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Efficient Capital Markets

by Steven L. Jones and Jeffry M. Netter
About the Author

he efficient markets theory (EMT) of financial economics states that the

price of an asset reflects all relevant information that is available about
the intrinsic value of the asset. Although the EMT applies to all types of
financial securities, discussions of the theory usually focus on one kind of
security, namely, shares of common stock in a company. A financial security
represents a claim on future cash flows, and thus the intrinsic value is the
PRESENT VALUE

of the cash flows the owner of the security expects to receive.

Related CEE Articles:

Behavioral Economics
Competition
Efficiency
Great Depression
Information
Information and Prices
Interest Rates

Theoretically, the profit opportunities represented by the existence of

undervalued and overvalued stocks motivate investors to trade, and their
trading moves the prices of stocks toward the present value of future cash flows.
Thus, investment analysts search for mispriced stocks and their subsequent
trading make the market efficient and cause prices to reflect intrinsic values.
Because new information is randomly favorable or unfavorable relative to
expectations, changes in stock prices in an efficient market should be random,
resulting in the well-known random walk in stock prices. Thus, investors cannot
earn abnormally high risk-adjusted returns in an efficient market where prices
reflect intrinsic value.
As Eugene Fama (1991) notes, market EFFICIENCY is a continuum. The lower the
transaction costs in a market, including the costs of obtaining information and
trading, the more efficient the market. In the United States, reliable information
about firms is relatively cheap to obtain (partly due to mandated disclosure and
partly due to technology of information provision) and trading securities is cheap.
For those reasons, U.S. security markets are thought to be relatively efficient.
The informational efficiency of stock prices matters in two main ways. First,
investors care about whether various trading strategies can earn excess returns
(i.e., beat the market). Second, if stock prices accurately reflect all information,
new investment capital goes to its highest-valued use.

Internet
Present Value
Privatization
Rational Expectations
Regulation
Stock Market
Related CEE
Biographies:
John Maynard Keynes
Paul Anthony Samuelson
Joseph E. Stiglitz
Related Econlib
Resources:
Eugene Fama on Finance.
EconTalk podcast, Jan.
30, 2012.

Go to 1st Edition

French mathematician Louis Bachelier performed the first rigorous analysis of STOCK MARKET returns in
his 1900 dissertation. This remarkable work documents statistical independence in stock returns
meaning that todays return signals nothing about the sign or magnitude of tomorrows returnand this
led him to model stock returns as a random walk, in anticipation of the EMT. Unfortunately, Bacheliers
work was largely ignored outside mathematics until the 1950s. One of the first to recognize the
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potential information content of stock prices was John Burr Williams (1938) in his work on intrinsic
value, which argues that stock prices are based on economic fundamentals. The alternative view, which
dominated prior to Williams, is probably best exemplified by JOHN MAYNARD KEYNESs beauty contest
analogy, in which each stock analyst recommends not the stock he thinks best, but rather the stock he
thinks most other analysts think is best. In Keyness view, therefore, stock prices are based more on
speculation than on economic fundamentals. In the long run, prices driven by speculation may converge
to those that would exist based on economic fundamentals, but, as Keynes noted in another context,
in the long run we are all dead.
Stock returns and their economic meaning received scant attention before the 1950s because there was
little appreciation of the role of stock markets in allocating capital. This oversight had several
contributing factors: (1) Keyness emphasis on the speculative nature of stock prices led many to
believe that stock markets were little more than casinos, with no essential economic role; (2) many
economists during the GREAT DEPRESSION and the immediate postWorld War II era emphasized
government-directed capital investment; and (3) the modern corporation, and the resulting need to
raise large sums of capital, was a relatively recent development. But the invention of computing power
in the 1950s, which made rigorous empirical analysis with large data sets more feasible, brought
renewed attention from academic researchers.
In 1953, British statistician Maurice Kendall documented statistical independence in weekly returns from
various British stock indices. Harry Roberts (1959) found similar results for the Dow Jones Industrial
Index, and later, Eugene Fama (1965) provided comprehensive evidence not only of statistical
independence in stock returns, but also that various techniques of chartists (i.e., technical analysts)
had no predictive power. While this evidence was generally viewed as supporting the random walk
model of stock returns, there was no formal understanding of its economic meaning, and some
mistakenly took this randomness as an indication that stock returns were unrelated to fundamentals,
and thus had no economic meaning or content. Fortunately, the timely work of PAUL SAMUELSON (1965)
and Benoit Mandelbrot (1966) explained that such randomness in returns should be expected from a
well-functioning stock market. Their key insight was that COMPETITION implies that investing in stocks is
a fair game, meaning that a trader cannot expect to beat the market without some informational
advantage. The essence of the fair game is that todays stock price reflects the expectations of
investors given all the available information. Therefore, tomorrows price should change only if
investors expectations of future events change, and such changes should be randomly positive or
negative as long as investors expectations are unbiased. This revelation had its roots in the developing
RATIONAL EXPECTATIONS theory of macroeconomics, and thus, some economists refer to the EMT as the
rational markets theory. It was later recognized that the fair game model allows for the expectation
of a positive price change, which is necessary to compensate risk-averse investors.
In 1970, Eugene Fama published his now-famous paper, Efficient Capital Markets: A Review of Theory
and Empirical Work. Fama synthesized the existing work and contributed to the focus and direction of
future research by defining three different forms of market efficiency: weak form, semistrong form, and
strong form. In a weak-form efficient market, future returns cannot be predicted from past returns or
any other market-based indicator, such as trading volume or the ratio of puts (options to sell stocks) to
calls (options to buy stocks). In a semistrong efficient market, prices reflect all publicly available

