premises upon which EMH are constructed require that all new information be discounted immediately and rationally in order for the market to be perfectly efficient. Efficient under EMH means that the market participants must react:
1. Instantaneously to all market information
2. Rationally to all market information
EMH requires new information in order for prices to change. Bullish news will cause prices to rise and bearish news will drive prices down. Acting rationally means that all participants will make the same logical decision based on the new information received. Instantaneously means acting or responding immediately to new information. Therefore, for the market to efficiently discount or reflect all information, all of its participants must act on all of the information in the same manner instantaneously. See Figure 1.27.
Figure 1.27 Efficient Market Adjusting to New Information.
EMH contends that since the markets are efficient, there is no point in employing technical analysis, as prices would have already adjusted to the new information and the analyst would have no way of forecasting future action without such information. The reality is that there is discounting in the markets, but it is in no way perfectly efficient. In other words, the markets are at best semi efficient. This is because it is impossible to have all market participants acting instantaneously and rationally. It is a physical and logistical impossibility in the physical world. A simple “handclap” test will prove the point. If a large group of participants was asked to clap in response to a specific single event like the ring of a bell, we would find that there is little chance of observing a perfectly coordinated handclap across the group once such an event occurred.
As we have already discussed earlier, not all participants in the real world would react in exactly the same manner or arrive at the same logical decision based on the new information. Some market participants may have a different view of the markets and view the new information as inconsequential with minor impact on the markets, and may even trade against the new information. Also, there are a large number of strategies that one can employ to trade the markets based on the same information. As a result, when new bullish information is released, participants may:
• Enter a long position immediately
• Enter a short position based on an average-up scale-trading strategy
• Scale in more positions as the market rises
• Scale out positions that may have already been in profit
• Wait for prices to become overextended before fading the breakout
Even if the market participants were to act rationally and all make the same logical decisions based on the new information, they may not be able to act on the information instantaneously. They may have received delayed information or were not standing by in readiness to act on the information when it arrived. They may also find it physically impossible to act on all information, especially when information streams in continuously in very quick succession. They may also be unable to afford the cost of such information. As such, the discounting of new information will take place at a slower rate, with a semi-efficient market adjusting gradually to the new information as market participants compete with each other for the best fills. See Figure 1.28.
Figure 1.28 A Semi-Efficient Market Gradually Adjusting to New Information.
Figure 1.29 is a 5-min chart of the EURUSD depicting the markets adjusting to new information, in this case the nonfarm payroll and unemployment report. Notice how prices swing back and forth as traders compete with each other in light of the new information. Price finally makes a top at the 61.8 percent Fibonacci projection (projecting AB from Point C) level and begins consolidating.
Figure 1.29 A Semi-Efficient Market Gradually Adjusting to New Information.
Source: MetaTrader 4
Nevertheless, EMH assumes three basic levels of information discounting:
1. The Weak Form: The weak form of EMH suggests that all current prices have already been fully discounted and, as such, reflect all past price information. Therefore, they cannot impact future prices. The application of technical analysis is therefore pointless and meaningless.
2. The Semi-Strong Form: The semi-strong form of EMH suggests that all information, once public, is of little use as price would have already adjusted to the new information making the use of such information unprofitable and pointless. Market participants would have little opportunity to take advantage of such information. This implies that even fundamental analysis is pointless and meaningless.
3. The Strong Form: The strong form of EMH suggests that all information, regardless of whether public or private, would have been already fully reflected in the current price. Consequently, all forms of analysis and forecasting are pointless and meaningless.
Random Walk
Closely related to the EMH is the concept of Random Walk. Random walk suggests that prices move in a purely random manner and that:
• Past prices do not have any influence on current price
• Current price has no influence on future price (Markovian condition)
All information is already incorporated into the current price. This would mean that there is no way whatsoever to forecast future action, and prices are as likely to go up as they are to go down. This renders all form of analysis and forecasting pointless and meaningless. Random walk is in a way related to EMH, insofar as current price represents the current state of all information. In random walk, prices do not adjust to any new information, unlike in EMH. Its motion is purely random or stochastic.
So, are the markets following a random walk? As we already know, the markets are driven by perception and expectation and not by random acts of buying and selling. It is totally inconceivable that all participants invest in the markets in a purely random fashion, completely unencumbered by cost, emotions, psychology, and biases. As we already know, market participants tend to react in a highly predictable manner time and time again. It is the author’s opinion that random walk is simply not a true representation of everyday market action. See Figure 1.30.
Figure 1.30 Random Walk, EMH, and Their Implications.
Real-World Discounting
In the real world, markets overreact and there is insider activity. With insiders buying and selling, prices adjust to reflect this information. See Figure 1.31. Once the new bullish or bearish information is released, the insiders would in fact be liquidating positions in profit, selling off the shares to the public.
Figure 1.31 Insider Activity Impacting Market Action.
Figure 1.32 shows the market overreacting to new information. We see the insiders accumulating shares prior to the release of the new information. The public joins in after the information is published. Public participation begins to increase as more participants join in the now
