What is the Strong form of Market Efficiency?
The strong form of market efficiency is a version of the EMH or Efficient Market Hypothesis. There are three versions of EMH, and it is the toughest of all the versions. It states that a stock’s price reflects all the information that exists in the market, be it public or private. In other words, each and every bit of information is available to one and all, and hence, an investor cannot make heavy profits. Even insider information or in-depth research cannot help an investor make abnormal profits or provide additional benefits because all the prospective investors have all the information related to the stock. The trade takes place basically on the perception of the individual investor and their assessment of the intrinsic value of the stock.
Burton G.Malkiel proposed this form of market efficiency in the year 1973. In his book titled “A Random Walk Down Wall Street,” he discussed and detailed his hypothesis about this phenomenon. According to him, all information that technical or fundamental analysis and other advisories generate or the earnings estimates that analysts provide is of no use. Instead, “buy-and-hold” is the best strategy that an investor can adopt in such a form of near-perfect market efficiency. This means that an investor should invest and hold the security from a long-term point of view because of the unpredictability of the capital markets and the price volatility.
Efficient Market Hypothesis
The concept of the Efficient Market Hypothesis is one of the various investment theories. And it is based on the research of “Eugene Fama” (Fama and French Three-Factor Model). It states that the asset pricing is indicative of all the available information in the market. Since there is no new information that can have any impact on the price of the securities, it is very difficult for an investor to make extraordinary profits or beat other investors.
Individual investors may act differently, but the collective market as a unit will always be right or rational. Thus, there will be the presence of outliers or the ones who make extraordinary profits or even losses in the short term. But most investors will make close to the average returns that security provides in the market in the long run. A good strategy in such a case is to invest in an index fund and earn returns that the securities of the underlying benchmark index make. In this manner, an investor will make average market earnings but not extraordinary gains.
The theory further states that all the securities are already trading at their fair price or their fair market value. Hence, there are very few chances of finding an overvalued or undervalued stock. Because of this fact, an investor cannot earn big by buying undervalued stocks or selling overvalued stocks. Making big profits is only possible by taking a high speculative risk.
What are the Cons of a Strong form of Market Efficiency?
The limitations of a Strong form of market efficiency are:
Sometimes there are legal restrictions that prevent the sharing of sensitive information with the general public. For example, important researches of a defense equipment manufacturing firm cannot go public. Hence, the market price of its security will not always be reflective of all the information. Similarly, insider trading laws will restrict the sharing of crucial internal information pertaining to a company with the outside world. Hence, the share prices will again not adhere to the principles of the strong form of market efficiency.
Market speculation and crashes
There have been multiple instances over the years of display of buying frenzy on the part of the investors. This may or may not have a direct dependence on the underlying value of the asset or market information. Similarly, there have been market crashes with markets tanking without a definite reason or information. Also, a few investors may benefit abnormally from such a situation by buying underpriced stocks at the time of market crashes and selling them later when the markets become normal. Such situations are an anomaly with regard to the concept of a strong form of market efficiency.
In fact, many researchers have directly blamed the efficiency hypothesis for causing market crashes. Financial leaders and advisors who rely on the hypothesis fail to estimate when an asset bubble is about to break, causing severe losses to one and all.
An Example of a Strong form of Market Efficiency
Let us take the example of Mr.A, who is the CFO of a major pharmaceutical company. The company is in the final stages of research and development of introducing a new cancer drug in the market. The drug is expected to be an effective cure for the disease and shall be priced at around a 40% lower rate than the other competing drugs in the market.
The drug should be a grand success in all probabilities and take the company to new heights. Based on this inside information and before the launch of the drug, Mr. A, through his relatives, makes a purchase of the Company’s stock in big volumes at the currently prevailing market prices. He has the notion that the price of the stock will shoot up once the drug is brought into the market.
After the successful launch of the drug, he is astonished to see that the price of the stock has not shot up as per his expectations. This is so because the market had already taken into account this piece of insider information. The effect of the launch is already calculated in the current stock price of the company. Hence, the launch does not provide an opportunity for making windfall gains to an individual investor, as per the phenomenon of a strong form of market efficiency.