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information about economic fundamentals, including the public market data (in weak form), as well as
the content of financial reports, economic forecasts, company announcements, and so on. The
distinction between the weak and semistrong forms is that it is virtually costless to observe public
market data, whereas a high level of fundamental analysis is required if prices are to fully reflect all
publicly available information, such as public accounting data, public information regarding competition,
and industry-specific knowledge. In strong form, the highest level of market efficiency, prices reflect all
public and private information. This extreme form serves mainly as a limiting case because it would
require even the private information of corporate officers about their own firm to be already captured in
stock prices.
A simple way to distinguish among the three forms of market efficiency is to recognize that weak form
precludes only technical analysis from being profitable, while semi-strong form precludes the
profitability of both technical and fundamental analysis, and strong form implies that even those with
privileged information cannot expect to earn excess returns. Sanford Grossman and JOSEPH STIGLITZ
(1980) recognized that an extremely high level of market efficiency is internally inconsistent: it would
preclude the profitable opportunities necessary to motivate the very security analysis required to
produce information. Their main point is that market frictions, including the costs of security analysis
and trading, limit market efficiency. Thus, we should expect to see the level of efficiency differ across
markets, depending on the costs of analysis and trading. Although weak-form efficiency allows for
profitable fundamental analysis, it is not difficult to imagine a market that is less than weak form but
still relatively efficient in some sense. Thus, it can be useful to define the efficiency of a market in a
more general, continuous sense, with faster price reaction equating to greater informational efficiency.
While most of the empirical research of the 1970s supported semistrong market efficiency, a number of
apparent inconsistencies arose by the late 1970s and early 1980s. These so-called anomalies include,
among others, the small-firm effect and the January effect, which together document the tendency
of small-capitalization stocks to earn excessive returns, especially in January. But financial economists
today attribute most of the anomalies to either misspecification of the asset-pricing model or market
frictions. For example, the small-firm and January effects are now commonly perceived as premiums
necessary to compensate investors in small stocks, which tend to be illiquid, especially at the turn of
the year. Fama (1998) also notes that the anomalies sometimes involved underreaction and sometimes
overreaction and, thus, could be viewed as random occurrences that often went away when different
time periods or methodologies were used.
More serious challenges to the EMT emerged from research on long-term returns. Robert Shiller (1981)
argued that stock index returns are overly volatile relative to aggregate dividends, and many took this
as support for Keyness view that stock prices are driven more by speculators than by fundamentals.
Related work by Werner DeBondt and Richard Thaler (1985) presented evidence of apparent
overreaction in individual stocks over long horizons of three to five years. Specifically, the prices of
stocks that had performed relatively well over three- to five-year horizons tended to revert to their
means over the subsequent three to five years, resulting in negative excess returns; the prices of
stocks that had performed relatively poorly tended to revert to their means, resulting in positive excess
returns. This is called reversion to the mean or mean reversion. Lawrence Summers (1986) showed
that, in theory, prices could take long, slow swings away from fundamentals that would be undetectable

