Nobel Price for Father of the Efficient Market Hypothesis

Abstract

Dear readers,Followers of the efficient market hypothesis finally lived to see andme among them when Eugene F. Fama, of the University of Chicago, hasearned on 14th October 2013 the Nobel Prize in economics. To be moreprecise: the Sweden's Central Bank's prize in economic sciences for thedevelopment of economics in memory of A. Nobel. The father of theefficient market hypothesis, E. F. Fama assumes that stock prices areinfluenced by both fundamental and non-fundamental information. A liquidstock market is considered by Fama as efficient when it absorbs veryquickly and accurately all important unexpected information. The marketprice of stocks on the liquid market is of the correct value, stocks areusually correctly priced and it is practically impossible to find undervaluedor overvalued stock titles on the market. The term efficient is used in thesense of ability to handle the unexpected information. The Fama’s workfrom 1965,1 in which he concluded that the prices on the American stockmarket with blue chips behave randomly, was of tremendous importancefor the efficient market hypothesis. This work has become a watershedfrom which very often dates the formation of efficient market hypothesisin American literature. Fama’s empirical research on the University ofChicago primarily focused on testing the hypothesis of efficient behaviorof stock markets in the following decades.2The efficient market hypothesis looks, at first glance, very logically,conclusively, and can explain the behavior of the stock prices in elegantmanner. Fama’s concept of the efficient markets does not anticipate thatinvestors are able to identify the future market price faultlessly. It onlyclaims that the current market price is the objective price, because itincludes all available ratemaking information. The stock market pricesthen behave randomly because investors constantly analyze the stockmarket, reflecting new information in their investment decisions, trying toachieve maximum yield in view of the risk and the liquidity. Investors dotherefore behave rationally, which then also means that even the stockmarket shows signs of rational behavior.Stock markets can have different degrees of efficiency. The weakformefficiency means that current stock price contains all the informationthat can be obtained from historical data. Therefore the investor cannotpredict the future using data from past translations and a movement andchange of the stock price is random. If the past trend cannot be used forthe prediction of the future development, then neither the Charles Dow’stheory (constituting the theoretical basis of technical analysis) can clarifythe nature of the behavior of stock prices.The semi-strong efficiency is a situation in which current stock priceincludes not only historical data, but responds also very quickly andaccurately to the publication of the new public information. If the stockmarket behaves efficiently in semi-strong form, then it is impossible to findincorrectly priced investment instruments on the stock market. In thesemi-strong form of stock markets makes sense neither technical analysis,nor the theory of intrinsic value, which forms the core of fundamentalanalysis. Strong-form efficiency signifies that the current stock pricereflects both public and private pricemaking information. In this form, notonly an analytical activity in the form of a technical or fundamentalanalysis loses its importance, but also non-public information is becomingworthless, because they are absorbed in the stock exchange as well.Efficient market hypothesis stands for an explanation of the behaviorof stock prices and represents the mainstream of modern investmenteconomics, which, however, has picked for its "laboratory" mainly theAmerican stock market as the largest, the most liquid and the mostadvanced stock market of the world. The vast majority of the world'seminent investment economists agree that the most liquid stocks on theUS stock market behave relatively economically efficiently.3 However, itshould also be realized that the efficiency of stock markets is not constant,but may change over time, because not only stock market liquidity doesvaries, but also occasionally a significant and groundbreaking change in theinvestment environment occurs, which may complicate fast and accurateabsorption of completely new ratemaking information for some time.Testing of the efficient market hypothesis has gradually begun tofocus on less liquid stock markets. It has also become a favorite theme ofempirical research in the Central European area. Tests which examinedthe efficiency of those markets in the 1990s came to the conclusion thatstock markets behave in most cases in an inefficient way. By contrast, thetests from the new millennium bring more and more evidence that theinefficiency of the most liquid stocks on the Central European marketshas decreased significantly and that they behave even efficiently in theweak-form in some periods, which means that technical analysis does notbring benefit in framing stock strategy even on the underdeveloped CentralEuropean equity markets.Supporters of the theory of efficient markets may, however, rejoiceonly partially, because this year's Nobel Prize for Economics acquiredalong with Fama also significant critics of Fama’s explanation of thestock market behavior at the same time, both a representative ofthe theory of behavioral finance Robert J. Shiller (Yale University), andLars Peter Hansen (University of Chicago), specializing in the econometricmodels of the behavior of equity instruments’ prices.