Historical background

The efficient market hypothesis was first expressed by Louis Bachelier, a French
mathematician, in his 1900 dissertation, "The Theory of Speculation". His work
was largely ignored until the 1950s; however beginning in the 30s scattered,
independent work corroborated his thesis. A small number of studies indicated
that US stock prices and related financial series followed a random walk model.
[1]
Also, work by Alfred Cowles in the 30s and 40s showed that professional
investors were in general unable to out perform the market. The efficient
market hypothesis emerged as a prominent theoretic position in the mid-1960s.
Paul Samuelson had begun to circulate Bachelier's work among economists. In
1964, Bachelier's dissertation along with the empirical studies mentioned above
were published in an anthology edited by Paul Coonter [2]. In 1965, Eugene
Fama published his dissertation[3] arguing for the random walk hypothesis and
Samuelson published a proof for a version of the efficient market hypothesis [4].
In 1970 Fama published a review of both the theory and the evidence for the
hypothesis. The paper extended and refined the theory, included the definitions
for three forms of market efficiency: weak, semi-strong and strong (see below)
[5]
.

Theoretic background
Beyond the normal utility maximizing agents, the efficient market hypothesis
requires that agents have rational expectations; that on average the population
is correct (even if no one person is) and whenever new relevant information
appears, the agents update their expectations appropriately. Note that it is not
required that the agents be rational (which is different from rational
expectations; rational agents act coldly and achieve what they set out to do).
EMH allows that when faced with new information, some investors may
overreact and some may underreact. All that is required by the EMH is that
investors' reactions be random and follow a normal distribution pattern so that
the net effect on market prices cannot be reliably exploited to make an
abnormal profit, especially when considering transaction costs (including
commissions and spreads). Thus, any one person can be wrong about the
market — indeed, everyone can be — but the market as a whole is always right.
There are three common forms in which the efficient market hypothesis is
commonly stated — weak form efficiency, semi-strong form efficiency and
strong form efficiency, each of which have different implications for how
markets work.

Weak-form efficiency

No excess returns can be earned by using investment strategies based

on historical share prices.
 Weak-form efficiency implies that Technical analysis techniques will not
be able to consistently produce excess returns, though some forms of
fundamental analysis may still provide excess returns.
In a weak-form efficient market current share prices are the best,
unbiased, estimate of the value of the security. Theoretical in nature,
weak form efficiency advocates assert that fundamental analysis can be
used to identify stocks that are undervalued and overvalued. Therefore,
keen investors looking for profitable companies can earn profits by
researching financial statements.

Semi-strong form efficiency

 Share prices adjust within an arbitrarily small but finite amount of time
and in an unbiased fashion to publicly available new information, so that
no excess returns can be earned by trading on that information.
 Semi-strong form efficiency implies that Fundamental analysis techniques
will not be able to reliably produce excess returns.
 To test for semi-strong form efficiency, the adjustments to previously
unknown news must be of a reasonable size and must be instantaneous.
To test for this, consistent upward or downward adjustments after the
initial change must be looked for. If there are any such adjustments it
would suggest that investors had interpreted the information in a biased
fashion and hence in an inefficient manner.

Strong-form efficiency

 Share prices reflect all information, public and private and no one can
earn excess returns.
 If there are legal barriers to private information becoming public, as with
insider trading laws, strong-form efficiency is impossible, except in the
case where the laws are universally ignored. Studies on the U.S. stock
market have shown that people do trade on inside information.
 To test for strong form efficiency, a market needs to exist where investors
cannot consistently earn excess returns over a long period of time. Even
if some money managers are consistently observed to beat the market,
no refutation even of strong-form efficiency follows: with tens of
thousands of fund managers worldwide, even a normal distribution of
returns (as efficiency predicts) should be expected to produce a few
dozen "star" performers.