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with short horizon returns. Additional empirical support for mispricing came from Narasimhan
Jegadeesh and Sheridan Titman (1993), who found that stocks earning relatively high or low returns
over three- to twelve-month intervals continued the trend over the subsequent three to twelve months.
These apparent inefficiencies contributed to the emergence of a new school of thought called behavioral
finance (see BEHAVIORAL ECONOMICS), which countered the assumption of rational expectations with
evidence from the field of psychology that people tend to make systematic cognitive errors when
forming expectations. One such error that might explain overreaction in stock prices is the
representative heuristic, which holds that individuals attempt to identify trends even where there are
none and that this can lead to the mistaken belief that future patterns will resemble those of the recent
past. On the other hand, momentum in stock returns may be explained by anchoring, the tendency to
overweight initial beliefs and underweight the relevance of new information. It follows that momentum
observed over intermediate horizons could be extrapolated over longer time horizons until overreaction
develops. This does not, however, imply any easily exploitable trading strategy, because the point
where momentum stops and overreaction starts will never be obvious until after the fact.
Resistance to the view that stock prices systematically overreact, as well as to the behavioral
interpretation of this evidence, came along two fronts. First, Fama and Kenneth French (1988) found
that stocks earn larger returns during more difficult economic conditions when capital is relatively
scarce and the default-risk premiums in INTEREST RATES are high. Higher interest rates initially drive
prices down, but eventually prices recover with improved business conditions, and hence the meanreverting pattern in aggregate returns. Second, adherents of the EMT argued that the cognitive failures
of certain individuals would have little influence on stock markets because mispriced stocks should
attract rational investors who buy underpriced and sell overpriced stocks.
Critics of the EMT responded to both of these charges. In response to the Fama and French evidence,
James Poterba and Lawrence Summers argued that the mean-reverting pattern in aggregate index
returns is too volatile to be explained by cyclical economic conditions alone. They claimed that
excessive mean reversion resulted from prices straying from fundamentals, similar to Shillers excess
volatility story. As to whether the marginal trader is fully rational or subject to systematic cognitive
errors, Andrei Shleifer and Robert Vishny (1997) and others noted that, while market efficiency requires
traders to act quickly on their information out of fear of losing their advantage, mispricing can persist
because it offers few opportunities for low-risk arbitrage trading. For example, how should one have
responded during the bubble in INTERNET-based stocks of the late 1990s? Most of these stocks were
difficult to short sell, and even if it was possible, a well-informed, fully rational short seller faced the
risk that less than fully rational traders (also known as noise traders) would continue to move prices
away from fundamentals. Thus, the market will not necessarily correct as soon as rational traders
recognize mispricing. Instead, the correction may come only after the mispricing becomes so large that
noise traders lose confidence in the trend or rational traders act in response to the additional risk
introduced by the noise traders.
The most striking examples of apparent inconsistencies with the EMT are the 1987 stock market crash
and the movement of Internet stock prices beginning in the late 1990s. Some economists, admittedly a
minority, believe that the 1987 crash and the Internet run-up and fall are consistent with market

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efficiency. For example, Mark Mitchell and Jeffry Netter (1989) argued that the large market decline in
the days before the market crash in 1987 was triggered by an initially rational response to an
unanticipated tax proposal, which in turn triggered a temporary liquidity crunch (or panic) due to much
higher sales volumes than the market was prepared to handle. The exchanges, traders, and regulators
learned from this experience making markets more efficient. Burton Malkiel (2003a, 2003b), analyzing
the Internet bubble, notes that Internet company values were difficult to determine, and while traders
in most cases were wrong after the fact, there were no obvious unexploited arbitrage opportunities.
Regardless of whether it is the exception or the rule, the favorable market conditions of the late 1990s
for technology and Internet-based stocks illustrate the stock markets critical role in resource allocation.
A firm whose stock has appreciated rapidly finds it easier to raise additional funds through a secondary
offering because higher prices mean a smaller percentage ownership of the firm needs to be offered to
raise a given amount of capital. Favorable conditions also make it easier for privately held firms to raise
funds through an initial public offering (IPO) of stock. Furthermore, a so-called hot IPO market entices
venture capital firms to invest funds in hot industries and sectors in hopes of taking their firms public in
such a favorable market. Many view these favorable market conditions as consistent with the markets
valuation of growth options and the motivating incentive necessary to make the fundraising portion of
venture growth and creation possible. But while favorable market conditions can attract the investment
capital necessary to grow a fledgling new industry, the market for technology and Internet-based stocks
in the late 1990s appears to have overheated and, in hindsight, directed too much investment capital
toward this sector. Thus, by the late 1990s, the return an investor in this sector could have rationally
expected had fallen below what economic conditions could justify, as well as below what most investors
actually anticipated.
While prices may take long, slow swings away from fundamentals, the EMT is still useful in at least two
important ways. First, over shorter horizons, such as days, weeks, or months, there is considerable
evidence that the EMT can explain the direction of stock price changes. That is, the response of stock
prices to new information reasonably approximates the change in the intrinsic value of equity. Second,
the EMT serves as a benchmark for how prices should behave if capital investments and other resources
are to be allocated efficiently. Just how close markets come to this benchmark depends on the
transparency of information, the effectiveness of REGULATION, and the likelihood that rational arbitragers
will drive out noise traders. In fact, the informational efficiency of stock prices varies across markets
and from country to country. Whatever the shortcomings of capital markets, there appears to be no
better alternative means of allocating investment capital. In fact, the PRIVATIZATION movement of the
1990s and early 2000s suggests that most governments, including Chinas, now recognize this fact.
Thus, academic inquiry in this area is likely to focus more on the conditions that explain and improve
the informational efficiency of capital markets than on whether capital markets are efficient.
About the Authors

