What do we mean by Weak Form of Market Efficiency?
The Efficient Market Hypothesis (EMH) Model has three versions – Strong, semi-strong, and weak. The weak form of market efficiency is the weakest form of this Hypothesis model. According to the EMH theory, the price of a publicly-traded asset or security is a reflection of all the past information that is available to the general public. In other words, the current price of the asset is the result of consideration of all the factors of the past that can affect its present price.
Therefore, there is no possibility of any investor earning windfall profits or substantial gains out of the line in the long run. This is so because each and every investor already has information about the security from the historical events. Equity research or technical and fundamental analysis can give an extra edge to any certain categories of investors in the short run only. Hence, all the market participants will have a level playing field. They will only be able to earn the average returns from the market eventually in the long run.
Weak Form of Market Efficiency: How Does it work?
The study of historical price movements is done by using technical analysis or by the use of charts. But these studies do not help an investor to earn excessive gains over a long period of time. No correlation exists between prices because of which there is no scope for substantial gains just by studying the past-price trend. Also, the prices of stocks do not show any pattern or repetitive up and down movement.
The basis of the theory of a weak form of market efficiency is that investors are rational, capable, and intelligent. They make rational investment decisions by correct calculation of the net present values of the cash flows one will earn in the future from the stock or security. Also, this net present value has to be discounted for the risk factor, and that too correctly. The only way they can make short-term profits higher than the market average is by correctly picking up stocks that have an undervaluation or an overvaluation. This is done by fundamental analysis and a thorough study of the financial statements of the company. In the long run, the high profits are wiped out by the influence of the efficient market hypothesis, and investors start making the average market returns.
In summary, the weak form implies that prevailing market prices of a stock or security have factored in all the past and historical price data. Moreover, any further technical analysis of any form will not help the investor decide on that particular stock or security. The only help he can have is from the fundamental analysis. That can only help the investor find out the undervaluation or overvaluation of the prevailing price.
The Anomalies or limitations of the Weak form of Market Efficiency
The above assumptions may sometimes not hold well in the usual course of business. For example, investors are often affected by herd instinct. They follow what the majority of investors in the market decide to buy or sell. Also, each and every investor reacts to news from the market or of security differently. There might be a considerable change from the past work or investment environment. Hence, always relying on past information to arrive at the correct, current price of a security can be misleading. The outliers or smart investors may actually find out a way to earn substantial gains from their investments rather than just market average returns.
This theory has some more anomalies other than the various points discussed above. As per the “small firm” effect, companies with small market capital or small-cap companies provide returns higher than that of companies with large market capitalization. This was the trend for decades.
This trend should have continued if only the past results were the basis for current prices and returns. But of late, this has not been the case. The results have been regularly inconsistent with the theory. So this exception again creates further doubt on the dependency or reliability of this weak form of market efficiency hypothesis.
Another effect known as the “January effect” is an anomaly of this theory. According to this effect, the small-cap stocks give substantial returns in the month of January every year. If a weak form of market efficiency is at play, such substantial returns at a particular time of the year should never exist. Instead, there should have been an averaging of the returns. But factually, this is not so.
Finally, let us look into the concept of mean reversion. Every under or over-performer stock or security gets back to its mean returns or industry average in the following years. A high-return provider stock will give much lower returns in the coming years to arrive at the average. Similarly, a low-return provider will provide higher returns in the upcoming years to average out the returns. Again, this is against the theory of the weak form of market efficiency. It rules out any chance of making a substantial gain from the market in the long run.
An Example of this Theory
Let us look at the example of Mr. A, who is planning to invest in the stock of a major automobile company. The company is doing well with a consistent increase in the demand for its products quarter after quarter. He has done the fundamental analysis of the company in detail, and the company financials are strong. Everything is indicative of an upward movement in the price of the stock of the company.
Mr. A decides to buy the stock of the company just before the quarterly results are due. He expects the price to shoot up as the result expectations are positive. On the day of the declaration of the result, the stock actually goes up. Hence Mr. A is able to make short-term gains from the situation, as per his analysis.
The markets are efficient enough to absorb the news and neutralize all opportunities for making extra profits. It wipes out all the extra gains. All investors again return to making average market returns from the stock, along with Mr. A.