Fama-French EMH
Market efficiency refers to the degree to which asset prices fully reflect all available information at any given time. An efficient market implies one in which assets are always fairly priced, implying that investors cannot achieve excess returns using available information. The classic Eugene Fama framework defines three levels:
- Weak-Form Efficiency - prices reflect all past market data (historical prices and trading volume).
- An outcome of this is that technical analysis cannot generate significant returns.
- Semi-Strong-Form Efficiency - prices reflect all publicly available information (i.e., financial statements, news), including past market data.
- An outcome of this is that fundamental analysis cannot generate significant returns.
- Strong-Form Efficiency - prices reflect all information, both public and private (including insider trading).
- An outcome of this is that no investor can generate excess returns.
It has been observed that the market supports weak-form efficiency, as there is little evidence that technical analysis works consistently, and partially supports semi-strong efficiency, as markets quickly react to public information, although sometimes behavioral biases get in the way. Strong-form efficiency is not supported, as insider trading results in so much excess returns that it is illegal.
Aside from assuming that market participants are rational, the EMH is based on the following underlying assumptions:
- If there exist irrational agents, their trades are random and cancel each other without affecting prices.
- If irrational agents trade in a correlated manner, rational arbitrageurs will eliminate their influence on prices.