STOCK MARKET AND STOCK PRICES: UNDER THE LENS OF EFFICIENT MARKET HYPOTHESIS

STOCK MARKET AND STOCK PRICES:

UNDER THE LENS OF EFFICIENT MARKET HYPOTHESIS

 

Introduction

            The invisible hand in economics implies that isolated benefits existing in the economy will not be apparent and will continue to be believed normal events.  This is because all economic actors are doing the same thing, which is, outwitting one another to get an upper hand with economic gains and benefits.  In specific areas such as stock markets, the invisible hand is redefined by efficient market hypothesis.  The mechanism is the same with reference to stock price indifference and absence of isolated case of attractive investment.  However, the historical stock market bubbles/ crashes as well as corporate scandals show that the hypothesis is merely a theory and has its limits. 

 

EMH and its Major Forms

Efficient market hypothesis or EMH is an investment theory that posits the zero possibility of outperforming the stock market by using fundamental (e.g. corporate date, economic factors) and technical (e.g. trending) analysis in investment appraisals ().  Due to this, EMH assumes that share prices are determined in the market through all possible and existing information.  There is no room for investors even an expert to achieve gains through available information.  EMH incorporates them to the current share price.  For example, there are no undervalued or overvalued stocks which can attract speculation for potential gain.  As a result, there is no other way to outperform the market rather than to invest and purchase for riskier stocks.  Although highly theoretical and controversial, EMH was evident during 1987 stock market crash and some corporate scandals.   

 

There are three forms of EMH; namely, weak, semi-strong and strong forms (Investopedia).  The first form states that technical analysis can be utilized to outperform the market because the current stock price reflects all past prices that it had during trading.  Alternatively, fundamental analysis can be used to measure if the stock is undervalued or overvalued.  The second assumes is in conjunction to the initial definition of EMH but gains can be held when investors will be able to use unpublished information about the stocks.  Therefore, only public information (i.e. published) are integrated to current stock price.  The third agrees with the complete definition of EMH that includes in the current stock price both the public and private (i.e. through insiders) information.  With this, even when investors will consider a huge amount of research to achieve price gains, this form retires the outcome.

 

EMH Failure and Capital Market Research 

            The historic Great Depression and Enron collapse are two cases in two different times that proved that EMH failure will not be discovered and addressed until adverse effects to stakeholders are at peak.  This calls for a pro-active approach in conducting capital market research in which the endeavor should be infused even if obvious effects are yet to emerge.  The more stringent policies may defer and discourage Enron-like firms temporarily but pro-activity to determine the culprit (client alone) or culprits (client plus auditor) is conceded to have its strategic merits for capital suppliers.  Every potential and existing shareholders and creditors are now bound to get all the help they need from financial advisors, government and peers to secure their funds to entities that have at least a sprinkle of EMH or some degree of the weak-form.  Otherwise, their investment can be easily diluted by the market and/ or the entity without even imploring some contingent measures.  In simple terms, they will lose the battle without pulling out their swords and shields.

 

            Being in chorus to the behavior of a certain financial market proved to be beneficial and less complicated for shareholders.  The case of Great Depression and Enron is not an everyday case while the general pulse of market participants is oftentimes correct and profitable.  However, there are several factors to consider when shareholders will completely give their trust and relate investment options to the capital markets.  For example, the efficiency of stock exchanges in which corporate shares is traded out of their traditional operations.  In economics, the role of the stock market is merely to provide a venue in which demanders and suppliers of capital can meet (1965).  Today, this venue becomes complicated due to brokers and traders, regulation from the government and involvement of foreign firms and investors as well as complexity and uncertainty of the environment. 

 

            For example, the London Stock Exchange had abolished Big Bang scheme that led to de-motivated independent brokers and conversely allowing entities to have their own dealers (1999).  In effect, the exchange can fail to limit the marketing campaigns private brokers can use to attract investors.  As Enron primarily utilized the lack of corporate disclosure and insider trading to obtain its objective, this situation can mimic the manipulative feature by misleading promises and bias advises.  In addition, the abolishment can hinder broker efforts (both private and independent) to seek markets diligently due to their “focused” clients that can ultimately limit the flow of capital in the economy.  Limiting the access to capital and interested borrower stimulates as well aggravates the inclination of firms to implement actions that continuously mitigate the functions and invisible hand of EMH.  Another Enron or perhaps Great Depression can follow in the coming years. 

