Efficient Markets

Section: Efficient Markets Estimated study time: 45 minutes Content: The Efficient Market Hypothesis (EMH), developed primarily by Eugene Fama in the 1960s and 1970s, asserts that financial market prices fully and immediately reflect all available information. If markets are efficient, active management cannot consistently generate risk-adjusted excess returns (alpha) because any exploitable mispricing is immediately arbitraged away. The EMH has three forms that differ by what "all available information" means. Weak-form efficiency states that prices reflect all historical trading data (prices, volume, returns). Semi-strong form efficiency states that prices reflect all publicly available information (financials, news, analyst reports, economic data). Strong-form efficiency states that prices reflect all information — including private (insider) information. Each form of market efficiency has specific implications for investment strategies. If weak-form efficiency holds, technical analysis (using historical price patterns) cannot generate consistent alpha — all information in historical prices is already incorporated. However, fundamental analysis (using new public information) could still generate alpha if semi-strong efficiency doesn't hold. If semi-strong efficiency holds, fundamental analysis cannot generate alpha either — all public information is already priced in. Only strategies using truly private information would work under semi-strong but not strong-form efficiency. Under strong-form efficiency, even insider information (illegally used) would not generate abnormal returns — an extreme position that most financial economists reject. Empirical evidence on market efficiency is mixed. Evidence supporting weak-form efficiency: studies find that past stock returns have little predictive power for future returns; filter rules and moving average strategies show no consistent alpha after transaction costs. Evidence for semi-strong form: event studies show that stock prices adjust rapidly and correctly to corporate announcements (earnings, dividends, M&A). Evidence against efficiency (market anomalies):…