Arguments concerning the validity of the hypothesis

Some observers dispute the notion that markets behave consistently with the
efficient market hypothesis, especially in its stronger forms. Some economists,
mathematicians and market practitioners cannot believe that man-made
markets are strong-form efficient when there are prima facie reasons for
inefficiency including the slow diffusion of information, the relatively great
power of some market participants (e.g. financial institutions), and the
existence of apparently sophisticated professional investors. The way that
markets react to surprising news is perhaps the most visible flaw in the efficient
market hypothesis. For example, news events such as surprise interest rate
changes from central banks are not instantaneously taken account of in stock
prices, but rather cause sustained movement of prices over periods from hours
to months. Only a privileged few may have prior knowledge of laws about to be
enacted, new pricing controls set by pseudo-government agencies such as the
Federal Reserve banks, and judicial decisions that effect a wide range of
economic parties. The public must treat these as random variables, but actors
on such inside information can correct the market, but usually in a discreet
manner to avoid detection.
Another observed discrepancy between the theory and real markets is that at
market extremes what fundamentalists might consider irrational behaviour is
the norm: in the late stages of a bull market, the market is driven by buyers
who take little notice of underlying value. Towards the end of a crash, markets
go into free fall as participants extricate themselves from positions regardless of
the unusually good value that their positions represent. This is indicated by the
large differences in the valuation of stocks compared to fundamentals (such as
forward price to earnings ratios) in bull markets compared to bear markets. A
theorist might say that rational (and hence, presumably, powerful) participants
should always immediately take advantage of the artificially high or artificially
low prices caused by the irrational participants by taking opposing positions, but
this is observably not, in general, enough to prevent bubbles and crashes
developing. It may be inferred that many rational participants are aware of the
irrationality of the market at extremes and are willing to allow irrational
participants to drive the market as far as they will, and only take advantage of
the prices when they have more than merely fundamental reasons that the
market will return towards fair value. Behavioural finance explains that when
entering positions market participants are not driven primarily by whether
prices are cheap or expensive, but by whether they expect them to rise or fall.
To ignore this can be hazardous: Alan Greenspan warned of "irrational
exuberance" in the markets in 1996, but some traders who sold short new
economy stocks that seemed to be greatly overpriced around this time had to
accept serious losses as prices reached even more extraordinary levels. As John
Maynard Keynes succinctly commented, "Markets can remain irrational longer
than you can remain solvent." The efficient market hypothesis was introduced in
the late 1960s. Prior to that, the prevailing view was that markets were
inefficient. Inefficiency was commonly believed to exist e.g. in the United States
and United Kingdom stock markets. However, earlier work by Kendall (1953)
suggested that changes in UK stock market prices were random. Later work by
Brealey and Dryden, and also by Cunningham found that there were no
significant dependences in price changes suggesting that the UK stock market
was weak-form efficient. Further to this evidence that the UK stock market is
weak form efficient, other studies of capital markets have pointed toward them
being semi strong-form efficient. Studies by Firth (1976, 1979 and 1980) in the
United Kingdom have compared the share prices existing after a takeover
announcement with the bid offer. Firth found that the share prices were fully
and instantaneously adjusted to their correct levels, thus concluding that the UK
stock market was semi strong-form efficient. The market's ability to efficiently
respond to a short term and widely publicized event such as a takeover
announcement, however, cannot necessarily be taken as indicative of a market
efficient at pricing regarding more long term and amorphous factors. Other
empirical evidence in support of the EMH comes from studies showing that the
return of market averages exceeds the return of actively managed mutual
funds. Thus, to the extent that markets are inefficient, the benefits realized by
seizing upon the inefficiencies are outweighed by the internal fund costs
involved in finding them, acting upon them, advertising etc. These findings gave
inspiration to the formation of passively managed index funds.[6] It may be that
professional and other market participants who have discovered reliable trading
rules or stratagems see no reason to divulge them to academic researchers. It
might be that there is an information gap between the academics who study the
markets and the professionals who work in them. Some observers point to
seemingly inefficient features of the markets that can be exploited e.g seasonal
tendencies and divergent returns to assets with various characteristics. E.g.
factor analysis and studies of returns to different types of investment strategies
suggest that some types of stocks may outperform the market long-term (e.g in
the UK, the USA and Japan). Skeptics of EMH argue that there exists a small
number of investors who have outperformed the market over long periods of
time, in a way which is difficult to attribute to luck, including Peter Lynch,
Warren Buffett, George Soros, and Bill Miller. These investors' strategies are to
a large extent based on identifying markets where prices do not accurately
reflect the available information, in direct contradiction to the efficient market
hypothesis which explicitly implies that no such opportunities exist. Among the
skeptics is Warren Buffett who has argued that the EMH is not correct, on one
occasion wryly saying "I'd be a bum on the street with a tin cup if the markets
were always efficient" and on another saying "The professors who taught
Efficient Market Theory said that someone throwing darts at the stock tables
could select stock portfolio having prospects just as good as one selected by the
brightest, most hard-working securities analyst. Observing correctly that the
market was frequently efficient, they went on to conclude incorrectly that it was
always efficient." Adherents to a stronger form of the EMH argue that the
hypothesis does not preclude - indeed it predicts - the existence of unusually
successful investors or funds occurring through chance. In addition, supporters
of the EMH point out that the success of Warren Buffett and George Soros may
come as a result of their business management skill rather than their stock
picking ability. It is important to note, however, that the efficient market
hypothesis does not account for the empirical fact that the most successful
stock market participants share similar stock picking policies, which would seem
indicate a high positive correlation between stock picking policy and investment
success. For example, Warren Buffett, Peter Lynch, and George Soros all made
their fortunes exploiting differences between market valuations and underlying
economic conditions. This notion is further supported by the fact that all stock
market operators who regularly appear in the Forbes 400 list made their
fortunes working as full time businesspeople, most of whom received college
educations and adhered to a strict stock picking philosophy they developed at a
relatively early age. If "throwing darts at the financial pages" were as effective
an approach to investment as deliberate financial analysis, one would expect to
see casual, part time investors appearing in rich lists as frequently as
professionals like George Soros and Warren Buffett. The efficient market
hypothesis also appears to be inconsistent with many events in stock market
history. For example, the stock market crash of 1987 saw the S&P 500 drop
more than 20% in the Month of October despite the fact that no major news or
events occurred prior to the Monday of the crash, the decline seeming to have
come from nowhere. This would tend to indicate that rather irrational behaviour
can sweep stock markets at random. Burton Malkiel, a well-known proponent of
the general validity of EMH, has warned that certain emerging markets such as
China are not empirically efficient; that the Shanghai and Shenzhen markets,
unlike markets in United States, exhibit considerable serial correlation (price
trends), non-random walk, and evidence of manipulation.[7]