 

Asymmetrical Information 

            According to Investopedia, asymmetrical information is a condition when one party in a transaction has a more substantial and relevant information than the other party.  In this case, it is likely that the former party will have higher bargaining power throughout the transaction until the latter discovers the error or default in the agreement.  When applied in the corporate setting, the theory of the separation of ownership and management can illustrate this case.  The theory states that investors have an indirect access to inside information with regards to the real corporate value compared to directly managing executives (2002).  As observed, investors can be applied with management tactics to raise self-vested interests of executives.  Traditionally, the latter opt to sell and issue shares when the firm is overvalued as well as the investors are unaware of such condition.  However, this dogma had long been discovered by the market.  as such, investors repel this executive behavior by revaluing their shares causing a negative market reaction.  In the end, the management could not maximize the traditional tactic due to unfolded information of its significance to investors.  

 

            The supposedly first stage of the collapse of Enron was derived from Skilling drastic imposition of rigid and hostile retention scheme (Thomas 2002).  This is a condition of moral hazard (1999).  Before Skilling took the post of Division Manager, former employees have symmetric information with the firm regarding their worth.  However, when Skilling tackled human resource issues, he tried to abort loyal but change-averse staffs with master-level and doctorate degree holders without full disclosure of the plan so that former staffs have adjusted their work ethics accordingly.  In a different case, the unethical accounting practice of Fastow and his collusion with Andersen auditors is an information asymmetry under signaling (2002; 1999).  The victims are the shareholders unknowingly handed by non-transparent corporate and financial reports.  Fastow and Andersen signaled to each other about the hidden action which transformed shareholders as one having asymmetric data from the start of the contract.

 

            Information asymmetry to employees was regarded as the first dark stages of Enron collapse because staff resistance to change is one of the top causes of failure of major corporate changes (2002).  Skilling, who had substantial experience as financial advisor, undermined human resources when it insisted to be hostile on them.  Without loyal employees, quality management is adversely affected because highly-qualified but new employees are neither capable nor motivated in conforming to the new methods under Skilling culture. This scenario may have been integrative-planned by  to limit the size of familiar employees to minimize their unethical exposure.  At this point, Enron was not looking strategically rather financially.  The incomplete information staffs would have been received (like the transition to highly-qualified and scholarly recruits) sparkled the negative atmosphere throughout the organization.  It ultimately impeded cultural cohesion and deepened the opportunity of higher executives to execute their self-vested practices.

 

            On the other hand, information asymmetry to investors as well as rating agencies led to unguided substantial investments.  This formed the foundation for the fame and fortune of Enron to emerge.  Although signaling is primarily evident to investors that purchase stocks or those who increase their holdings under Andersen regime, moral hazard can be more appropriately tagged to initial investors of the company way back in 1980s.  The loophole of this practice by colluding parties, however, is that the huge amount of stakes that used to support the firm’s operations, stock attractiveness and continuity of the unethical practices made them very crucial to the existence of Enron.  As a result, when the scandal cropped up in the offing of the new millennium, the firm had faced not a gradual demise rather instant shutdown. 

 

Option Grants

Under opportunistic perspective, the economic incentives of Enron can vary depending if they opt to engage in fraud or take risks with regards issuing options.  The perspective is an accounting policy used by an organization that is based on manager’s incentives to increase their wealth; however, this will be shouldered by other parties within and beyond the organization (1997).  When they employ fraud, they can manipulate accounting methods providing a tampered profits and performance ratios.  According to the survey of  (1997), most managers are remunerated from the profits or ROA of their respective firms.  In effect, executives will not only impress employees to undergo option grants but as well impress the investors to provide higher incentives believing that the firm is doing well. 

