Background to Study
The efficiency of stock markets is an issue that elicited massive research for several decades as investors try to find ways of maximizing the value of their money in the securities exchange market. While a section of the researchers have argued that stock markets are efficient, meaning that market price offers the best value estimates. However, some scholars believe that stock markets are inefficient and open to manipulation by individuals who have personal selfish interests. Damodaran defines an efficient market as that where market prices are an unbiased estimate of an investment value (4). This means that if an investor goes to the market to purchase a given stock, the value offered is approximately equal to the price it is paid for without any unbiased hidden information. This concept also holds that information about a given stock will make its value adjust in the market to reflect the new value. For instance, when Apple Inc announced the introduction of its new series of smartphones, the investors knew that the firm will earn huge profits out of the sales of the new line of products. The news will, therefore, inform the investors that the value of Apple stock is expected to increase. Subsequently, the stock prices of Apple Inc increased as people rushed to buy them to benefit from the expected returns. However, it is important to note that sometimes the market may not react to the news as one would expect. Moreover, some information sent to the public is always deceitful, meant to give a new value to a stock in a misleading way. In this paper, the researcher will investigate stock market efficiency.
In this section, the researcher will focus on the existing literature to understand stock market efficiency. According to Gagan and Mandeep, stock market efficiency is as complex as it is confusing to many investors around the world (138). The basic principle that drives the stock market all over the world is that the stock market is efficient and that the price presented shows an accurate value of the stock. If this principle is proven to be ineffective, then the stock market system may not work as it is because it will force investors to launch a private valuation process to any stock they want to purchase. To have a comprehensive valuation of stocks of a large firm such as Coca Cola which has branches almost in every country on earth is almost impossible for a private investor. Such a valuation process is not only expensive but time-consuming. By the time the valuation process is completed, the dynamics shall have changed necessitating another valuation process. It means that even the rich cannot rely on the private valuation of stocks of a firm they want to buy because of the complexities. Fama notes that most of the investors in the securities exchange market are the middle class who may not afford an extra cost of conducting valuation (295). They have just enough to invest into their desired firms and they hope that the price is the closest estimate of the stock value. It means that this principle of stock market efficiency is the main driving force in the stock market.
The research by Malkiel focused on two large firms, Enron and Lehman Brothers that have remained historic for their fall after an impressive performance in the New York Stock Exchange (62). The researcher used these two firms to explain how deceitful the market price can be, insisting that stock market efficiency is still a fallacy that investors should be very wary of when making their investment. Enron Corporation was once one of the leading American energy, services, and commodity firms that had its headquarters in Houston, Texas. This was one of the firms that were admired by investors, not only in the United States but in Europe and parts of Asia. At the dawn of the millennium, it was evident that this was one of the firms that would define America’s future, especially in the Energy sector. The stock prices of this firm were experiencing impressive growth in the market because of the perceived excellence in the market. For six consecutive years, Fortune Magazine named it the most innovative firm in the United States. At the time when investors knew that this firm was at its peak, a revelation about accounting fraud at the firm hit the investors. The value that was in the market was hypothetical. Within a few months after the revelation, the firm was declared bankrupt, and with it went all the funds of the investors. The Lehman Brothers is another firm whose fall is entirely blamed on the mortgage crisis that hit the United States in 2007. It was another case of an investment made based on hypothetical figures that did not reflect the truth. The result of this stock market inefficiency was the fall of a financial institution that was the fourth largest in the United States at the time of crisis.
According to Dimson and Mussavian, stock market efficiency does not entirely mean that the stock price is an exact reflection of the value of a firm’s stock (144). The deviations are common and should not be construed as inefficiency in the market. The leading assumption in the concept of market efficiency is that information is readily available to investors and that they use such information to determine the price of the stock. Sometimes investors may be slow in responding to the information, while in other cases they can be very swift. The reaction of the investors to the information presented to them may vary a great deal based on their level of confidence in a firm or lack of it thereof. For instance, the world is keen on replacing machines and cars that heavily rely on fossil fuel with those that rely on renewable energy. This is information that is known to investors in the motor industry. However, it has not affected the stock prices of companies producing engines that rely on fossil fuel. This is so because the investors believe that the shift from petroleum-powered engines to renewable energy-powered engines is an issue of the future that cannot be used to determine the value of the stocks. In an efficient stock market, information is made available to the investors, but their decision to act on it remains theirs to make. A situation where investors decide to ignore the information cannot be considered as inefficiency unless the information was misleading.
