Strong Form

The strong form of the efficient market hypothesis holds that stock prices reflect all public and private information. Consequently, this information cannot be used to beat the market. Private information includes information known only to the insiders in management, boards of directors, and others who may be privy to this information such as investment bankers. This hypothesis assumes that the market is highly efficient and that stock prices react very quickly to insider information. If this is so, even corporate insiders will not have information that will benefit them because stock prices will have already reacted to the information. According to this form, no investors or groups of investors who are privy to monopolistic information (insider information) will benefit by earning superior returns because the markets are virtually perfect.

Research does not support the strong form of the efficient market hypothesis. This form of the efficient market hypothesis has been studied and tested with regard to returns earned by specialists and by insiders using insider information. A specialist on the stock exchange has a book of orders that are waiting to be executed at different prices. Specialists buy and sell stocks from their own inventories in order to provide a liquid market for stocks. The specialist thus has some valuable information about the direction of stock prices. For example, if a specialist has many unfilled limit orders to buy a stock at $9 per share and the stock is trading at $12, the specialist knows the price will not fall below $9 per share. A study sponsored by the Securities and Exchange Commission (SEC) reported that specialists earned, on average, a return of over 100 percent on their capital (SEC, 1971). Table 12–1 discusses how specialists and insiders affect the stock market.

Table 12-1
Specialists and Insiders and How They Affect the Stock Market
Specialists on the NYSE act on behalf of investors to bring buyers and sellers together. In other words, specialists are the “middlemen” on the floor of the exchange carrying out trading orders. These people are required to keep an orderly market, which means that if more selling than buying takes place, specialists will need to buy and sell from their own inventories of stock to provide liquidity in the stock. Thus the line between trading for self-interest and keeping an orderly market in the stock can be blurred easily. Specialists are not supposed to trade ahead of their clients’ orders so that they can profit from the trades. This practice, known as front-running, occurs when specialists know that they can profit from buying shares ahead of clients. An NYSE investigation of the trading of some specialists has raised investors’ concerns about the pricing of shares and left them clamoring for increased transparency of pricing. Proceeding in this direction does not please institutional clients, who do not want their orders disclosed. It is this knowledge of unfilled limit orders that give specialists the monopolistic information that allows them to earn excessive returns on their invested capital. One way to take this type of self-interest out of the equation is to do away with the specialist system by changing to automated trading, in addition to making prices more transparent.
Corporate insiders are the other group that earns excessive returns by using nonpublic information. Three arguments take place in defense of insider trading (Manne, 2003, p. A14). The first is that insider trading does not have an adverse impact on individual trading in the market. The second is that insider trading moves share prices to their “correct” prices, resulting in efficient markets. The third is that insider trading acts as a successful form of incentive compensation for hiring innovative and successful management.
Critics of insider trading have not been silent. They argue that if investors think that insider trading results in an “unfair” market, they will not invest, resulting in a market that is not liquid. The second argument is that if specialists and market makers are faced with insider trading, they will increase their bid and ask pricing spreads, resulting in higher prices for individual investors in the market.
There has been no overwhelming support to eliminate insider trading. Although the SEC requires periodic disclosure by insiders, the most powerful argument for insider trading is still the efficient pricing mechanism, which has prevailed. Corporate insiders trade their stocks until the “correct” price is reached.

Corporate insiders are privy to special information that brings about superior returns. Studies show that insiders achieve greater returns than those expected of a perfect market (Lorie and Niederhoffer, 1966, pp. 35–53). Insiders are defined as officers and directors of a company and those shareholders who own at least 10 percent of a company’s stock.

Insiders are privy to information that has not been made available to the public. Hence there is a fine line that distinguishes between legal and illegal use of this information. Corporate insiders have access to privileged information but are not allowed to use that information to earn short-term profits or to engage in shortterm trading (six months or less). They are allowed to trade and make profits on the stock on a long-term basis, and their trades must be reported to the SEC.

Despite the fact that specialists and insiders are able to earn superior returns, which rejects the strong form of the efficient market hypothesis, some support exists for the strong form based on the performance of mutual fund managers. Mutual fund managers receive information faster than the investing public, yet they have not been able to consistently outperform the market averages. The different outcomes can be summarized this way: The use of privileged (monopolistic) information may help generate superior returns, and the use of publicly available information may not be able to assist in consistently earning superior returns.

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