The Efficient Market Hypothesis (EMH) is a foundational theory in financial economics, asserting that asset prices reflect all available information. The EMH posits that it is impossible to consistently achieve higher returns than the average market return on a risk-adjusted basis, as all known information is already integrated into stock prices.

The EMH is categorized into three distinct forms.

Weak Form Efficiency

This form asserts that all past trading information is reflected in stock prices, implying that technical analysis cannot yield excess returns. The weak form can be represented as:

Where:

• $P_t$ is the current price

• $P_{t-1}$ is the previous price

• $V_{t-1}$ is the trading volume

Studies have shown mixed results regarding the validity of weak form efficiency, with some suggesting that patterns in stock prices can be exploited.

Semi-Strong Form Efficiency

This form posits that all publicly available information is reflected in stock prices. Consequently, neither fundamental nor technical analysis should provide an advantage. The adjustment of stock prices to new public information can be represented as:

Where:

• $I_t$ is the new information

• $P_{opt}(I_t)$ the optimal price given the new information

• $c_{adj}$ is a coefficient representing the speed of adjustment

Research supports this form, indicating that markets react quickly to new information.

Strong Form Efficiency

The strongest form asserts that all information, public and private, is reflected in stock prices. This can be mathematically expressed as:

Where:

• $I_{public}$ is public information

• $I_{private}$ is insider information

This form is widely criticized, as insider trading has shown that individuals with non-public information can achieve superior returns.

Critiques of the EMH

While the EMH has been influential, it has faced significant criticism.

Behavioral Economics

Behavioral economists argue that psychological factors can lead to irrational behavior among investors, resulting in mispriced assets. This can be illustrated with the following equation representing investor sentiment $S$:

Where:

• $S$ is the sentiment

• $c_0$ if a bias coefficient

• $c_1$ is the price margin multiplier coefficient

• $err$ is the error term

Studies have shown that investor sentiment can drive prices away from their fundamental values.

Market Anomalies

Numerous anomalies, such as the January effect and momentum effects, challenge the EMH. For example, the January effect can be expressed as:

Where:

• $R_{January}$ is the return in January

• $E[R]$ is the expected return

• $D$ is a positive adjustment reflecting the anomaly

These phenomena suggest that certain patterns can be exploited for excess returns, contradicting the notion of market efficiency (assuming not everyone are acquainted with the effect).

Information Asymmetry

In reality, not all investors have access to the same information. This asymmetry can lead to inefficiencies, particularly in less liquid markets or for smaller companies, where information dissemination is slower. This can be modeled as:

Where:

• $E[R_{public}]$ is the expected return based on public information

• $E[R_{private}]$ is the expected return based on private information

Conclusion

The Efficient Market Hypothesis is a foundational theory in finance, providing insights into market behavior and the challenges of achieving excess returns. However, ongoing research in behavioral finance and the existence of market anomalies suggest that while markets may be efficient to a degree, they are not perfectly so.

And that's where we come in, at ForecastQ we seek and exploit areas of market inefficiencies, leveraging those for higher market returns.