The theory behind the news affecting stock prices-Efficient Market Hypothesis
Posted On June 27, 2018
The efficient market theory or the efficient market hypothesis, which fetched Eugene Fama, a Nobel Prize, says, that market efficiently incorporates all public information and that is the reason why you cannot beat the market because it has all the requisite data necessary. Giving a rudimentary introduction to the idea, according to the theory, the market wins every time, and it is impossible to beat it.
The first statement of the ‘Efficient Market Hypothesis’ as defined by George Gibson 1889 in his work, “Stock exchanges of London, Paris and New York” writes, “when shares become publicly known in an open market the value which they acquire there may be regarded as the judgement of the intelligence concerning them”, what he is trying to say is that the smartest people using the ‘clues’, buy and sell accordingly and thus aggressively affect the value. So, the reason you cannot beat the market is that it is a modern-day Wikipedia where information flows faster than the speed of light. And the stock market is a Wikipedia in itself, where the prices are public, and the back data is already available to the trader.
During 1960, multiple institutions started using CRSP tapes as a standardized measure to evaluate market efficiency, which was then used by Fama to write his Nobel laureate study. Fama configures the market efficiency cycle into three forms, i.e., the weak form, the strong form and the semi-strong form.
‘The Weak Form’ is the easiest form of market efficiency to achieve. With weak market efficiency, it means that the price that you see today for an asset incorporates all the information on the past crises.
Therefore, if you know past price information, then you work on patterns and cyclicity in the prices. What is important is that the market has to be weak form efficient or you cannot take advantage of the model. Technical analysis plays an important role here. The weak form is subsumed by or is a part of ‘Semi-Strong forms’, where all the public information is available, such as the news, the current trends and other stock related details. The third type of market efficiency is the ‘Strong Form’; this scheme says that prices include all information, whether it is public or private and hence the strong form says that you cannot create excess returns or even generate profits from any kind of efficiency.
What we call as an ‘Informationally Efficient Market’ impounds how information can affect the market and how soon does the market absorb the information details. The market reaction to the information has become crucial in the current scenario, where prices are accumulated on the basis of data efficiency. Analyses of the data affect the volume of stocks rapidly, which is also called the quantitative representation of the market that facilitates the significance of information, may it be private and public.
For instance in the case of ‘Black Wednesday,’ when the ERM fell all over Europe and the speculators like George Soros taking advantage of small detail to acquire high profit through shorting of the pound. A small information, and sometimes a mere rumor can derive activities that can become dangerously fatal to the market or a stock.
In the age where technology is advancing at a pace which is impossible to keep up with, intricate information is acute when it comes to electronic trading. Analysts, place major decisions based on the minutest of factors. Trading and its ever-evolving strategies performance are analyzed on these multiple speculations and activities existing in the market.