Is the market always right?

Companies and investors do not need capital markets to be perfect; but to be efficient and to offer fair prices so they can make reasoned investment and financial decisions (Watson, 2013). In the recent past, there has been much debate questioning the notion that stock markets are efficient. To add to this debate, in 2013 two economists with completely opposing interpretations of the ways markets behave were jointly awarded the 2013 Nobel memorial prize for economics (BBC, 2014). How can two opposing theorists win the same prize?

Market efficiency research goes back to 1900 when Louis Bachelier published his idea that government bonds followed a random course. He understood that if it was obvious that a share would be worth more next week, then surely the price would already have risen in anticipation of that? Correct! Predictable moves have already happened, because the market is efficient – and all that is left are unpredictable surprises.

In the 1960’s, Eugene Fama wasn’t satisfied with Bachelier’s theory as there wasn’t “an economical model behind it”. Fama’s theory established the prices of capital market securities and stated that the prices of securities fully and fairly reflect all relevant available information’. Market efficiency therefore refers to both the speed and the quality of the price adjustment to new information (Watson, 2013). If I was a new investor entering the market, the main consequence of the market being efficient, is that the market would always be one step ahead of me. If this is the case, I would be much better off investing broadly and diversifying my portfolio of shares, to increase my chances of higher returns. This is the concept that underpins Markowitz’s (1952) portfolio theory.

Fame (1970) identified three forms of efficiency:

Weak form efficiency: current share price reflects all past movements, which implies that if I carried out a ratio analysis on a company, it would immediately be out of date. Share prices will change as new information arrives on the market and, since new information arrives at random, share price movements will also be random (Samuelson, 1965). This supports the ‘Random Walk Hypothesis’ theory by Kendal (1953) that there is no systematic link between one price movement and subsequent ones, therefore a share prices at any one time reflects all known information. Because of the nature of the news, when it arrives it is unknown if it will be good or bad.

Semi-strong efficiency: share prices reflect all historic and publicly available information and react quickly and rationally to new information. This means that you can’t make abnormal returns by studying publicly available information, as the market has already adjusted to the news. 

I believe the UK stock market is semi-strong efficient. To support my statement I have created a graph to show Twitter’s share price during the first week of February 2015 (see diagram 1). On the 6^th February, Twitter’s Chief Executive announced that the social media company saw a 97% increase year on year for revenue growth. Based on Fama’s theory, this means that as soon as the news was released, share prices should have immediately reflected this new information. This is exactly what is illustrated by diagram 1.  

Diagram 1: Twitters share price during the first week of February 2015

Strong form efficiency: reflects all information, whether it is publically available or not. Investors cannot make abnormal returns from share dealing, not even investors who act on ‘insider information’. Capital markets clearly do not meet all the conditions for strong form efficiency as prosecutions for this offence has taken place.   

As an investor I might as well behave as though the market is efficient and that nothing is therefore underpriced. The market quickly and rationally integrates new information, as supported by the Twitter example, which therefore means that abnormally high returns can only be made where there is access to information that is not yet published (insider information) or by chance.    

So the market is always right. Or is it?

In 1981 Robert Shiller a challenger to the efficient market hypothesis arrived on the scene. His argument was ‘market volatility is too high for the efficient markets theory to be true’. He believed that investors’ behaviour cannot be fully based on rationality and must acknowledge the role played by psychology (Malkiel, 2003). In the 1980’s, he showed that stock prices tend to fluctuate more than corporate dividends. This should not happen if investors were fully rational, since stock prices forecast future dividends (Financial Times, 2013). His idea was that markets have a tendency to overreact to news, or to react to non-news. 

By using share price data, I have constructed a graph to show the change in Apple’s share price throughout February 2015 (see diagram 2). In two instances during the month, ‘rumours’ circulated within the news about potential new products and release dates. Although no official announcements had been made by Apple, share prices increased even though the news could potentially be ‘non-news’, demonstrating Shiller’s theory that the market overreacts, and in this case to ‘non-news’.

Diagram 2: Apple’s share price over February 2015

Shiller went on to write a best-selling book called Irrational Exuberance, and applied his insights to the US housing market, which he believed was overvalued. He claimed that behaviour of house prices was driven by excessive optimism over future valuations (Shiller, 2007). This finding was proven to be remarkably prescient when the market crashed in 2007.  

In his book, Shiller explained that stock analysts commonly look at how company profits, or earnings, compared to their share price. What Shiller and his colleague John Campbell investigated was the longer-term view of this price earnings ratio. They compared the share price to the average earnings for the past 10 years. This long-term price-earnings ratio showed a sharp peak in 1929, just before the great Wall Street crash. And the peak in the late 1990s was even bigger (The Economist, 2014). So why didn’t investor spot these irrational booms? Stiller compared it to the expression “no-one should shout fire in a crowded theatre”. Earnings were increasing and so were prices. Everything looked positive!

So, is the market always right? As identified in this blog, I expressed that I believe that the U.K's stock market is semi-strong efficient, as demonstrated by the Twitter case when information is released, the market reacts appropriately. On the other hand, Shiller also has a strong argument as the Apple case illustrates that markets do overreact to news, or react to non-news. By applying the two opposing theories to real life events, it is understandable why both theorist were awarded the nobel prize. I believe that both methods will continue to be standard tools in academic research, and provide guidance for the development of theory as well as for investment practice. 

References 

BBC News (2013) Are markets ‘efficient’ or irrational? Retrieved from  http://www.bbc.co.uk/news/magazine-24579616

Malkiel, B. G. (2003). The efficient market hypothesis and its critics. Journal of economic perspectives, 59-82

Shiller, R. J. (1981). The Use of Volatility Measures in Assessing Market Efficiency*. The Journal of Finance, 36(2), 291-304.

Shiller, R. J. (2000). Irrational exuberance. Princeton University Press. 

The Economist (2014) Rational or not? Retreived from http://www.economist.com/blogs/buttonwood/2014/03/equity-markets

The Financial Times (2013) Fama, Hansen and Shiller win Nobel Prize for economics. Retrieved from http://www.ft.com/cms/s/0/6f949e8c-34c1-11e3-8148-00144feab7de.html

The Guardian (2015) Twitter shares soar after sharp revenue increase but growth still slowing. Retrieved from http://www.theguardian.com/technology/2015/feb/05/twitter-shares-soar-revenue-increase-growth-slowing

The Independent (2015) Apple could be planning virtual reality headset. Retrieved from  http://www.independent.co.uk/life-style/gadgets-and-tech/news/apple-could-be-planning-virtual-reality-headset-10053916.html?origin=internalSearch

The Independent (2015). New Apple watch expected to launch. http://www.independent.co.uk/life-style/gadgets-and-tech/news/apple-event-on-9-march-apple-watch-expected-to-launch-10073354.html?origin=internalSearch

Watson (2013) Corporate finance: principles and practice. 6^th Ed.

Diagram 1 - Yahoo Finance (2015) Apple share price figures. Retrieved from https://uk.finance.yahoo.com/q/hp?s=AAPL

Diagram 2 - Yahoo Finance (2015) Twitter share price figures. Retrieved from https://uk.finance.yahoo.com/q?s=TWTR