The EMH and popular culture

Despite the best efforts of EMH proponents such as Burton Malkiel, whose book
A Random Walk Down Wall Street achieved best-seller status, the EMH has not
caught the public's imagination. Popular books and articles promoting various
forms of stock-picking, such as the books by popular CNBC commentator Jim
Cramer and former Fidelity Investments fund manager Peter Lynch, have
continued to press the more appealing notion that investors can "beat the
market." The theme was further explored in the recent The Little Book That
Beats The Market (ISBN 0-471-73306-7) by Joel Greenblatt. One notable
exception to this trend is the recent book Wall Street Versus America (ISBN 1-
59184-094-5), by investigative journalist Gary Weiss. In this caustic attack on
Wall Street practices, Weiss argues in favor of the EMH and against stock-
picking as an investor self-defense mechanism. EMH is commonly rejected by
the general public due to a misconception concerning its meaning. Many believe
that EMH says that a security's price is a correct representation of the value of
that business, as calculated by what the business's future returns will actually
be. In other words, they believe that EMH says a stock's price correctly predicts
the underlying company's future results. Since stock prices clearly do not reflect
company future results in many cases, many people reject EMH as clearly
wrong. However, EMH makes no such statement. Rather, it says that a stock's
price represents an aggregation of the probabilities of all future outcomes for
the company, based on the best information available at the time. Whether that
information turns out to have been correct is not something required by EMH.
Put another way, EMH does not require a stock's price to reflect a company's
future performance, just the best possible estimate of that performance that
can be made with publicly available information. That estimate may still be
grossly wrong without violating EMH.