports the theory of market efficiency. He observed the movement of price 8 hours before and after the preliminary annual report of 227 firms from June 1993 – October 1993. In Table 4 below are the results he found;
Source <Opong (1996)>
The table extracted from the report highlights the probability of the change of price ranging significantly from zero. Firstly observed are all other hours besides -8 and 0 and 1. Looking at these results it is clear there is no statistically significant changes in the absolute mean excess return (see probability column). However by observing hour 1 and 0 primarily, a significant change in the prices can be seen throughout. These results support the theory that prices are reactant to information. It also illustrates that the market processes and factors the information into the price efficiently since after these hours the results become insignificant. One last result to observe is the -8 hour. Significant changes in price are shown at the 0.01 level (99%) 8 hours before the information has been made public suggests that insider trading may have occured. People in the industry could be receiving these results and trading on the information earlier than it gets announced to the public (Opong, 1996).
Fama (1970, 1991) broke down market efficiency down into three categories;
1, Weak Form – (test for return predictability) all information about the future is discounted into the price of the share
2, Semi Strong (event studies) prices adjust immediately and in an unbiased way to new information.
3, Strong form (tests for private information) refers to insider trading where information that is not made public is known and used to make a profit. This is illegal but seems to be one the only way to make substantial gains in the market
The results discovered by Ball & Brown, Samuelsson, and Kendall support that the market price movement is random. Even though it does react to information, this information can be randomly better or worse than expected and the market digests this information into the price quickly leaving little time to make substantial gains on any market investment.
Pilbeam’s (2010) textbook supports the statements and work of the previous authors mentioned. He states in various chapters that, although people have tried, previous behaviour of the price of a security should have no indication on what will happen in the future. Pilbeam explains the best indicator is the price as it is at that current time. He also explains that the vast majority of testing methods do indicate a random walk.
In the Pilbeam (2010) text, he suggests that if the EMH test for weak form efficiency holds true, then Technical Analysts and Chartists who attempt to forecast future price direction are doing so at no profitable use.
The EMH uses all the available information efficiently when determining the price of any securities. Therefore, if a company chooses to cut its dividends in order to retain profit, on the news of this the market should adjust price efficiently to re-consider all future profitability (Howells & Bain 2007).
Some financial analysts and economists take the idea of EMH a step further. They believe that not only are the prices are unpredictable but also believe that the market price reflects the intrinsic value of the security i.e. the underlying fundamentals of the security. They believe this makes the financial markets perfectly efficient (Howells & Bain 2007). This stronger view of market efficiency gives rise to three fundamental problems;
- All investments are just as good as one another other because the security prices are correct.
- All available information about the intrinsic value is reflected in the price.
- Mangers can use the security prices to make accurate decisions as to whether an investment is worth making.
How about market psychology and behavioural finance?
Proof that the above statements cannot be assumed is seen in the existence of market bubbles and crashes, where the price of assets can fall or rise well beyond the fair market value.
Of course we don’t take the above theory as gospel. This information is quite dated and doesn’t take in to consideration many factors such as behavioural finance and herd mentality of psychological trading.