Stock market efficiency - Predictable or game of chance?

According to Stratman (1999) market efficiency has two meanings. Firstly ‘that investors cannot systematically beat the market’ neither with technical or fundamental analysis, and secondly ‘that security prices are rational.’ In this sense he refers to the fact that prices are based on fundamental issues such as risk rather than psychological tendencies like regret. So, bearing in mind these definitions how efficient are stock markets?

Efficiency can come in three different forms – operational, allocational and pricing, for the purposes of this blog I am going to focus on price based efficiency. In this view if markets are efficient then share price should rise on receiving positive news and should fall in response to negative news, but in reality does this always happen?

Google recently proved that markets don’t always react in the way we might expect! Despite the company’s revenue exceeding $10billion dollars for the first time, a 6% increase in profits was below the expectations of the market and led to a 9% dip in their share price wiping billions of the market value (Mail Online, 2012). How can this be? Have expectations become too high when a company yielding $2.7billion in one quarter is facing a share sell off. Or are investors being extremely cautious due to the current economic conditions? Analysts have been weary of increased spending on developing ideas, particularly its expansions into the social networking sector.

 A similar situation emerged on February 9^th 2012; Diageo announced positive half year results with a 15% rise in profits (BBC, 2012). This information however did not impact the company’s share price at all reflecting the under-reaction of markets. 

So, should we be paying more attention to the theories of Kendal (1993) he suggested that the way in which prices rise and fall has no systematic pattern and branded financial analysts as being irrelevant! The concept of ‘random walks’ comes in here, this is due to the fact that share price reflects all available information at one point in time and will only change when new information is published (Arnold, 2008). Like a stumbling man not knowing which way to turn, looking at past information will not help predict what might happen in the future. This is due to the fact price fluctuations are based on new information being released and the market reactions to this… until it happens we cannot possibly know whether it is going to be positive or negative information!

So is investing in the stock markets merely just a game of chance? Would we be better of blindly picking a company to invest in out of a hat? Might this be just as successful as if we’d spend valuable time and effort assessing all the available information relating to possible investments? Surely not?!

If this was the case then why do we still have analysts? Someone must believe we still need their expertise and knowledge to help guide us. If I was looking to invest I’d certainly value this information, but maybe that’s just me wanting not wanting to feel as though I’m taking a huge risk with what little money I have! Perhaps the gamblers amongst us would like the risk?

Fama (1970) on the other hand identified that efficiency of markets can come in three forms: Weak form, semi-strong form and strong form. In an ideal, perfect world everyone would expect markets to be strong form – efficient, but examples like the ones above show this is not always the reality. That is not saying in some companies it can’t happen… but is this just down to chance?

As always people have contradicted this concept, Warren Buffet for example suggested that share price only reflects people’s emotions such as regret which are not always logical. The concept of ‘regret aversion’  (Baker & Nofsinger, 2010) means that although an investment might be losing money people are likely to keep it until they break-even again just so that they don’t have to admit they made the wrong decision – if this is the case then no wonder stock markets don’t operate in the manner we expect them to!

As a final point, I feel the IPO of Facebook will be an interesting one to watch out for in the future. As anticipation builds over the availability of shares pushing the price up to premium levels will this result in an over-reaction of the market? I guess we’ll have to wait and see!