The fundamental thesis of the efficient capital markets hypothesis (ECMH) is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never over- or under-priced. The current price is an accurate reflection of the market?s consensus as to the commodity?s value. Of course, there is no real world condition like this, but the U.S. securities markets are widely believed to be close to this ideal.
Studies of the ECMH, as applied to the securities markets, have explored three forms of the theory. Each tests a different level on which markets process information. The weak form posits that all information concerning historical prices is fully reflected in the current price. Put another way, the weak form predicts that price changes in securities are random. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices go up on good news and down on bad news. If a company announces a major oil find, all other things being equal, the stock price will go up. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices. (People trying to sell you technical analysis hate this, but it's true.)
An important question for investors is the extent to which the ECMH is a valid model for emerging markets. An interesting new paper, Testin g the Weak-Form Efficiency of the United Arab Emirates Stock Market, sheds light on that question:
This study examines the behavior of stock prices in United Arab Emirates (UAE) stock market. The data consist of the daily prices of the 43 stocks included in the Emirates market index covering the period commencing October 2, 2001 through September 1, 2003. The returns of all the 43 sample stocks do not follow the normal distribution, so the study utilizes only the nonparametric runs to test for randomness. The results reveal that the returns of 40 stocks out of the 43 are random at a 5% level of significance. Hence, the empirical study supports the weak-form EMH of UAE stock market.
These results are surprising and challenging to traditional views because the UAE stock market is newly developed and just recently became official with sound regulations. Furthermore, the market is very small and thin suffering from infrequent trading. However, the results of the paper may be attributed to the essential steps that have already been taken by the authorities to improve the operating and pricing efficiency of UAE stock market during the last two years.
I find this a particularly significant result, because it suggests that weak form efficiency may develop quite early in an emerging market's development. Hence, a whole host of trading strategies (such as charting), likely will be unprofitable - or even counter-productive - even in relatively underdeveloped capital markets. (On the other hand, as the paper notes, studies of other thin capital markets have reached the opposite result. Caveat emptor.)
