Evaluate the following statement regarding market efficiency: Stocks that outperform over the last month, on average, will underperform the market the next month .Is this a violation of the efficient market hypothesis? If so, which form?
a. No b. Yes, weak form (and therefore also semi-strong and strong form) c. Yes, semi-strong form (and therefore also strong form) d. Yes, strong form
The correct answer and explanation is:
The correct answer is b. Yes, weak form (and therefore also semi-strong and strong form).
Explanation:
The Efficient Market Hypothesis (EMH) suggests that all available information is already reflected in stock prices, making it impossible for investors to consistently achieve higher returns than the market average without taking on additional risk. EMH is categorized into three forms: weak, semi-strong, and strong, based on the type of information incorporated into stock prices.
- Weak form EMH argues that all past trading information, such as historical stock prices and volume, is fully reflected in current stock prices. This implies that technical analysis, which uses past price movements to predict future trends, cannot consistently lead to excess returns. If stocks that have performed well over the last month tend to underperform the next month, this would indicate that past performance does not provide a reliable indicator of future results. This violates the weak form of EMH because it suggests the possibility of exploiting past stock performance to predict future price movements.
- Semi-strong form EMH takes it a step further by stating that all publicly available information (including financial reports, news, and analyst recommendations) is reflected in stock prices. Since the weak form is a subset of the semi-strong form, a violation of the weak form would also be a violation of the semi-strong form.
- Strong form EMH includes all information, both public and private (insider information). A violation of the weak form would also violate the strong form, but the strong form is harder to test because it deals with private information, which is not easily observable.
Therefore, if stocks that outperform in one period underperform in the next, this suggests that past price trends are predictable and could be exploited, violating the weak form of EMH and, by extension, the semi-strong and strong forms as well.