Efficient market hypothesis (EMH) evolved from a Ph.D. dissertation by Eugene Fama in a 1960’s dissertation. EMH states that financial markets are efficient and that prices already reflect all known information. Furthermore any stock or other security reacts very quickly to reflect any new information that at any given time. Essentially in a highly liquid market, security prices fully and immediately reflect all available information.
In layman’s terms, everything that is known is priced into the market and therefore highly liquid markets are fairly valued. Therefore, the price of a stock, ETF or commodity is at all times fairly priced and truly reflects its’ value. Proponents maintain that news is irrelevant as it is already priced into the security. Those who subscribe to the efficient market theory assert that a liquid, two-sided market will always reflect the “real” price of the stock, ETF, commodity.
There are several versions of EMH that differ in what is interpreted as “information” and what constitutes “all available information”. If you fully subscribe to the EMH then the only factor that can impact the movement of a security is the drag of the “risk-free” rate. Therefore, assuming all information is priced in the underlying then the current value must be “fairly priced”.
However, the majority of investors don’t embrace EMH because they point to the impact of a news item on the price of the stock or ETF. But if you stop to consider that when an unknown binary event is released and the underlying reacts radically to the news, in short order as the news is processed the stock or ETF quickly reaches its’ new equilibrium.
Another reason that the majority of investors don’t support EMH is that they do not truly believe that all information that is available is not known to them. Investors always refer to the mystical “they” as the counter-party to their trade and assume they have an unfair advantage.
If you accept this hypothesis then only new information will move stock prices significantly. Then you must conclude that this “new information” is presently unknown to every investor and occurs at random. Therefore any future movement in the price of the stock is also unknown and the stock must move randomly.
I base all of my trading on the premise that “all available information” includes not only what is currently known about the security, but any and all future expectations including but not limited to earnings or dividend payments. This supports probability based trading which is the methodology that I use in my trading business, and what I introduce to my clients.
In a future article I will introduce “random walk” and how I believe it compliments EMH. If you would like to discuss how to use EMH to generate consistent positive returns please call me at 239.272.3424…………..I answer my own phone!