“When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
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This report will analysis the statement by Warren Buffett, and it considers the contrasting evidence on the validity of the observation on the Efficient Markets Hypothesis. The report briefly outlines the forms of the Efficient Market Hypothesis, the report also analysis’s the evidence both seminal and recent on the theory relating to the three forms of the hypothesis. It also examines the theoretical role and motivation of analysts in creating market efficiency; lastly it looks at alternative perspectives on the pricing of securities.
Introduction
In 1984 Warren Buffett penned an article titled “The Superinvestors of Graham-and-Doddsville”, based on a speech he had given on the occasion of the 50th anniversary of his mentor Ben Graham’s legendary textbook, Security Analysis. In it, Buffett rejected the then growing (and now entrenched) view in academia that markets are ''efficient'' because ''stock prices reflect everything that is known about a company’s prospects and about the state of the economy.'' Warren Buffett argued against EMH, saying the preponderance of value investors among the world's best money managers rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others. (Hoffman, 2010) This report will either agree with Buffet or somewhat sit on the fence.
A market is said to be efficient with respect to an information set if the price ‘fully reflects’ that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient. Twenty years later Fama had modified his definition by saying that the market is efficient if it incorporates all the information that is available, it means that efficient markets are acting rationally and that relevant information is integrated and there are no systematic errors. In 1968 Jensen noticed that the information access cost should be considered. (Beechey et al., 2000)

There are three basic forms of market efficiency: weak, semi-strong and strong. Those types of efficiency describe the price changes as a response to diverse in their scope information sets. Information set in weak form efficiency covers current share prices that fully reflect all information concerning historical movements and patterns. Semi-strong efficiency hypothesis covers sets with all publicly available information and the strong form of efficiency covers not only the previous ones but also includes all private information.

Weak Form Efficiency

In weak-form efficiency, future prices cannot be predicted by analyzing prices based on historical share prices or other historical data. That is, nobody can detect mis-priced securities and “beat” the market by analyzing past prices. The weak form of the hypothesis got its name for a reason – security prices are arguably the most public as well as the most easily accessible pieces of information. Thus, one should not be able to profit from using something that “everybody else knows” (Han, 2008, p.6). On the other hand, many financial analysts attempt to generate profits by studying exactly what this hypothesis asserts is of no value - past stock price series and trading volume data. This technique is called technical analysis. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.
The Empirical evidence such as that of Cootner (1962), Osborne (1962) and Fama (1965) are very suggestive towards the fact that it is very difficult to make money on publicly available information such as past price movements, due to a low degree of serial correlation and high transaction costs associated with the collection and analysing of such data.
Semi-strong Form Efficiency

The semi-strong-form of market efficiency hypothesis suggests that the current price fully incorporates all publicly available information. Public information includes not only past prices, but also data reported in a company’s financial statements examples are annual reports, filings for the Security and Exchange Commission, income statements, earnings and dividend announcements, announced merger plans, the financial situation of company’s competitors, expectations regarding macroeconomic factors such as inflation, unemployment. The Semi-strong level of efficiency is arguably the most controversial of all three efficiencies, due to the fact that if it is true, the work of millions of fundamental analysts would be useless, the time and money that has been spent on analysing publicly available information would have been a complete waste as all new information has already been absorbed into the share price. Unfortunately for analysts, there is much evidence to support this claim.

Scientists use tools such as event studies. “An event study averages the cumulative performance of stocks over time, from a specified number of time periods before an event to a specified number of periods after” (Dimson, Mussavian, 1998) To provide evidence for against that level of market efficiency we could construct a shares portfolio based on the fundamental analysis. We could check such indicators as P/E ratio or P/B ratio (www.ivestopedia.com, 12/12/11) and once again if the market has semi-strong efficiency then our portfolio will not give us profits more that average. Researchers such as Ball and Brown (1968) and Davies and Canes (1978) show that, particularly after transaction costs are taken into account, there is little chance of large excess returns being earned by fund managers. Fund managers would argue that if markets really were efficient in a semi-strong form, how have investors such as Warren Buffet consistently beaten the market and earned large returns time after time? Supporters of EMH would argue that Buffet is simply one of the lucky individuals in the 50% group of people that have earned higher than normal gains from the market. But this only occurs by chance, and for every one Buffet there are thousands of investors that have drastically underperformed in the market.

