Today’s presentation is largely academic in nature. But, in the end, I sought to draw a conclusion on whether this topical discussion is of relevance to Guyana’s Financial Market in respect to its operation and inherent structure – in practice.
The Efficient Market Hypothesis (EMH) assumes that Financial Markets are efficient in terms of a plethora of information, news and communication involved, basically the availability and accessibility of information with respect to financial markets activities regarding the values of financial securities. Theoreticians of financial economics advocated that efficient markets constitute large numbers of market participants, characterised as rational profit maximizers actively competing to predict future values for individual securities on the basis of freely available current information within the market. Thus this assertion implies that, effectively, both individual and aggregate stock market fully reflect available information, and can integrate in current stock prices.
EMH encompasses three differently distinguished forms: strong form, semi-strong form, and weak form efficiency. A strong form efficiency exists where information (public, personal and confidential) is fully reflected and is incorporated in stock pricing; and therefore this in effect prohibits investors from achieving competitive advantage in their investment processes and strategies.
A semi-strong form exists where stock prices reflect publicly available financial information such as balance sheets, assets, announcement of listed companies etc.; and a weak efficiency exists where current stock prices reflect historic information, past stock prices to be specific, and as such they cannot be utilized for future predictions.
The Global Financial Crisis and the Efficient Market Hypothesis
Many economists and analysts placed the blame on the efficient market hypothesis as one of the main contributors to the global financial crisis. However, others challenged and refuted this assumption. Proponents of the EMH highlighted that this claim was ‘wildly exaggerated’. It was argued that, despite the efficient market theory constitutes many obvious limitations, all good theories have limitations. In support of this premise, they pointed to the occurrence of the 1637 Dutch Tulip ‘mania’ as the first event of an asset bubble that has been recorded, followed by the South Sea Company Bubble, the 1926 Florida Land Bubble, among a few others, all of which had taken place long before the appearance of the efficient market hypothesis in the financial economics theory.
Further, it was posited that market efficiency does neither predict nor implicitly imply in any way that it should predict remarkable failures of large banks or investment banks. In this sense, reference is made to the collapse of large financial institutions such as the Lehman Brothers among other institutions that collapsed during the 2007-2009 financial crisis. Case in point: the demise of the Lehman Brothers conclusively illustrates that taking massive risky positions financed by phenomenal leverage, in a competitive capital market, incurring a huge loss is bound to happen one day in spite of how prestigious and large the institution may be. Furthermore, if the EMH could have predicted the crisis or a market crash, then this would mean the market prices are inefficient, because they would not have reflected the information embodied in the prediction.
The efficient market hypothesis constitutes two facets: it combines the simple competitive economic theory with an information-based view of security prices. This framework irreversibly changed the way the financial markets are viewed today. This is the case even if it may not represent completely how markets behave, in the same way like all other important insights. Despite the inevitably obvious limitations of the efficient market framework, its impact has thus far proven to be durable, and therefore it seems likely to continue to be relevant in the context of its impact and effects of its applicability and use on financial markets.
A theory is an abstraction of reality, and is not necessarily sacrosanct and perfect when applied in real world context. It is not a conclusive fact of reality. Unlike scientific experiments that develop and enhance scientific theories which are more justifiable in a factual and realistic sense, in the field of economics and finance, theories are not developed on scientific experiments. Rather, they are developed based upon studies and assumptions. The fact that it is not practical nor possible to carry out a study on every single organisation in the world to develop or support a theory, this in itself sufficiently proves that all theories existing in the economics and finance field are not perfect, are not comprehensively factual, and all must have limitations. This very fact is the fundamental reason why a critical approach and analysis is necessary by experts in the field.
In fact, it is concluded that, indeed, while it may appear paradoxical in light of its critics, the efficient market framework remains relevant and highly endorsed by many in the field, as it relates to the operations of financial markets.
And finally, Guyana’s financial market is obviously characterised as a weak form efficiency. Put differently, it is not truly efficient; or, as the theory suggests, strong form or even semi-strong form in nature. The reason for this is very simple. It is largely so because it is not structurally advanced. The stock exchange, for example, is not technologically driven, it is still operated manually; and, more importantly, stock prices are not affected by any adverse or positive non-financial developments of the firms in question. In the advanced economies, on the other hand — the U.S, for example — those markets are highly efficient in that regardless how financially sound a firm may be, if there is any negative event that would tarnish the reputation of that firm, that information would have an instant impact on the stock price, which would of course likely cause stock prices to fall, thus causing investors to incur huge losses.