Damodaran talks about three forms of stock market efficiency which include the weak form, semi-strong form, and strong form efficiencies (21). In a weak form efficiency stock market, the current prices are based on information about the past prices. It means that the availability of information is limited, and investors are forced to base their decisions on information about the past as a way of predicting the present. In semi-strong efficiency, the current stock prices are based on the past prices and all public information such as news reports and financial statements. In strong-form efficiency, the current stock prices are based on all available information, both private and public, about past and present. According to Fortune, achieving market efficiency is not an automatic process (28). It is a deliberate effort of the investors to sense bargains and effect schemes meant to achieve the best offers that bring about efficiency. As Fama puts it, stock market efficiency is achieved when investors identify potential returns caused by inefficiency in the market and take advantage of those returns until market efficiency is achieved (302). The point of equilibrium is the state where the stock market achieves efficiency under normal market forces that occur naturally without influences from people with personal interests. It means that profit-seeking investors are the major driving force to achieving stock market efficiency. These investors will be keen on gathering information about their firms of interest from all the possible sources. Once they get the information, they act on it as soon as possible to either maximize their profits or avoid loss. This explains why the stock prices of a firm can fall very rapidly in the face of negative information. For fear of losing their investments, investors would rush to the market to offload their shares as fast as possible before their value is significantly diminished.
Data Collection and Research Methodology
In this study, it was important to collect reliable data that would help in explaining the concept of stock market efficiency and all its mechanisms. Data was collected from two main sources. The first source of information came from a review of the literature. Stock market efficiency has attracted the attention of scholars for decades, and their works are readily available in books, journal articles, and websites among other forms. The literature provided a fundamental background of this study. The researcher was keen on identifying conflicting views in this literature and the gaps that had to be addressed.
The second source of data was obtained from sampled respondents who accepted to participate in the study. It is important to note that most of the data were gathered from the literature. The decision to collect extra information from experts was driven by the fact that the researcher could easily reach them. They would help address some of the conflicts in the literature and the existing gaps in explaining this concept. After reviewing the literature, the researcher analyzed the primary data to help arrive at a common solution informed by facts. The analysis of the primary data took the form of case studies. The respondents provided case studies that help in putting this concept into perspective. The use of a case study was considered very relevant in explaining the actual events that took place in a company and the outcome of those events.
Analysis and Discussion
The researcher used qualitative studies to help in elaborating on the findings obtained from the literature review. The researcher was specifically interested in a case study that was observed in the literature review, the case about Enron Corporation. The researcher identified two individuals who worked in mid-managerial positions at the firm in the years preceding its fall. They had first-hand information about the underhand dealings at the firm and how information was manipulated for the benefit of a few individuals.
Stock Market Efficiency: A Case Study of Enron Corporation
Enron Corporation was once one of America’s leading companies in the energy and commodity sector. The firm enjoyed a prolonged period of economic success that was driven by consumer and investor confidence. In the late 1990s, the firm started experiencing financial problems. Its debts were increasing and the incomes were on the decline due to poor strategic decisions by the top management and slowing economy. In the year 2000, the top managers realized that the firm was headed for a crisis, especially if the actual accounting reports were to be revealed to the public. The management, therefore, creatively planned for accounting fraud that estimated the firm’s revenues at the end of the year 2000 at over $ 110 billion. The main idea in this accounting fraud was that if the investors were retained within the firm, the managers would buy more time to address all the issues affecting the firm to restore it to its glorious position in the energy sector. However, this scheme failed when the financial woes at the firm worsened in 2001. The firm could no longer run normally under its financial position and the accounting fraud could no longer save the firm. The truth had to come out, and the beneficiaries were the top managers at the firm and their associates who knew the actual events going on at the firm ahead of the public. They sold all their shares before the announcement, sparing them from the massive loss. From January 2000 to January 2001, Enron’s Corporations’ market capitalization had declined by over $ 63 billion, a phenomenon that had never been witnessed in the country. Within that same period, the stock prices of the firm had fallen drastically. The firm was declared bankrupt in 2001.
Analysis of the case
The case study points out some of the important factors that define the stock market efficiency. The first factor is the need to provide valid information to the public. Lack of valid information in the stock market breeds inefficiency because it incapacitates the ability of the investors to make informed decisions. An efficient stock market can rarely lead to massive losses that were experienced by Enron’s shareholders within such a short period. Losses in an efficient stock market are normal because investors always know they are gambling. However, over 50% loss of investment within a short period is abnormal.
Stock market efficiency is the major principle that guides all the operations in any stock market. Investors are like gamblers who use specific determinants to guess the most appropriate stocks in the market. These determinants are based on the information provided to them in the stock exchange market. Stock market efficiency helps in ensuring that market prices are unbiased estimates of the actual value of the stock. It eliminates cases where investors are duped into buying worthless stocks at very high prices.
Damodaran, Aswath. Market Efficiency: Definitions and Tests. International Journal of Economics 11.4 (2009): 1-42.
Dimson, Elroy, and Massoud Mussavian. A brief history of market efficiency. European Financial Management 4.1 (1998): 91-193.
Fama, Eugene. Market efficiency, long-term returns, and behavioral finance1. Journal of Financial Economics 49.3 (1998): 283–306.
Fortune, Pater. Stock Market Efficiency: An Autopsy. New England Economic Review 18.3 (1991): 16-39.
Gagan, Sharma, and Mahendru Mandeep. Efficiency Hypothesis of the Stock Markets: A Case of Indian Securities. International Journal of Business Management 4.3 (2009): 136-142.
Malkiel, Burton. The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives 17.1 (2003): 59-82.