Why might the efficient market hypothesis be less likely to hold when fundamentals suggest stocks should be at a lower level?

The efficient market hypothesis holds that when new information comes into the market, it is immediately reflected in stock prices; neither technical analysis (the study of past stock prices in an attempt to predict future prices) nor fundamental analysis (the study of financial information) can help an investor generate returns greater than those of a portfolio of randomly selected stocks. The author reviews the recent findings of three schools of thought that challenge the efficient market hypothesis based on their claims that evidence of predictable patterns in stock prices exists.

One school of thought challenging the efficient market hypothesis is momentum investing, a combination of technical and fundamental analysis that claims that certain price patterns persist over time. The second is behavioral finance, which maintains that investors are guided by psychology more than by rationality and efficiency. And the third is fundamental analysis, which holds that certain valuation ratios predict outperformance and underperformance in future periods.

Momentum investors base their argument against the efficient market hypothesis on the following. In a truly efficient market, the short-term serial correlations among stock prices should be zero, but several studies have shown examples of short-term serial correlations that are not zero, thus indicating the possibility of a discoverable pattern. The author, however, shows that although these findings are statistically significant, they may not be economically significant. For example, as soon as evidence of the so-called January effect was made public, investors incorporated the information into their investment decisions and the effect disappeared. Furthermore, momentum strategies do not perform well in all markets. Although they led to excess performance in the late 1990s, they generated underperformance relative to the poorly performing market of the early 2000s.

The author then addresses the findings of behavioral finance, which indicate that investors overreact to some events and underreact to others. He cites research indicating that underreaction is as common as overreaction and that postevent continuation of abnormal returns is as common as postevent reversals. In other words, what appears to be a trend according to the tenets of behavioral finance may merely be a random event.

With regard to fundamental analysis, many believe that initial dividend yield and price-to-earnings multiples can be used to predict future stock results. The author points out, however, that these measures do not consistently predict stock performance in all time periods, which means that they do not contradict the efficient market hypothesis. The author concludes that occasional anomalies do not violate the efficient market hypothesis; they lose their predictive power when they are discovered and do not hold true in the long run.

The author, a well-known proponent of the efficient market hypothesis, refutes the claims of all these schools of thought currently challenging the efficient market hypothesis. He notes, however, that a difference between market efficiency and perfect pricing exists; the market often misprices securities, at least in the short run, but an investor cannot know before the fact when mispricing will occur.

An important debate among investors is whether the stock market is efficient—that is, whether it reflects all the information made available to market participants at any given time. The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according to their inherent investment properties, the knowledge of which all market participants possess equally.

Financial theories are subjective. In other words, there are no proven laws in finance. Instead, ideas try to explain how the market works. Here, we take a look at where the efficient market hypothesis has fallen short in terms of explaining the stock market's behavior. While it may be easy to see a number of deficiencies in the theory, it's important to explore its relevance in the modern investing environment.

• The Efficient Market Hypothesis assumes all stocks trade at their fair value.
• The weak tenet implies stock prices reflect all available information, the semi-strong implies stock prices are factored into all publicly available information, and the strong tenet implies all information is already factored into the stock prices.
• The theory assumes it would be impossible to outperform the market and that all investors interpret available information the same way.
• Although most decisions are still made by humans, the use of computers to analyze information may be making the theory more relevant.

There are three tenets to the efficient market hypothesis: the weak, the semi-strong, and the strong.

The weak make the assumption that current stock prices reflect all available information. It goes further to say past performance is irrelevant to what the future holds for the stock. Therefore, it assumes that technical analysis can't be used to achieve returns.

The semi-strong form of the theory contends stock prices are factored into all information that is publicly available. Therefore, investors can't use fundamental analysis to beat the market and make significant gains.

In the strong form of the theory, all information—both public and private—are already factored into the stock prices. So it assumes no one has an advantage to the information available, whether that's someone on the inside or out. Therefore, it implies the market is perfect, and making excessive profits from the market is next to impossible.

The EMH was developed from economist Eugene Fama's Ph.D. dissertation in the 1960s.

While it may sound great, this theory doesn't come without criticism. 

First, the efficient market hypothesis assumes all investors perceive all available information in precisely the same manner. The different methods for analyzing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock's fair market value. Therefore, one argument against the EMH points out that, since investors value stocks differently, it is impossible to determine what a stock should be worth under an efficient market.

Proponents of the EMH conclude investors may profit from investing in a low-cost, passive portfolio.

Secondly, no single investor is ever able to attain greater profitability than another with the same amount of invested funds under the efficient market hypothesis. Since they both have the same information, they can only achieve identical returns. But consider the wide range of investment returns attained by the entire universe of investors, investment funds, and so forth. If no investor had any clear advantage over another, would there be a range of yearly returns in the mutual fund industry, from significant losses to 50% profits or more? According to the EMH, if one investor is profitable, it means every investor is profitable. But this is far from true.

Thirdly (and closely related to the second point), under the efficient market hypothesis, no investor should ever be able to beat the market or the average annual returns that all investors and funds are able to achieve using their best efforts. This would naturally imply, as many market experts often maintain, the absolute best investment strategy is simply to place all of one's investment funds into an index fund. This would increase or decrease according to the overall level of corporate profitability or losses. But there are many investors who have consistently beaten the market. Warren Buffett is one of those who's managed to outpace the averages year after year.

Eugene Fama never imagined that his efficient market would be 100% efficient all the time. That would be impossible, as it takes time for stock prices to respond to new information. The efficient hypothesis, however, doesn't give a strict definition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable, but will always be ironed out as prices revert to the norm.

But it's important to ask whether EMH undermines itself by allowing random occurrences or environmental eventualities. There is no doubt that such eventualities must be considered under market efficiency but, by definition, true efficiency accounts for those factors immediately. In other words, prices should respond nearly instantaneously with the release of new information that can be expected to affect a stock's investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit that absolute market efficiency is impossible.

Although it's relatively easy to pour cold water on the efficient market hypothesis, its relevance may actually be growing. With the rise of computerized systems to analyze stock investments, trades, and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution.

Despite the increasing use of computers, most decision-making is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the surefire method of achieving greater returns than the market averages.

It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater efficiency to occur, all of these things must happen:

• Universal access to high-speed and advanced systems of pricing analysis.
• A universally accepted analysis system of pricing stocks.
• An absolute absence of human emotion in investment decision-making.
• The willingness of all investors to accept that their returns or losses will be exactly identical to all other market participants.

It is hard to imagine even one of these criteria of market efficiency ever being met.