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THE SEMI-STRONG AND STRONG
FORMS OF THE EFFICIENT-
MARKET THEORY
The academic community has rendered its judgment.
Fundamental analysis is no better than technical analysis in
enabling investors to capture above-average returns.
Nevertheless, given its propensity for splitting hairs, the
academic community soon fell to quarreling over the precise
definition of fundamental information. Some said it was what
is known now; others said it extended to the hereafter. It was
at this point that what began as the strong form of the
efficient-market theory split into two. As we have seen, the
“semi-strong” form says that no public information will help
the analyst select undervalued securities. The argument here
is that the structure of market prices already takes into
account any public information that may be contained in
balance sheets, income statements, dividends, and so forth;
professional analyses of these data will be useless. The
“strong” form says that absolutely nothing that is known or
even knowable about a company will benefit the fundamental
analyst. According to the strong form of the theory, not even
“inside” information can help the investors.
The strong form of the theory is obviously an
overstatement. It does not admit the possibility of gaining
from inside information. Nathan Rothschild made millions in
the market when his carrier pigeons brought him the first
news of Wellington’s victory at Waterloo before other traders
were aware of the victory. But today, the information
superhighway carries news far more swiftly than carrier
pigeons. And Regulation FD (Fair Disclosure) requires
companies to make prompt public announcements of any
material news items that may affect the price of their stock.
Moreover, insiders who do profit from trading on the basis of
nonpublic information are breaking the law. The Nobel
laureate Paul Samuelson summed up the situation as follows:
If intelligent people are constantly shopping around
for good value, selling those stocks they think will turn
out to be overvalued and buying those they expect are
now undervalued, the result of this action by intelligent
investors will be to have existing stock prices already
have discounted in them an allowance for their future
prospects. Hence, to the passive investor, who does not
himself search for under- and overvalued situations,
there will be presented a pattern of stock prices that
makes one stock about as good or bad a buy as another.
To that passive investor, chance alone would be as good
a method of selection as anything else.
This is a statement of the efficient-market theory. The
“narrow” (weak) form of the theory says that technical
analysis—looking at past stock prices—cannot help
investors. Prices move from period to period very much like a
random walk. The “broad” (semi-strong and strong) forms
state that fundamental analysis is not helpful either. All that
is known concerning the expected growth of the company’s
earnings and dividends, all of the possible favorable and
unfavorable developments affecting the company that might
be studied by the fundamental analyst, is already reflected in
the price of the company’s stock. Thus, purchasing a fund
holding all the stocks in a broad-based index will produce a
portfolio that can be expected to do as well as any managed
by professional security analysts.
The efficient-market theory does not, as some critics have
proclaimed, state that stock prices move aimlessly and
erratically and are insensitive to changes in fundamental
information. On the contrary, the reason prices move
randomly is just the opposite. The market is so efficient—
prices move so quickly when information arises—that no one
can buy or sell fast enough to benefit. And real news
develops randomly, that is, unpredictably. It cannot be
predicted by studying either past technical or fundamental
information.
Even the legendary Benjamin Graham, heralded as the
father of fundamental security analysis, reluctantly came to
the conclusion that fundamental security analysis could no
longer be counted on to produce superior investment returns.
Shortly before he died in 1976, he was quoted in an interview
in the
Financial Analysts Journal
as saying, “I am no longer
an advocate of elaborate techniques of security analysis in
order to find superior value opportunities. This was a
rewarding activity, say, 40 years ago, when Graham and
Dodd was first published; but the situation has changed….
[Today] I doubt whether such extensive efforts will generate
sufficiently superior selections to justify their cost…. I’m on
the side of the ‘efficient market’ school of thought.” And
Peter Lynch, just after he retired from managing the Magellan
Fund, as well as the legendary Warren Buffett, admitted that
most investors would be better off in an index fund rather
than investing in an actively managed equity mutual fund.
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