Strong Form Efficiency

The strong form of EMH states that the current price fully incorporates all existing information, both public and private often referred to as inside information. The main difference between the semi-strong and strong efficiency hypotheses is that in strong efficiency, nobody should be able to systematically generate profits even if trading on information not publicly known at the time. In other words, the strong form of EMH states that a company’s management are not able to systematically gain from inside information by buying company’s shares ten minutes after they decided to pursue what they perceive to be a very profitable acquisition. The rationale for strong-form market efficiency is that the market anticipates, in an unbiased manner, future developments and therefore the stock price may have incorporated the information and evaluated in a much more objective and informative way than the management.

Empirical tests of the strong-form version of the efficient markets hypothesis have typically focused on the profitability of insider trading. If the strong-form efficiency hypothesis is correct, then insiders should not be able to profit by trading on their private information. Jaffe (1974) finds considerable evidence that insider trades are profitable. Another paper by Rozeff and Zaman (1988) finds that insider profits, after deducting an assumed 2 percent transactions cost, are 3% per year. Thus, it does not appear to be consistent with the strong-form of the EMH. Madura and Wiant (1995) came to the same conclusion. Kerr (1980) and Lin and Howe (1990) found evidence to suggest that Strong-form efficiency does hold, however, the majority of studies and tests support the theory that markets are not efficient on a strong-form level. Insider trading was made illegal in the UK in 1980 to ensure confidence was not lost in the market. However, it can be quite difficult to prove such illegal actions have taken place and it is believed insider trading is still very much a part of the market system today.

Although there are large amounts of empirical evidence to support EMH, there are a majority of sources refuting the EMH, these sources are connected with a behavioural finance idea (Buczek, 2005). The behavioural theory assumes that people do not act in an ideal way. It denies that every investor uses sophisticated mathematical models to make investment decisions during the day. There will always be some restrictions for example technological restrictions or time constraints. According to Herbert Simon who defined the homo oeconomicus behaviour as ‘satisficing’ which is an amalgam of words ‘satisfy’ and ‘suffice’. It means that people are looking for results that are satisfactory but not necessarily the best possible.

Also a number of anomalies have been found in the market which suggests that large returns can be made from analysing and researching relevant and current information. Many of these anomalies are concerned with seasonal factors. One such anomaly is known as the weekend effect where there seem to be excess returns in the market on Fridays and lower returns on Mondays. There is also the January effect where shares tend to produce higher than average returns in the first few days in the month of January. Other such seasonal effects include the Sunny day effect, the geometric storms effect and even the lunar phases effect (Yuan, Zheung and Zhu, 2001) which implies that stock returns are lower on days around a full moon than on days around a new moon, all such studies throw support towards the argument that EMH does not hold. There is also the bubble effect which is concerned with explosive movements of share prices. Then there is value investing which has been highlighted as a useful means of apparently beating the market. Evidence such as that of Keim (1988) and Lakonishok (1994) are very supportive towards the value investing theory. During the period 1973 to 1991 Michael Higgins used a method known as the Ten-stock strategy to beat the market and made really high returns. Such evidence suggests that the work of fund managers may not be such a waste of time after all and with the correct analysis, ways of making excess gains can be identified.

Conclusion

Through analysing research on Efficient Market Hypothesis there are many pros and cons. The different forms of efficient market hypothesis were discussed as well as the sources supporting and refuting this hypothesis. After the introduction of Effective Market Hypothesis, early evidence supported the theory suggesting that markets were fully efficient. However, more recent studies have found anomalies do exist in the market and large gains can be made from indicating under-priced shares through the analysis of relevant information. Critics of EMH would say that this evidence is enough to prove markets are in fact inefficient and in the future, more anomalies can be found to exploit such inefficiencies. On the other hand, supporters of EMH would argue that explanations can be found for the majority of these anomalies and that evidence in favour of the theory proves that markets are efficient at least in a semi-strong form. Also, with continuing advances in technology and more stringent rules and regulations (e.g Vickers Report) being placed on companies operating in the market place, our markets will become even more efficient as time progresses. Therefore as Jenson once said “I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis."(Jensen, 1978) "and my finally conclusion is if the Efficient Markets Hypothesis was a publicly traded security, its price would be enormously volatile." (Shleifer and Summers, 1990)

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