If there is to be one “father” of the efficient market hypothesis, this man is Eugene Fama, who remains an outspoken proponent of the hypothesis to this day. In Fama (1970, 1991, 1998), he gave comprehensive overviews of the literature on the topic. But before Fama, there are also a lot of works done to approach this theory. Back in the 16th century the prominent Italian mathematician, Girolamo Cardano, in The Book of Games of Chance (Cardano, c. 1564) wrote:
‘The most fundamental principle of all in gambling is simply equal conditions, e.g. of opponents, of bystanders, of money, of situation, of the dice box, and of the die itself. To the extent to which you depart from that equality, if it is in your opponents favors, you are a fool, and if in your own, you are unjust’. In 1900 a French mathematician, Louis Bachelier, published his PhD thesis, Thi?? eorie de la Spi?? eculation. He deduced that He deduced that ‘the mathematical expectation of the speculator is zero,’ which is 65 years earlier before Samuelson (1965) explained efficient markets in terms of a martingale.
In 1944, Cowles reported that investment professionals do not beat the market (Cowles, 1944). Holbrook Working showed that in an ideal futures market it would be impossible for any professional forecaster to predict price changes successfully (Working, 1949). And then Larson (1960) presented the results of an application of a new method of time series analysis in which notes that the distribution of price changes is ‘very nearly normally distributed for the central 80 per cent of the data, but there is an excessive number of extreme values.
‘ Fama and Blume (1966) concluded that for measuring the direction and degree of dependence in price changes, serial correlation is probably as powerful as the Alexandrian filter rules. In 1968 Michael C. Jensen evaluated the performance of mutual funds and concluded that ‘on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses’ (Jensen, 1968). Fama et al. (1969) undertook the first ever event study, and their results lend considerable support to the conclusion that the stock market is efficient.
Eugene F. Fama’s published the definitive paper on the efficient markets hypothesis first of three review papers: ‘Efficient capital markets: A review of theory and empirical work’ (Fama, 1970). He defines an efficient market thus: ‘A market in which prices always “fully reflect” available information is called “efficient. “‘ He was also the first to consider the ‘joint hypothesis problem’. The efficient markets theory reached its height of dominance in academic circles around the 1970s.
At that time, the rational expectations revolution in economic theory was in its first blush of enthusiasm, a fresh new idea that occupied the center of attention. The idea is that speculative asset prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information meshed very well with theoretical trends of the time. Prominent finance models of the 1970s related speculative asset prices to economic fundamentals, using rational expectations to tie together finance and the entire economy in one elegant theory.
For example, Robert Merton published “An Intertemporal Capital Asset Pricing Model” in 1973, which showed how to generalize the capital asset pricing model to a comprehensive intertemporal general equilibrium model. Robert Lucas published “Asset Prices in an Exchange Economy” in 1978, which showed that in a rational expectations general equilibrium, rational asset prices may have a forecastable element that is related to the forecast ability of consumption. In the years from the 1950s to the 1970s, most studies based on the CAPM and fair game models found evidence consistent with the efficient market hypothesis.
Ball (1978) wrote a survey paper which revealed consistent excess returns after public announcements of firms’ earnings. Jensen (1978) wrote, ‘I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis. ‘ He defines efficiency: ‘A market is efficient with respect to information set ? t if it is impossible to make economic profits by trading on the basis of information set ? t. ‘ Robert E. Lucas Jr. built a theoretical model of rational agents which shows that the martingale property need not hold under risk aversion (Lucas, 1978).
After coming into the 21st century, the theory develop rapidly to go further research. Lewellen and Shanken (2002) concluded that parameter uncertainty can be important for characterizing and testing market efficiency. Chen and Yeh (2002) investigated the emergent properties of artificial stock markets and show that the EMH can be satisfied with some portions of the artificial time series. Malkiel (2003) examined the attacks on the EHM and concludes that stock markets are far more efficient and far less predictable than some recent academic papers would have us believe.
G. William Schwert showed that when anomalies are published, practitioners implement strategies implied by the papers and the anomalies subsequently weaken or disappear. In other words, research findings cause the market to become more efficient (Schwert, 2003). Malkiel (2005) showed that professional investment managers do not outperform their index benchmarks and provides evidence that by and large market prices do seem to reflect all available information.
Wilson and Marashdeh (2007) demonstrated that co-integrated stock prices are inconsistent with the EMH in the short run, but consistent with the EMH in the long run. The elimination of arbitrage opportunities means that stock market inefficiency in the short run ensures stock market efficiency in the long run. In a paper on the global financial crisis Ball (2009) argued that the collapse of Lehman Brothers and other large financial institutions, far from resulting from excessive faith in efficient markets, reflects a failure to heed the lessons of efficient markets. Lee et al.
(2010) investigated the stationary of real stock prices for 32 developed and 26 developing countries covering the period January 1999 to May 2007 and conclude that stock markets are not efficient. Except CAPM model, there is a second class of models used to test market efficiency focuses on variance as the key characteristic. Among them are the model of Shiller (1981), who reported that stock prices were too volatile to be efficient when compared to subsequent dividend payouts, and the model of Marsh and Merton (1986), which showed that Shiller’s results could be reversed by a change in assumptions regarding the dividend model.
The reply of Schwartz (1970) to the seminal paper of Fama (1970) could also be considered to fall into the category of variance efficient market models, as it propagated the use of models that tested for variance-based strategies to generate excess returns in capital markets. The first variance efficient market models in the early 1980s coincided with the advent of behavioral finance and behavioral market models, which soon started to erode the solid standing the efficient market hypothesis had (until that time) enjoyed in academic circles.
A number of anomalies were discovered in empirical data, suggesting that the universal belief in the applicability of the efficient market theory had been overly optimistic. Today, evidence of widespread efficiency in developed markets coexists with well-recognized anomalies, both in these highly developed markets in industrialized countries and – much more frequently – in less developed market economies. These anomalies can be subsumed under a few broad categories, which are summarized in the following section.
