On Wednesday, January 27, 2021, the US SEC released a public statement commenting on heightened stock market volatility. The one-paragraph statement said the regulator was “actively monitoring” the volatility that was unfolding in the US capital market and that it would take necessary steps to maintain “orderly and efficient markets.”

Reading the statement once more, two things immediately come to mind. First, the SEC seems to imply that market volatility signals market inefficiency. The regulator also seems to imply that inefficient markets are disorderly and inherently unfair to investors.

The statement begs another urgent question. Does the SEC presume stock market efficiency? In this article, we dive into the issue of market efficiency, and we will enlist Eugene Fama’s Efficient Market Hypothesis (EMH) to spice up the discussion.

What does the EMH have to say about market efficiency?

What does the EMH have to say about market efficiency?

The Efficient Market Hypothesis first made an entrance into global finance in 1970 in a doctoral thesis that Eugene Fama authored. Since the concept of an efficient market is vast, EMH focuses on informational efficiency. The stock market attains this kind of efficiency when asset prices reflect available information immediately after it becomes available.

Efficiency in the perspective of EMH is the ability of the market to assimilate economic information into an asset’s price in a rapid, equable, and accurate manner. Therefore, in a perfectly efficient stock market, there is informational symmetry, which prevents traders’ investment returns from beating the market performance.

Another essential suggestion that EMH makes is that stock prices are random, hence unpredictable. If there were any market imbalances – asset prices being unequal throughout the market – any chances of abnormal profits would be eliminated through arbitrage. In short, a perfect stock market will always push stock prices towards their fair value.

Variations of market efficiency in the context of EMH

While Fama thought stock markets could achieve informational efficiency, he was certain that the market could not achieve absolute efficiency. That is why he segmented the market into variations of efficiency depending on the kind of available information. They include:

  1. Weak form efficiency 

This kind of efficiency exists when stock prices are reflective of all the publicly available fundamental information. In other words, investors cannot gain an edge by performing technical analysis because all the current price movements reflect the fundamentals. In this form of market efficiency, price movements are non-trending, i.e., they follow a random walk. 

  1. Semi-strong form efficiency

When news about a publicly-traded company breaks, investors interpret and react to the reports fast. Each investor will rely on certain biases when interpreting the news, which leads to an inefficient market. If, however, the interpretation of the news is unbiased, the price movement of the stock will fluctuate in a manner that prevents investors from earning excess returns. This form of market efficiency also does not allow technical/fundamental analysis to produce market-beating trades.

  1. Strong form efficiency

In this scenario, a stock’s price reflects all the information there, both private and public. This form of market efficiency is impossible under current circumstances anywhere in the world because of insider trading regulations. 

Illustration of what market efficiency means from EMH’s perspective 

Consider a company operating in the technology sector. It trades on NASDAQ; let us call it TEK Inc. TEK Inc. It puts out information that releases a new enterprise software to make customer relationship management (CRM) more efficient. This news release should not impact TEK Inc.’s share price if the stock market is efficient. Why?

Illustration of what market efficiency means from EMH’s perspective

Let us assume that NASDAQ is an efficient market. If so, the current TEK Inc.’s share price considers all the company’s information, including the release of the new CRM software. Therefore, all investors on NASDAQ could predict that TEK Inc. would unveil the CRM software at a certain, and would have already priced the information in the share price. 

According to EMH, market efficiency does not mean …

… that the current share price is the true value

From TEK Inc.’s illustration, one might think that market efficiency insinuates that the prevailing share price is the real price. Far from it. The implication here is that share prices are non-trending – past performance is not a basis for future prices. It means investors cannot consistently predict the future direction of a share price.

… that investors are rational

One of the principal topics that Behavioral Economists tackle daily is how different market participants interpret share price information. For a market to achieve perfect efficiency, all participants should act reasonably, which implies that stock market traders are rational. However, rationality is not a necessary condition for market efficiency, according to EMH. Stock markets can only achieve meaningful efficiency if rationality is independent and uncorrelated. 

Problems with EMH

Efficient Markets Hypothesis (EMH) suffers its biggest blow when it comes to access to information. As it is currently, the dissemination of tradeable information in the stock market is asymmetric. For example, high-frequency traders have a time advantage against all the other participants. As such, there is no way investors can make identical trading decisions.

Another problem with EMH is the psychology of investors. Some people panic easily, while others can hold their own under intensive pressure. Whenever emotions come into the picture, investment decisions will never be similar. 

Conclusion

Back to the SEC statement at the beginning of this article. It seems the inefficiencies that triggered the heightened volatility stemmed from informational asymmetry. Hedge funds had heavily shorted some stocks beyond capacity, some as much as 140%. Senator Elizabeth Warren’s statement accused the hedge funds of treating “the stock market as their own personal casino…” The implication here is that big players are distorting the stock market.

EMH might not have much to say about the issue that the SEC and Senator Warren are referring to, but its primary concept helps to see through the complexity. Also, careful consideration of the issue helps you to see the weaknesses of EMH; that informational efficiency is not the only aspect of stock markets that matters.