Economic Theory Suggests That Markets Are Efficient and Security Prices Are Determined on the Basis of Fundamental Value

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¡§Economic Theory Suggests that Markets are Efficient and Security Prices are Determined on the Basis of Fundamental Value¡¨

Market efficiency requires that security prices react immediately in an unbiased way to the receipt of new information (Robert Shiller S1998). In other words, an efficient capital market is one in which stock prices fully reflect available information. In addition, there are three conditions for market efficiency; information flows freely, market is composed of rational investors where all competing against each other with the objective of maximizing wealth and there is no market imperfections. In efficient market, investors actively compete in the market based upon perceived mispricing derived from an analysis of available information. In such a world, prices are soon driven to their fair value or to a level where investors are unable to identify stocks whose prices are at variance with fair value. Therefore, investors cannot consistently generate returns over and above the level necessary to compensate for the inherent risks of the investments. Given the statement that economic theory suggests markets are efficient and security prices are determined on the basis of fundamental value; all publicity information should reflect onto the stock prices. Nevertheless, the theory of market efficiency faces several arguments.

Rationality: Is all or most investors rational? In fact, many investors do not achieve the degree of diversification that they should. Others trade frequently, generating both commissions and taxes. Many are more likely to sell their winners than their losers, a strategy leading to high tax payments. Irrational investor will continue to buy overprice stocks and causes further disparity from its fair price (Werner F. M. De Bondt and Richard H. Thaler WDT 1994).

Practice of investment strategies: Research done by Ron Bird 2005 shows that the markets are becoming less efficient with changes in the composition of investors who follow disparate investment styles. The increasing popularity of index investing and momentum investing requires no exploitation of identifying mispricing. Information and fair pricing are largely irrelevant to the decision process. Such practice of investment strategies contributes inefficiencies in security pricing within equity markets.

Manipulation of information: The outsider generally analysis the information announced by the company and further determine the fair stock price. With concerns of external reputation and bonuses, manager will have the incentive to manipulate the published information and fool the market. Research done by Lopez and Rees shows that firms would benefit from manipulating earnings and/or expectations to maximise the occurrence of positive earnings surprise. Although it is not possible to manage earnings in the long term, there is clear evidence that the management of many firms attempts to do so in short terms. Such behavior might drive the stock price away from its fair value.

Limits to arbitrage: Arbitrage opportunity is not a sure thing when an investor buying an underpriced asset and selling overpriced asset. Deviations from parity could actually increase in the short run, implying losses for the arbitrageur. ¡§The markets can stay irrational longer than you can stay solvent.¡¨ The well-known statement attributed to John Maynard Keynes. Risk considerations may force arbitrageurs to take positions that are too small to move prices back to parity (Russell J. Fuller 1995).

Earnings surprises: common sense suggests that prices should rise when earnings are reported to be higher than expected and prices should fall when the reverse occurs. However, market efficiency implies that prices will adjust immediately to the announcement, while behavioral finance would predict another pattern. Report done by Fama, E 1998, suggests that prices adjust slowly to the earnings announcements.

Crashes and bubbles: the bubble...
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