Competitive Market Hypothesis and Market Inefficiencies

Competitive Market Hypothesis

An efficient market has been defined as one where share prices always fully reflect available information on companies. In practice, no existing stock market is perfectly efficient. There are evident shortcomings in the pricing mechanism. Often, the complete body of knowledge about a company’s prospects is not publicly available to market participants. Further, the available information would not be always interpreted in a completely accurate fashion. The research studies on EMH have shown that price changes are random or independent and hence unpredictable. The prices are also seen to adjust quickly to new information. Whether the price adjustments are correct and accurate, reflecting correctly and accurately the meaning of publicly available information is difficult to determine.

All that can be validly concluded is that prices are set in a very competitive market, but not necessarily in an efficient market. This competitive market hypothesis provides scope for earning superior returns by undertaking security analysis and following portfolio management strategies.

Market Inefficiencies

Many studies have proved the prevalence of the market efficiency. At the same time, several studies contradict the concept of market efficiency. For example, the studies conducted Joy, Lichtenberger and Mc. Enally over the period of 1963-1968 gave different results. The authors have examined the quarterly earnings of the stock prices. The earning of one quarter was compared with the same quarter of the previous year. If the current year’s earnings were 40% or more than the earnings for the same quarter in the previous year, the earnings were classified as good earnings than anticipated. If the current quarter’s earnings were below 40% of the previous year’s earnings, they are classified as bad than expected.

Then the abnormal returns were calculated from 13 weeks prior to the announcement of the earnings to 26 weeks after the announcement of the earnings. The stocks whose earnings are substantially greater than anticipated gave positive abnormal returns. The stocks whose earnings are below the anticipated earnings generated negative abnormal returns.

The author’s main claim is that after the announcement of the earnings, stocks that reported earnings substantially above those of the previous year continued to earn positive abnormal returns. According to the study, the investors could have earned positive abnormal returns of around 6.5 per cent over the next 26 weeks simply by buying stocks that have reported earnings 40% above the previous quarterly earnings. Meanwhile for those stocks with earnings substantially below the previous year, the cumulative average abnormal return remained relatively stable. This shows evidence against the semi-strong market hypothesis because it states that when the information is made public the analyst could not earn abnormal profits. A study made by C.P. Jones, R. S. Randleman for the period 1971-1980 had also given similar results to those of JLM.

Low PE effect many studies have provided evidences that stocks with low price earnings ratios yield higher returns than stocks with higher PEs. This is known as low PE effect. A study made by Basu in 1977 was risk adjusted return and even after the adjustment there was excess return in the low price-earnings stocks. If historical information of P/E ratios is useful to the investor in obtaining superior stock returns, the validity of the semi-strong form of market hypothesis is questioned. His results stated that low P/E portfolio experienced superior returns relative to the market and high P/E portfolio performed in an inferior manner relative to the overall market. Since his result directly contradicts semi-strong form of efficient market hypothesis, it is considered to be important.

Small firm effect the theory of the small firm effect maintains that investing in small firms (those with low capitalization) provides superior risk adjusted returns. Bans found that the size of the firm has been highly correlated with returns. Bans examined historical monthly returns of NYSE common stocks for the period 1931-1975. He formed portfolios consisting of 10 smallest firms and the 10 largest firms and computed the average return for these portfolios. The small firm portfolio has outperformed the large firm portfolio.

Several other studies have confirmed the existence of a small firm effect. The size effect has given rise to the doubts regarding the risk associated with small firms. The risk associated with them is underestimated and they do not trade as frequently as the those of the large firms. Correct measurement of risk and return of small portfolios tends to eliminate at least 50% of the small firm effect.

The weekend effect French in his study had examined the returns generated by the Standard and poor Index for each day of the week. Stock prices tend to rise all week long to a peak on Fridays. The stocks are traded on Monday at reduced prices, before they begin the next week’s price rise. Buying on Monday and selling on Friday from 1953 to 1977 would have generated average annual return 3.4% while simple buy and hold would have yielded 5.5% annual return. Yet the knowledge of the weekend effect is still of v Purchases planned on Thursday or Friday can be delayed until Monday, while sale planned for Monday can b delayed until the end of the week. The weekend effect is a small but significant deviation from perfectly random price movements and violates the weekly efficient market hypothesis.

Similar to this Venkatesh B. of the BL Research Bureau has stated that the Bombay Stock Exchange reveal a discernible pattern. Usually, Monday, is characterized by trading blues, and Friday by frenzied activity The Friday rush is more to do with speculators covering their open position. If the short sellers to cover their position within this period, their open positions are called to auction where prices are dear.