Efficient Market Theory

Question 1

Internal Efficient Market

Answer 1

An internally efficient market is one in which brokers and dealers compete fairly so that the cost of transacting is low and the speed of transacting is high.

Question 2

External Efficient Market

Answer 2

In an externally efficient market, information is quickly and widely disseminated, thereby allowing each security’s price to adjust rapidly in an unbiased manner to new information so that it reflects investment value.

Question 3

Sources of market information (Weak Form)

Answer 3

Weak Form: Historical information on a company would be available from libraries, bookstores, computer databases and the Internet. This information represents past data. Technical analysts rely on past performance data that would lead to security selection. It is in fact the ability to perform fundamental analysis with the expectation of outperforming the market, that is the key difference between the weak form and the other forms (semi and strong). Only under the weak form, can one analyze all available public information (annual reports, develop and study financial ratios, review all press releases for the company and industry, etc.) and expect to outperform the market. Since under the weak form, fundamental analysis is worthwhile, it is the one form that is most readily acceptable to the financial analyst community.

Question 4

Sources of market information (Semi Strong Form)

Answer 4

Semi-strong Form: Public information includes both historical information and all current publicly known information. This information would include published financial data about companies, government data about the state of the economy, earnings estimates disseminated by companies and securities analysts, and so on. It is important to note, that since all public information is already factored into equity prices, under the semi-strong form fundamental analysis is worthless. The only way to differentiate semi-strong form from the weak form is with the fact that fundamental analysis works under the weak form only. Furthermore, as we will discuss next, under the strong form even inside information has already been factored into a securities price. Therefore, the only way to differentiate the semi-strong and strong forms, is with the use of inside information. (does not allow someone to outperform the market under the strong form, but does under the semi-strong form).

Question 5

Sources of market information (Strong Form)

Answer 5

Strong Form (Perfectly efficient market): All information, including historical, public, and private information is reflected in price. Knowable information would include all relevant valuation data. For example, this includes information known only to corporate insiders, such as imminent corporate takeover plans and extraordinary positive or negative future earnings announcements. Such inside information can be used in two ways:

A corporation’s board of directors can direct the corporation to buy back some of its own shares. This is a way of creating new treasury stock. Thus, the inside information about what the directors think the stock is worth has an impact on the market prices. It is legal to use inside information in this manner.
On the other hand, one of the corporation’s directors, or an outsider, may engage in private trading, based on such inside information. In some countries, including the U.S., it is illegal to utilize inside information in this manner.

Question 6

Conclusions of Efficient Market Theory

Answer 6

Investors who want to buy stocks should avoid doing so late on Friday or early on Monday. Conversely, investors who want to sell stocks should try to sell late on Friday or early on Monday.

If the stocks of small firms are to be purchased, they should be purchased in late December or somewhat earlier. If the stocks of small firms are to be sold, they should be sold in mid-January or somewhat later.

If the stocks of large firms are to be purchased, they should be purchased in early February or somewhat later. If the stocks of large firms are to be sold, they should be sold in late December or somewhat earlier.

If an investor is buying and holding stocks over the duration of the business cycle, a portfolio of value stocks will outperform growth stocks.