Weak, Semi Strong, Strong EMH

After reviewing these different classifications of EMH, will someone explain what kind of EMH we typically participate in? I would guess Semi Strong since material nonpulic information is not reflected in most stock prices.

From my understanding, tests for the strong, semi-strong and weak forms of EMH have generated results that are not unanimous. Regarding the semi-strong form of the EMH, event studies like stock-splits, IPOS, accounting changes etc have generated unanimous results, while exchange listing studies have generated mixed results. In contrast, studies that predict the rates of returns over time or for a cross section of stocks presented results that support the semi-strong form of the EMH. As for the strong form of the EMH, the results for the corporate insiders and stock exchange specialists do not support the hypothesis as these 2 groups have monopolistic access to important info that is used to gain above-average returns. However, studies done on money managers generated mixed support. Some money managers (those in the non-mutual fund universe) generated retruns that beat the Russell 3000 index but equity mutual funds generated results tthat are consistent with the EMH for long term periods.

I see now. So our current market situation is not thrown into any bucket. Example, if you believe in strong form, one would invest only in index funds. If one believes in weak form, they would assume active management can beat the indexes. Or am I way off?

Weak Form: Technical Analysis is worthless - exceptional profits can’t be made from analysis of previous prices. Semi-Strong: Fundamental Analysis doesn’t generate exceptional returns - all publicly available information (financial statements etc) is already priced into the market value of stocks. Strong: All information, public AND nonpublic is priced into stock market values. This says that even with insider information, one can’t make extraordinary profits. Weak-form has been shown to be correct. Semi-Strong form is HIGHLY debated (convincing evidence exists for efficiency, but anomalies do exist). Strong Form is a pipe dream (“prevented” with insider trading laws).

“Shown to be correct”? How come I don’t believe it?

So which form does active management fall into.

…I should have said “is generally accepted by the academic circle in finance”.

Semi-strong implies that active management based on fundamental analysis will not outperform the market (ie buy index funds).

I’m assuming that weak form suggests active managment can outperform the indexes. Otherwise what are all these PM’s thinking? If you believe in efficient markets, then one will benefit soley from index funds. If one does not, then active managment can outperform.

Weak form doesn’t address fundamental analysis (most actively managed portfolios focus on fundamental analysis), so it leaves open the possibility that exceptional returns can be earned through active fundamental management. Semi-strong form closes the door on fundamental analysis (if you agree with it) and is advocated by the likes of Burton Malkiel and John Bogle (founder of Vanguard).

Ok, that clears things up. Burton Malkiel wrote that incredible book A Random Walk Down Wall Street where he openly admits the high paid analyst in pin stripe suites more often than not cannot predict the market. One of my favorite books. Regardless, I want to take a stab at finding the holy grail which compliments my drive for the CFA/CAIA etc.

I think markets are not created equal, some are very liquid and active with hundreds of highly skilled participants monitoring possible arbitrage opportunities, others illiquid and with minimal activity. Take, for instance, GOOG on Nasdaq vs. some small stock, so many analysts and institional investors watching GOOG and eliminating arbitrage opportunities instantenously vs. few people following the small stock and even if they do, they may not have the capital to eliminate all arbitrage opportunities. Similarly, I would think with the influx of computers and various quant methodologies over the past 30 years, major markets are probably more efficient now. Still, observing market behaviour, it does seem markets get overbought/oversold based on investor sentiment (sadly I know nothing about behavioural finance) so I would side with Joey to say that even the weak form is suspect.

I think liquidity has a strange interaction with market efficiency. As FourCastles says, GOOG should be efficiently priced as it is heavily covered by oodles of analysts, trades huge volume, has lots of infomation publicly available, etc… On the other hand, how do day traders feel about GOOG? (They like it - I guess day traders are either fooling themselves or perhaps there’s money to be made in a highly liquid inefficient market). I’ve used technicala analysis to trade bond futures, Euros, DAX futures, etc… The problem with all these efficient market studies is that they are just using some very limited set of tools to make broad and vague conclusions.

Efficient market studies do no justice to technical analysis. It’s as if technical analysis consists of a bunch of rigid rules, when it’s more of a risk mitigation technique that relies on subjective reasoning. Do yourselves a favor and read Stan Weinstein’s Secrets for Profiting in Bull and Bear Markets. Personally, I think EMH is useless. It makes good filler material in textbooks.