Video Transcript: Efficient Markets Hypothesis

Hello, welcome. We're going to be discussing efficient markets hypothesis. So  let's talk about what is considered a random walk, and how that associates to  efficient markets. So A Random Walk is a theory that stock price movements are unpredictable, so there is no way to know where prices are headed. Studies of  stock price movements indicate they do not move in neat patterns. This random  pattern is natural outcome of markets that are highly efficient and respond  quickly to changes in material information. Now you can notice this is American  states, water company, just a random stock that was picked. You can notice over this three year period, you can see it looks like a real random walk. There is no  real order or process you would think behind the stock movement. Why is it  trading like this? Why is it selling off? Why are people buying so random walk is  the theory that say, Hey, there is no real order to stock price movement. Now  let's think about efficient markets. Efficient Market is a market in which securities reflect all possible information quickly and accurately. To have an efficient  market, you must have many knowledgeable investors actively analyzing and  trading stocks. You need the reason why price movements happen so much is  because there are fluctuating market conditions. Maybe the individual company  is having some volatility. So there are people taking positions, trading in and out, buying the stock, and it's kind of moving sideways, like we'll see here. And the  random walk, this stock is kind of moving sideways. And another thing,  American states water company, it's a water company, right? So water  companies are utilities. They're not really going to have a lot of new demand  drivers, right? We already have plenty of demand for water, right? So American  states water as a utility, isn't going to be trying to capture revenue growth.  They're not trying to capture greater profit, one, because we probably have a  cap on prices that they can charge for water for one, so they can't really grow  their revenues by increasing prices over time. So really, inflation of asset prices  doesn't help a company like American states water, notice how the pattern is just moving kind of sideways. It's not on a real upward trajectory, right or a  downward trajectory. It's just kind of chopping out sideways. Now you notice this may happen too to a company that isn't a utility, that's maybe a retail store or  another type of just producing stock that isn't really heavily regulated by the  government. If there is times of uncertainty and stock traders don't know which  way the stock is going to go, if it's going to move up or down, because the  company is kind of performing neutrally, you'll see this kind of price action that is just sideways. We're just staying in this range because we are trying to figure  out what is the next move of the company. But in this theory of random walk, you can see that it seems random. Why are what are the reasons behind the price  fluctuations? And a lot of this is just buying and selling, people taking positions  traders in the market, manipulating the stock price. So in a way, it is kind of a  random walk, but information of all sorts are being priced in as the stock moves.  That's why you need investors that are knowledgeable, that can digest 

information quickly, so that way, you can have all of the information priced into  that stock price that is out there. Public or private information is widely available  to all investors, public information about all companies, from financials to press  releases, as far as what new products are out there, change in CEO board of  directors, shake up all. Most information is public and is easily priced in to  stocks. Events such as labor strikes or accidents tend to happen randomly, so  when those happen, something that's a negative event that impacts the firm  negatively, their stock price will see a change as well. And if it's a negative  event, more than likely that stock price will be going down in vector investors  react quickly and accurately to new information. That's why you see the prices  change so much as information is priced in knowledge about the company,  ideas, any kind of news, any kind of market conditions, they are all priced in to  the stocks very, very quickly. So the efficient market hypothesis is information is  reflected in prices, not only the type and source of information, but also the  quality and speed with which it is reflected in prices. The more information that is incorporated in the prices, the more efficient the market becomes. So let's look  at levels of the efficient market hypothesis. There's a weak form of efficient  markets, a semi strong form of efficient markets and a strong form of efficient  markets. Take a look at the weak form. So past data on stock prices are no use  in predicting future stock price changes. So they're saying everything's already  already priced in, all the all the past data is already priced in that price, that data will no longer affect the pro the stock price moving forward again, everything is  random in the weak form. They believe that there is really no data that moves  the stock simply, it should be a buy and hold strategy. If you're just buying the  index and you think that we're in a strong market economy and the stock price is going up, there's no reason for these interperiod movements, you need to look  at the long term projection of the price, and if it is upward, buy and hold semi  strong form of efficient markets. So semi strong form abnormally large profits  cannot be consistently earned using public information. That is because the  public information should already be priced in to the stock price. Any price  anomalies are quickly found out, and the stock mark and the stock price adjusts. Adjustments in prices happen quickly. As data comes out, information comes out to the public. All of that information is digested quickly. That is the reason for  market swings, price changes in the semi strong form of the efficient market  hypothesis, strong form, there is no information because everything is already  priced in. So we have, when you have a strong form of efficient market  hypothesis, there is all the information that is out there, private, public, is already priced in, and there is no more room for price depreciation or depreciation based on new data, market anomalies that can affect stock prices, the calendar effect  stock returns may be closely tied to the time of year or time of week in the stock  and stock trading. You'll hear people talk about cyclical trades, getting into retail  stocks whenever it's around the holidays, things like that, questionable if it really 

provides any opportunity, a lot of stock prices do appreciate, especially in retail,  around Christmas time, so they are experiencing sales growth, a lot of revenue  generation during the holidays in retail. So you'll see a lot of people get in retail  stocks at the end of the year during the holidays, because they're expecting  

greater revenue growth in that time period, the small firm effect the size of a firm impacts its stock returns. For example, small firms may offer higher returns than  larger firms, even after adjusting for risk. Sometimes, larger firms can get  bloated, cost heavy, whereas smaller firms are more lean, cost conscious and  more effect and more efficient and effective at managing their risks, so they may offer a higher return because of their flexibility and nimbleness and able to  control costs. Earnings announcements, stock price adjustments may continue  after earnings adjustments have been announced. So usually, Wall Street has  analysts. Firms on Wall Street have analysts, and they will predict out their  future earnings of companies that they follow, and if the company comes in and  beats the estimate of earnings, typically, you'll see a stock price really jump  because they've outperformed the market estimates unusually good quarterly  earning. Earnings reports may signal buying opportunity. That means where the  firm is operating better than expected. Wall Street analysts cover every aspect  of the firm so they know it inside and out, so they're predicting this type of  growth, and if they exceed those estimates, typically, they'll ensue with a lot of  buying and appreciation of stock price. The price to earnings, or the PE effect, or the value effect, uses the price to earnings ratio to value stocks, we'll talk more  about that later. Low price to earning stocks may outperform high price to  earning stocks even after adjusting for risk.