2-8: Efficient markets hypothesis

During this course, we've been operating under many assumptions. For technical analysis, we assume that there is information in historical price and volume data that we can discover and exploit in advance of the market. For fundamental analysis, we assume that fundamental data like earning can be exploited and traded upon in advance of the market. The Efficient Markets Hypothesis says we're wrong about both.

EMH assumptions

The Efficient Markets Hypothesis assumes the following:

  • Large number of investors - a large number of investors are interested in the market, and are interested in leveraging technical data to make a profit from undervalued securities. Because of all of these investors, any time new information arrives the price moves.
  • New information arrives randomly - new information arrives randomly at different times and rates.
  • Prices adjust quickly - investors are constantly making decisions based on new information, thus the price of a stock is constantly changing due to these decisions.
  • Prices reflect all available information - this is a result of the other three assumptions.

Origin of information

The following are originators of information:

  • Price / volume - used for technical indicators
  • Fundamental - available to everyone, usually released quarterly
  • Exogenous - information about the world that affects the company
  • Company insiders - reflects information that you have vs. information that people outside of the company do not have

3 forms of the EMH

  • Weak - future prices cannot be predicted by analyzing historical prices. This does leave potential room for fundamental analysis.
  • Semi-strong - prices adjust rapidly to new public information. This somewhat prohibits fundamental analysis, and enables insider-information.
  • Strong - prices reflect all information, public and private. This prohibits even insider information from being effective. This hypothesis suggests that the only way to make money is by holding the market portfolio.

EMH prohibition matrix

Below is a matrix breaking down which type of analysis is prohibited by different forms of the EMH: