
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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