Do anomalis disprove Fama's efficient market theory?

Do anomalis disprove Fama's efficient market theory?

This is the second in a series of blogs in which I hope to cover a range of topics. I originally intended to follow directly on from my first blog that discussed employee owned companies, however, I wanted to look into Fama;s theory after discussing it in my lecture. For anyone that hasn't read my first blog, you can find the link right here --> Employee ownership.

The theory's origin

So before, we look at Fama's hypothesis, we must first look at Kendall as it is widely agreed that this is where Fama built his theory. In 1953, Kendall's paper suggested that price changes occured in a random fashion so a price movement will only occur when new information enters the market (Kendall, 1953). Here then, he is stating that you can't predict a price movement systematically as there is no connection between shares.

Fama's hypothesis

Fama agreed with Kendall and built upon his theory in 1970. He identified three forms of efficiency which, were seperated into the following (Fama, 1970):

1. Weak form efficiency;

• Current share prices reflect all past movements
• No trading rules based on historical movements will generate above market profits

    2.  Semi-strong form efficiency;

• share prices reflect both historical and current market data while reacting quickly to any new information that enters the market
• As a result of the market adjusting to new information, an investor can not make any abnormal returns.

   3.  Strong form efficiency;

• share price reflects all information, no matter if it has been made public or not
• abnormal returns can not be made
• markets can be strong form inefficient

Abnormalities

There are a few relevant abnormalities that need to be discussed but the first ties in well with what has just been mentioned in, strong form inefficiencies.

Strong form inefficency
    This is when only some people have privilaged information, known as insider traders. This allows certain indivuals to buy more, or get rid of stock before information is released to the market. This results in higher returns or reduced losses. This of course is illegal but is still believed to occur in most markets, however, only those that have been proved can be studied. Examples of insider trading can be found in Melvin Backman's blog here (Backman, 2014) --> Insider trading.

Time of the day effect
   This was a short term abnormality that was quickly corrected. When the markets become available for people to trade

Turn of the year effect
   As the year ends, individuals and small companies often change their portfolios by selling their shares in an effort to avoid a higher amount of taxation. Keim and Reinganum (1983) stated that their research found a 'two week abnormality' during the first two weeks of January for smaller companies where they will experience substantial short term losses where investors sell their stocks for income tax purposes. This pressure to sell will reduce the price of the stock short term, however, following this period investors repurchase their holdings to reestablish their position (Schwert, 2003).

 The small firm effect        
   Schwert also explains how the 'small firm effect' creates an abnormality in Fama's theory. He states that smaller companies usually outperform larger companies as there is a higher level of growth opportunity. Small companies have a much more volatile environment, so correcting an existing issue, can result in abnormal returns, and given that their stock prices are generally lower than larger companies, it means that the price appreciation tends to be higher (Schwert, 2003).

So has Fama's theory been disproven?
   Well, Warren Buffet, one of the most successful investors in the world once said that there will continue to be wide discrepancies between price and value in the market place, and as a result, he remains convinced that there is much inefficiency in the market place (Insider Monkey, 2010).

"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.” (Warren Buffet, 1984). 

    Buffet then, disagrees with the theory's of Fama and Kendall, believing a current stock price does not reflect every piece of information, and investors can capitalise on the emotions of a person. He strongly believes that if stock is performing well, then you should buy them, rather than trying to spread risk by diversifying and ultimately minimise your potential profit.
   It does appear that the success of Buffet and the anomalies shown above show that Fama's theory can't be used in a complete sense, however, it is argued that his theory does appear to have been important in the development of researches understanding between risk and return. In this sense, it is still an important theory to understand and study, and is discussed as an important viewpoint in most theory's relating to the efficient market hypothesis.

   For anyone with a further interest into Fama's reasoning into his theory, I have found a video link that is a very interesting watch, which you can find right here --> Fama discusses his theory
   Thank you for reading and please leave comments or discussion points below.

References

Backman, M. (2014). Five famous insider trading cases. Retrieved from http://money.cnn.com/gallery/investing/2014/06/02/insider-trading-famous-cases/

Fama, E. F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work (2nd ed.). New York, USA: Blackwell Publishing for the American Finance Association.

Insider Monkey. (2010). Here's What Warren Buffet Thinks About The Efficient Market Hypothesis. Retrieved from http://www.businessinsider.com/warren-buffett-on-efficient-market-hypothesis-2010-12 

Kendall, M.G. (1953). The Analysis of Economic Time Series, Part I. Prices. Journal of the Royal Statistical Society, 96(1), pp 11-25

Schwert, W. (2003). Anomalies and Market Efficiency. University of Rochester, 943. Retrieved from http://schwert.ssb.rochester.edu/hbfech15.pdf.