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Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) investment theory suggests that the market is impossible to beat because efficiencies within the stock market cause publicly traded shares to reflect all updated and relevant information (Investopedia, 2008). “Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed” (Investopedia, 2008, Ð'¶ 2). This paper presents three forms of the EMH, sources to support and refute the theory and whether or not the EMH applies to mergers.

Three Forms of the Efficient Market Hypothesis

Weak Form

“The вЂ?Weak’ form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use” (Investor Home, 2008, Ð'¶ 6). Security prices are the most publicly and easily accessible pieces of information (Han, n.d.). Some financial researchers study past stock price series and trading volume data in an attempt to generate profit (Han, n.d.).

Semi-Strong Form

“The вЂ?Semi-strong’ form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use” (Investor Home, 2008, Ð'¶ 6). All publicly available information is available to investors and states “not only past prices but also data reported in a company's financial statements, company's announcement, economic factors and others” (Han, n.d., Ð'¶ 2.3). According to the EMH, a company's financial statements are of no help in forecasting future price movements and securing high investment returns (Han, n.d.).

Strong Form

“The вЂ?Strong’ form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use” (Investor Home, 2008, Ð'¶ 6). Even an employee of the company would not make a profit from the inside information they know (Han, n.d.). “The rationale behind to support is that the market anticipates in an unbiased manner, future development and therefore information has been incorporated and evaluated into market price in much more objective and informative way than insiders” (Han, n.d., Ð'¶ 2.4).

Research Supporting the EMH

Evidence suggests that stock prices can be predicted with a fair degree of reliability based from the three forms of the EMH (Rao, 2007). “Proponents of the EMH maintain that such predictability results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken” (Rao, 2007, P. 34). The fact that professional investors by in large do not beat the market suggests that the markets generally are quite efficient at adjusting correctly to new information (Malkiel, 2005).

Analysts that reject the EMH believe that prices adjust gradually because information takes time to reach the market (Ivkovic, 2007). “However, proponents of the EMH have never claimed that prices adjust perfectly and have always allowed the possibility that there could be an initial over or under adjustment. Since those initial imbalances cannot be predicted or influenced, it stands to reason that abnormal returns cannot be exploited from adjustment errors” (Ivkovic, 2007, Ð'¶ 8).

Research Refuting the EMH

Analysts who refute the EMH hold issue with “how much one can reasonably assume the integrity of the stock pricing mechanism without undertaking any investigation or analysis” (Findlay & Williams, 2000, P. 3). Another argument is that the presumption of reliance is valid even if investors do not rely. The precondition for this theory is that вЂ?if the EMH holds’ (Findlay & Williams, 2000).

“Critics of the EMH argue that the predictability of stock returns reflects the psychological factors, social movements, noise-trading, and fashions or вЂ?fads’ of irrational investors in a speculative market” (Rao, 2007, P. 34). History shows “periods of large scale irrationality, such as the technology-internet вЂ?bubble’ of the late 1990s extending into early 2000, has convinced many analysts that the efficient market hypothesis should be rejected” (Malkiel, 2005, P. 2).

Until professional traders can prove consistent trading profits, the EHM must be doubted. The evidence on the performance of professionally managed funds generally does not support the efficacy of technical analysis (Bodie, Kane & Marcus, 2004).

EMH and Mergers

“Efficient studies are often used to test the EMH” (Kritzman, 1994, P. 17). Mergers must be filed publicly with the SEC within 10 days of the open market cash purchase (Madden, 1981). A study of price effects of mergers of 86 corporations was conducted in which the companies were