The Mostly Efficient Market Hypothesis

The efficient market hypothesis, or EMH, is a fiercely-debated theory. It says that, given the presence of intelligent, well-informed investors, it is very unlikely that prices in securities markets will vary significantly from their true value. Therefore it's unlikely that investors will be able to obtain excess returns through either technical or fundamental analysis, and we should all just buy index funds and spend our research time at the beach.

There are different forms of the EMH, though, so today I'll give you my take on each of them and describe how I use that information to make trades. Tomorrow I'll discuss specific market inefficiencies that I've observed that you can capitalize on.

First, a little bit of background. The EMH was first described in the 1967 Ph.D. dissertation of Eugene Fama, now a finance professor at the University of Chicago. Subsequent academic and investment management research has found evidence for and against the efficiency of markets.

I subscribe to the theory that markets are mostly efficient, but that there are times when efficiency breaks down. It's my job as a money manager to avoid getting harmed by the inefficiencies and to profit from them.

Three Forms of Efficiency

The weak form of the EMH assumes that all information about stock prices and price trends is already reflected in the current market price. For example, if investors think a trend in a company's stock price forecasts a future, higher price, they bid the stock price up right now. Technical analysis, including moving averages, trend following, breakouts and volume analysis should then be of no use. Some studies have shown that stock price changes appear to be random.

This conclusion only makes sense to me if you examine price movements while ignoring the context in which the price changes occur. In the absence of news, stock prices fluctuate randomly in response to short-term imbalances between buy and sell orders.

But in the context of company-specific, sector and economic news, stock prices exhibit definite trends in one direction or the other. TSC's Gary B. Smith does an excellent job of mapping price movements to company fundamentals, pointing out the key levels where money can be made.

In my own work, I've seen patterns such as double tops and double bottoms occur more frequently than random chance would dictate. How do I interpret these patterns? A major assumption of the EMH is that market participants are fully informed and rational. In fact, a substantial number of investors only buy stocks because they rise, and only sell stocks because they fall.

A stock may have a long rise based on some favorable news, but eventually get to the point where it is "fully valued" and some investors take profits. The stock then falls to a lower level. Less disciplined investors then see a chance to get on the bandwagon, which drives the stock back to the previous high, but on falling volume. When the stock fails to break above the previous high, the marginal investors dump the stock in disappointment, and other investors rush in to capture their profits, causing the stock price to fall on rising volume and forming the double top.

While I would never buy or sell a company based solely on its chart pattern, I do use this information to fine-tune the timing of my investments.

The Middle Way

The semistrong form of the EMH assumes that, in addition to information about a stock's price movement, all information about a company's fundamentals is already reflected in the current market price. Studying a company's growth rates, cash flow, market share and analysts' forecasts then won't give you an edge in picking out superior stock investments, because the stock price has already taken these factors into account.

Generally, I believe this concept is true -- it's very unlikely that my analytical skills will lead me to the one "perfect pick." However, I believe these same skills do give me an edge in building portfolios (i.e., 30 to 45 equally weighted picks spread across multiple sectors) that have a reasonable chance of outperforming the market.

The Strongest

Finally, the strong form of the EMH assumes that, in addition to information about a company's stock price movements and fundamentals, information known by company insiders is already discounted in the current stock price. Even insiders, the theory maintains, cannot obtain excess returns by trading around their stock, because the effect of their buying or selling gets transmitted to the stock's price market pretty quickly.

Given that insider trading, legal or otherwise, is such a small part of overall stock trading volume and subject to blackout periods around major announcements, it's hard for me to determine whether insiders do have superior insights.

Generally, though, I find that publicized insider selling has little predictive value -- people liquidate their holdings for many reasons besides concern that the stock price will go down. On the other hand, there's only one reason insiders might buy their stock -- they think the stock will go up. That information is useful to me if I'm already predisposed to buy the stock because of other research.

Tomorrow I'll look at some practical applications of these theories for individual investors.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York investment management firm. Edwards appreciates your feedback at [e-mail].