1a)  Briefly outline the main contentions of the efficient market hypothesis. In your answer, discuss the
contentions of the efficient market hypothesis within the context of technical analysis and fundamental
analysis.

1b)  How can the hypothesis be tested? In your response, distinguish between the weak, semi-strong and
strong forms of efficiency.

ANSWER

1

a)

The efficient market hypothesis holds that when new information comes into the market, it is immediately reflected in stock prices; neither technical analysis (the study of past stock prices in an attempt to predict future prices) nor fundamental analysis (the study of financial information) can help an investor generate returns greater than those of a portfolio of randomly selected stocks. The author reviews the recent findings of three schools of thought that challenge the efficient market hypothesis based on their claims that evidence of predictable patterns in stock prices exists.

One school of thought challenging the efficient market hypothesis is momentum investing, a combination of technical and fundamental analysis that claims that certain price patterns persist over time. The second is behavioral finance, which maintains that investors are guided by psychology more than by rationality and efficiency. And the third is fundamental analysis, which holds that certain valuation ratios predict outperformance and underperformance in future periods.

With regard to fundamental analysis, many believe that initial dividend yield and price-to-earnings multiples can be used to predict future stock results. The author points out, however, that these measures do not consistently predict stock performance in all time periods, which means that they do not contradict the efficient market hypothesis. The author concludes that occasional anomalies do not violate the efficient market hypothesis; they lose their predictive power when they are discovered and do not hold true in the long run.

b)

Hypothesis testing is an act in statistics whereby an analyst tests an assumption regarding a population parameter. The methodology employed by the analyst depends on the nature of the data used and the reason for the analysis.

Hypothesis testing is used to assess the plausibility of a hypothesis by using sample data. Such data may come from a larger population, or from a data-generating process. The word "population" will be used for both of these cases in the following descriptions.

Weak Form

The three versions of the efficient market hypothesis are varying degrees of the same basic theory. The weak form suggests that today’s stock prices reflect all the data of past prices and that no form of technical analysis can be effectively utilized to aid investors in making trading decisions.

Advocates for the weak form efficiency theory believe that if the fundamental analysis is used, undervalued and overvalued stocks can be determined, and investors can research companies' financial statements to increase their chances of making higher-than-market-average profits.

Semi-Strong Form

The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.

Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market.

Strong Form

The strong form version of the efficient market hypothesis states that all information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.

Advocates for this degree of the theory suggest that investors cannot make returns on investments that exceed normal market returns, regardless of information retrieved or research conducted.