Stock Market Efficiency: Understanding Price Behavior

Stock Market Efficiency

A stock market is considered efficient when the information available within it is identical for all investors, and when prices over time are independent. This means that in an efficient market, current and future prices have no direct correlation with past prices. Therefore, historical price series are not indicative of future price behavior and cannot be reliably used to predict price movements.

When new information emerges that could influence the intrinsic value of a security or securities, an efficient market reflects this new information immediately. It is possible that from the moment news is rumored until it becomes public, more experienced investors might use it to their advantage, even if the information eventually becomes widely known.

However, if the market reacts immediately to new information, then even experts cannot consistently use that information to gain an advantage.

The prevailing view is that a market is efficient when it immediately reflects all available information, and this information is recognized uniformly by the general public. The efficiency of a stock market is typically categorized into three degrees, each based on different assumptions about information incorporation:

Degrees of Market Efficiency

• Strong Form Efficiency

  In a strong-form efficient market, prices incorporate all information about a company, including non-public or privileged information. This implies that no investor, not even insiders, can consistently achieve abnormal returns.

• Semi-Strong Form Efficiency

  A semi-strong form efficient market means that prices incorporate all publicly available information. This includes not only information related to trading volumes and prices but also fundamental data such as growth in results, financial situation, and competitive position. This concept is closely aligned with the principles of fundamental analysis, suggesting that publicly available information is already reflected in stock prices.

• Weak Form Efficiency

  In a weak-form efficient market, prices incorporate information derived solely from the historical evolution of prices and trading volumes. Therefore, analyzing past price patterns cannot yield any rule that consistently produces profits. This concept is closely related to technical analysis, suggesting that historical price data cannot be used to predict future price movements.

To test whether prices behave according to a random walk model, three well-known statistical tests are commonly employed:

Tests for the Random Walk Hypothesis

• Serial Correlation Test

  This test examines whether there is any correlation between prices over different periods. If prices are independent, then the rates of return in different periods should also be independent, supporting the random walk hypothesis.

• Test of Signs

  The Test of Signs analyzes price trends. If systematic trends are found, it rejects the hypothesis that prices behave according to a random walk, suggesting some predictability.

• Filter Rule Test

  This test analyzes the weak-form efficiency hypothesis. It operates on the premise that if a security's price moves up or down by a certain percentage for a period longer than expected, it will continue to move in that direction. If such a rule consistently generates profits, it would contradict the weak-form efficiency and the random walk hypothesis.