- The efficient market hypothesis (EMH) means that current prices fully reflect information available. This means that the price changes immediately when new information becomes available. There are three forms of the EMH: (1) Weak form, (2) Semi-Strong form, and (3) Strong form efficiency.
- Weak form efficiency means that current prices fully reflect all historical stock prices. For example, if you can look at historical prices (or price patterns) and determine those stocks which will give you higher than normal returns (which means they are currently underpriced), then the market is not weak form efficient. Most empirical tests indicate that the market is very close to being weak form efficient.
- Semi-Strong form efficiency means that current prices fully reflect all publicly available information. This means that you should not be able to analyze all publicly available information and determine underpriced and overpriced stocks. A more moderate form of this type of market efficiency states that an abnormal return could be earned to the extent of fairly compensating the most efficient analyst for the effort spent accurately analyzing stocks to determine true mispricing. Empirical research shows that the market is close to being semi-strong efficient, but there are some small, unexplained anomalies.
- Strong form efficiency means that current prices fully reflect all public and private information. This means that you should not be able to make abnormal returns even if you traded on insider information (for example, advance knowledge of a pending hostile takeover). Empirical research shows evidence that the market is not strong form efficient.
- One of the major implications of an efficient market is that current prices change immediately as new information becomes available. For example, suppose that Intel were to announce they had invented a new way to manufacture computer chips that would make computers run ten times faster at half the cost, but that it would take at least a year to implement in all their manufacturing plants. An efficient market implies that the stock price would increase immediately when the information is available -- not a year from now when the technology is implemented or even later when extra profits are received. In effect, the EMH says that stocks respond immediately to the NPV of new information.
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