Stock Market efficiency: Can you predict the market or is it random chance and what does that mean for efficiency?

Stock market efficiency is a topic that has various theories and ideas surrounding it. The main focus in this area is the efficient market hypothesis with the main focus being on pricing and looking at how we get it right. It is argued that in order to test the efficiency of the market, there needs to be an event or news to determine how the market moves in relation to this occurrence.  If a company released their quarterly report which showed good results, the share price would go up (this is in a perfect world with a perfectly efficient market). So basically simply put ‘In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient," or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information.’ (Miller, 2009) However, we don’t live in a perfect world and therefore it is likely that we don’t have a perfectly efficient market. If the market isn’t perfect (which anything rarely is) can we actually predict what is going to happen?

The BBC news reported on February 9th that Rolls Royce had seen its profits rise by 21% this year, increasing to £1.16bn! My first thought was, we should definitely see the market reacting positively to this information, especially when their orders rose 5% as well reaching £62bn, a substantial amount. However, the London Stock exchange, reported something completely different from expected as the share price for Rolls Royce had gone down from the 8th Feb by 18.5. This would highlight that markets are completely random, as who could have predicted the price would go down after such a positive result?  This leads to the belief that Kendal (1953) is correct and that the stock market is completely random, with price and movements reacting in an unpredictable way.  However, Kendal (1953) also argues that ‘changes occur when new news enters the market’ and ‘share prices at any time reflects all known information’. This seems to be untrue in the case of Rolls-Royce because surely the market would react positively to profits rising to 21% this year. However, profits don’t mean everything when it comes to the market, what about the dividends and other factors that could influence people’s reactions?

When looking at Fama (1970) argument, the likely form of efficiency for the UK market is the semi-strong theory, which states that share prices do reflect the information available both publically and historically, he also argues that the market ‘reacts quickly and rationally to new information.’ However, how can this be the case when Rolls Royce shares have gone down after releasing information that shows huge profits and good increases in orders? This brings us back to the fact the some information may not affect the share price as dramatically as others. If Rolls Royce released that it was not going to pay out any dividends this year, it would most likely be predicted that the market would react very negatively to this information. However, as stated above, profits aren’t the main basis of interest for those buying and selling shares, although important, there are other more essential results that may be more likely to impact the market. If this is the case, then is the market semi-strong in terms of efficiency? It would appear when looking at the recent case of Rolls Royce, that the market doesn’t react as dramatically as is expected over every piece of information. Therefore its level of efficiency is questionable, because it would be expected to see fluctuations and rises over the trading day, however on a day like February 9th 2012, a more dramatic movement would be expected because of the news coverage of Rolls Royce. This highlights that the market isn’t predictable, saying it is portrays the fact that we can read the future! No one can predict what things will happen to a company on a day to day, month to month or year to year basis, we can guess but to know for sure would be impossible. Therefore it is impossible to know definitely how the market will react; of course we can make educated guesses but that’s about as far as we are able to go. This then raises the question, if it is so unpredictable, is it efficient? 

Sources used: BBC news, The Financial Times, Fama 1970, Kendal 1953, Miller 2009, Arnold: Corporate Financial management 2008.