EMH: Fact or Fiction?

As the impending doom of the CFA Level 1 test date approaches my review of the material has prompted me to talk about Efficient Market Hypothesis. In the texts they outline 3 scenarios, weak form EMH, Semi-strong form and Strong form EMH. It is humorous how the text essentially says if EMH holds then no single person can really earn above average returns on a risk adjusted basis. At the end it basically says there is conflicting information.

The odd thing to me is how it barely touches on market psychology and behavioral finance when I think that is the more relevant factor that drives markets. The amusing thing to me is when they compare fundamental analysis to technical analysis and how they seem to be mutually exclusive. I always take fundamental analysis to be the more "conservative" discipline however when it is examined more closely how conservative is it? In addition how much different is it to technical analysis? The reason I say that is because no matter what you are doing, either fundamental or technical analysis, it involves two things: speculation and confirmation.

In fundamental analysis, which is supposedly more conservative you are speculating about future earnings and future cash flows of a company and hoping past performance is repeatable. Then you wait for confirmation at earnings time, whether it has an upside suprise or a disappointment, then everyone scrambles to readjust their outlooks and price targets. Earnings is apparently the number one reason for stock appreciation. Analysts themselves are generally fairly poor at determining future earnings. Hell, I got much closer than most on my Apple estimates and I had yet to learn anything about future cash flow discounting, WACC, etc... I think also some studies have shown that analyst ratings are a 50/50 shot at best, which makes me wonder what they are doing. Some of that could be political or business reasons, which obviously shouldn't factor in.

I guess the point I am trying to make is that how can a market be efficient when it is supposedly being efficient based off of speculation and incorrect information in the first place. Yes, once news comes out it is fairly quickly adjusted to, but it is adjusted to again based on speculation and the psychology of investors and traders that push stocks up or down.

Technical analysis is not without its drawbacks either however I think now more than ever it has been shown to be more useful than fundamental analysis. Someone may have sworn that GE was a steal at 18.50(which has acted as long term support so that lends support to the argument). However, the bottom line is everything is driven by supply and demand, if that level no longer holds because demand is not there then clearly people don't think it's cheap or want to buy it. Forced selling and uncertainty about earnings threw any type of speculation on future earnings and "fundamentals" out the window. In that scenario all you can do is watch price and volume movement and wait for things to stop going down. Obviously once things do stop and there seems to be price stability either people now find that stock attractive to buy or new news came out to make them buy it. Either way it doesn't matter, what does matter is that you now see the demand there.

The above example also lends credence to behavioral finance or how market psychology effects things. An efficient market would never have bubbles and subsequent bursting of those bubbles. However the fact is that there are bubbles and they overshoot on the upside just like they do on the downside. Take oil for example, it got to nearly 150, now its down at 50, it's actual fundamental supply and demand is likely around 75, but again you have speculators trying to gauge how bad the recession will be and large hedge funds that were far too leveraged and overweight oil and had to get out. The Oracle of Omaha Warren Buffet thought GS was a screaming buy at 120, he must really have liked it at 55 too. The market is driven by fear and greed and you constantly see things get mispriced because the market is either too fearful or too greedy.

The last thing I want to ponder is the matter of self fulfilling prophecies. Whether it is a GS analyst saying oil will go to 150, or a price pattern, some things just seem like they just get the market to buy into it so it happens regardless if it "should". I was told a statistic(that I need to verify) that head and shoulder patterns complete close to 90% of the time. So even if I am going only off technicals I remain curious as to why the pattern forms and why if it does form should it automatically increase as high as its pattern past the neckline? I have to guess that some of it is just because people think it should do that, it does. Same thing with fibonacci retracements, IMO they have absolutely no basis for working because you can chose a high and low wherever you want and they may or may not line up with support and resistance, but if everyone uses them, they work. My opinion is that most traders use rules and price targets and possibly the lines themselves when trading so they appear to work.

Self fulfilling prophecies are again a market behavior and could be exploited for above average returns if they work. I have to assume they are for the most part self fulfilling because I don't think that as a stock confirms a price pattern like a head and shoulders all the analysts following the company immediately agree(or just before it happens agree) that the stock is under valued by the amount the stock "Should" increase according to the pattern.

Anyways, those are my thoughts. EMH is mostly fiction in my opinion, I wish I had a true way to profit from these opinions but sadly I am sure they are nothing new. What the CFA books did show is that to consistently earn above average risk adjusted returns you just have to trade off of inside information, no big deal LOL.