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Theories and models are subject to criticism, and the concept of efficient-market hypothesis is not an exception. The economists who employ a psychological and behavioral approach to analyze stock market characteristics have significantly criticized the efficient-market hypothesis as being unrealistic in terms of predictability and efficiency. The idea of efficient-market hypothesis sometimes referred to as the efficient capital markets were proposed during the 1970s, the model proposed that security markets played a significant role in depicting the information concerning individual stocks, and consequently the whole stock market. According to the efficient market hypothesis, technical and fundamental analysis of past trends of stock cannot help investors in predicting the undervalued stocks. The efficient-market hypothesis is of the view that prices of stocks varied randomly, irrespective of the current stock prices. The model was an intellectual approach to economics. The efficient market analysis was subject to criticism basing on the argument that stock prices are predictable and depends on the current price due to psychological and behavioral elements that are used in stock evaluation (Brooks, 2010). This paper attempts to provide an insight towards the three forms of EMH and an in depth understanding towards the relevance between the financial crisis that began during 2007, the idea of rational markets and the EMH.
Forms of EMH
There are three basic forms of EMH: the weak-form efficiency, the semi-strong efficiency and strong form efficiency. Each of the EMH form has varying implications on the operations of the stock market.
For the case of weak-form efficiency, the stock prices in the future cannot be determined by carrying an analysis of the current prices and the past prices. According to weak-form efficiency, excess returns cannot be realized in the long run through the use of investment approaches, which significantly rely, on historical data or a historical record of the share prices. In this context, technical analysis approaches have no capability of continuously generate returns, although a small number of fundamental analysis techniques can produce excess returns. Stock market share prices do not tend to depict serial dependencies; this implies that there are predictable patterns that can be used to determine future stock prices in weak-form efficiency-market hypothesis (Kirman, 2009). The significant factor that determines the future stock market prices is the availability of information that is not contained in the price domain. Therefore, prices tend to follow the random walk theory. In a weak EMH, stock prices do not necessarily need to maintain equilibrium or maintain a value near equilibrium, what this infers is that the market participants cannot gain from the market. A criticism directed at weak-form efficiency-hypothesis is because a significant number of studies have reported that stock prices have depicted a marked tendency over a longer duration despite the absence of fundamental information. This means that there is some degree of relationship between the duration a stock is traded and its price (Brooks, 2010).
For the case of semi-strong-form efficiency, stock share prices tend to vary depending on the available new information. Price variations are rapid and unbiased, implying that excess returns cannot be generated through trading basing on the available information. In this case, both fundamental and technical analysis techniques cannot be deployed to generate excess returns. In order to valuate semi-strong form EMH, changes in the recently unknown news or information have to be immediate and should be of a reasonable size. Therefore, investors have to analyze consistent changes that occur upwards or downwards after the change has been reviewed. If the outcome is that there are changes in the stock price, then the investors must have interpreted the trend in a manner that can be deemed biased and inefficient (Brooks, 2010).
Strong form EMH depicts that stock prices should be based on all available information, that is both private and public and that no excess returns can be generated. This means that insider information serves no role in determining the prices of the securities. In order to evaluate strong form efficiency, a stock market requires that the investors in the market do not continually profit from excess returns in a long duration. In cases where private information is deterred from becoming public, possibly due to legal constraints, strong form EMH is typically impossible unless there is a market scenario that is characterized by the ignorance of universal laws.
There is a relationship that exists between the financial crises that began during 2007, the concept of rational markets and EMH. EMH can be stated as being primarily responsible for the 2007-2010 financial crises. This is because financial leaders ignored the idea of rational markets and laid more emphasis on EMH, resulting to the underestimation of the dangers associated with intellectual economics. The EMH resulted to the ignorance of the psychological and behavioral strategies that are used to evaluate stock market trends. The functionality of the stock market cannot be argued to follow the trends depicted in EMH; rather they follow the psychological and behavioral trends in determining and evaluation of excess returns. The flaw in the hypothesis resulted to many financial investors making wrong decisions, which ultimately played a significant role in influencing the financial crisis of 2007 to 2010 (Kirman, 2009).
In conclusion, the criticisms directed towards the efficient market hypothesis are warranted because the hypothesis does not put into consideration the fundamental factors that determine the trends in price of securities. The behavioral approach to economics has some sense in comparison to the efficient-market hypothesis. The belief in EMH by economists and financial investors can be deemed as one of the key causes of the financial crisis of 2007.