 

Further,  (1987) showed that restrictive covenants formed by corporate debts are surmountable by fraud to improve accounting numbers.  The process will begin after executives have manipulated financial ratios permissible to the constraints of creditors.  In effect, the firm can enjoy strategic actions it cannot implore when the manipulation did not take place.  In return, the firm can implement strategies that will ultimately lead to profitability and growth in either prospective or actual sense.  When this information is delivered to employees, they will think that stock options are attractive investments.  They will purchase stocks unknowing that they are merely funding the efforts of executives to conceal mismanagement or possible bankruptcy.  As a result, executives are rewarded two-fold.  They can manage the firm with the support of creditors and implementing strategies with employees in full support due to the stock options the latter is currently holding.  The cover-up ultimately leads effective fraud on the part of executive whose incentives goes beyond remuneration rather long-term employment, promotion and fame within the industry.         

 

            In a similar case, political groups can impede strategic actions of the firm if it reports high earnings or disclose issues pertaining to adverse external effects of their operations (1997).  The government may impose tax sanctions or legal remedies on tax evasion while environmental groups can boycott its products when informed about negative externalities (like oil spills).  These situations have their adverse impacts in both short-term and long-term existence of the company.  In effect, fraud to accounting methods can result to lack of disclosure and computational manipulation to arrive at a standard level of accounting reports.  This is why the study of  (1996) found that firms with environmental disclosures still used them for corporate image building.  As a result, similar to the benefits of corporate ability to bypass creditor restrictions, the firm can induce its strong business outlook to employees deepening the need of the later to resort to option grants.  Executives can distort the likelihood of disruptions from external actors from a major mental lapse in decision-making through designing accounting methods that can hinder such mistake.   

 

            On the other hand, under efficiency perspective, the efficiency of the contracting parties or transactions at hand is pursued to end at a minimum agency cost.   According to  (1999) accounting alternatives are adopted by executives because it reflects the underlying and true performance of corporate assets ().  This makes fraud selection for executives ineffective, if not, legally impaired.  In this case, risk taking is the more strategic choice for executives to maximize their incentives.  For example, there are different methods to compute for depreciation or amortization.  When this will be related to stock options, executives have minimal control over the options due to the absence of fraud.  In effect, it is left to accept the repercussions of the market.  Although this is ambiguous making a less enthusiastic employee to involve their investment in options, this can be an effective mechanism keep employees and executives “unattached” to corporate performance. 

 

            Due to this, executives will not be pressured to take unethical accounting practices.  One incentive of this is that employees may see the worth of their executives that can induce corporate cohesion.  By doing so, executives can freely implement their strategies and run the organization more smoothly.  Through this, they can reap the benefits of fraud tactics through similar economic benefits plus the recognition they can derive from complimenting and idolizing employees.  They can extend affect their investment decision in the long-run which inevitably acquire employee’s trust.  By this time, executives can opt to apply fraudulent actions as they wish.  Another incentive is that accounting best practice can be awarded to the company by external actors as well as investors. In effect, executives can go away from unethical practices and manipulation that can minimize the costs of hiring additional skilled accountants and the cost of “greasing” to auditors, politicians and other colluding parties. 

 

Conclusion

            The stock markets of today are likely positioned in the middle of reality and theory, that is, under semi-strong EMH.  It allows gains for the issuers and investors alike to make investing exciting and thrilling that is compatible to the appetite of rich businessman and influential people.  The discussion shows that EMH failure is necessary to give way for all the stock market actors to reap specific gains and achieve their personal/ corporate interests.  However, the drawback is that inefficiency in macroeconomic sense is detrimental for the people in the lower bracket of earnings-capacity (i.e. those in poverty or even the working class).  They are completely unable to participate in the stock market, minimal access to assess companies based on credible/ accurate financial statements and controlled by their employers.  As a result, this serve as a policy issue for authorities that requires review and appreciation of EMH and the appropriate EMH form to use in different economic conditions.        

Credit:ivythesis.typepad.com