Steven L. Jones is an associate professor of finance at Indiana Universitys Kelley School of Business, Indianapolis. Jeffry
M. Netter is the C. Herman and Mary Virginia Terry Chair of Business Administration in the University of Georgias Terry
College of Business. From 1986 to 1988, he was a senior research scholar at the U.S. Securities and Exchange
Commission.

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Further Reading

DeBondt, Werner F. M., and Richard Thaler. Does the Stock Market Overreact? Journal of Finance 40 (1985): 793805.
Fama, Eugene F. The Behavior of Stock Market Prices. Journal of Business 38 (January 1965): 34105.
Fama, Eugene F. Efficient Capital Markets: A Review of Empirical Work. Journal of Finance 25, no. 2 (1970): 383417.
Fama, Eugene F. Efficient Capital Markets II. Journal of Finance 46, no. 5 (1991): 15751617.
Fama, Eugene F. Market Efficiency, Long-Term Returns, and Behavioral Finance. Journal of Financial Economics 49, no. 3
(1998): 283306.
Fama, Eugene F., and Kenneth R. French. Dividend Yields and Expected Stock Returns. Journal of Financial Economics 22
(October 1988): 325.
Grossman, Sanford J., and Joseph E. Stiglitz. On the Impossibility of Informationally Efficient Markets. American
Economic Review 70 (June 1980): 393408.
Jegadeesh, Narasimhan, and Sheridan Titman. Returns to Buying Winners and Selling Losers: Implications for Stock
Market Efficiency. Journal of Finance 48 (March 1993): 6591.
Kendall, Maurice. The Analysis of Economic Time Series, Part I: Prices. Journal of the Royal Statistical Society 96 (1953):
1125.
Keynes, John M. The General Theory of Employment, Interest and Money. New York: Harcourt, 1936.
Malkiel, Burton G. The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives 17, no. 1 (2003a):
5982.
Malkiel, Burton G. A Random Walk down Wall Street. 8th ed. New York: Norton, 2003b.
Mandelbrot, Benoit. Forecasts of Future Prices, Unbiased Markets and Martingale Models. Journal of Business, special
supplement (January 1966): 242255.
Mitchell, Mark, and Jeffry Netter. Triggering the 1987 Stock Market Crash: Antitakeover Provisions in the Proposed House
Ways and Means Tax Bill? Journal of Financial Economics 24 (1989): 3768.
Poterba, James M., and Lawrence Summers. Mean Reversion in Stock Market Prices: Evidence and Implications. Journal
of Financial Economics 22 (1987): 2759.
Roberts, Harry. Stock Market Patterns and Financial Analysis: Methodological Suggestions. Journal of Finance 14
(1959): 1125.
Samuelson, Paul. Proof that Properly Anticipated Prices Fluctuate Randomly. Industrial Management Review 6 (1965):
49.
Shiller, Robert J. Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? American
Economic Review 71 (June 1981): 421435.
Shiller, Robert J. From Efficient Markets to Behavioral Finance. Journal of Economic Perspectives 17, no. 1 (2003): 83
104.
Shleifer, Andrei, and Robert W. Vishny. The Limits of Arbitrage. Journal of Finance 52 (March 1997): 3555.
Summers, Lawrence. Does the Stock Market Rationally Reflect Fundamental Values? Journal of Finance 41 (July 1986):
591601.
Williams, John Burr. The Theory of Investment Value. Cambridge: Harvard University Press, 1938.

Footnotes
1. For an excellent review of the debate on market efficiency, see Shiller 2003 for the behavioral finance view, and Malkiel
2003a for the proefficiency view.
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