An efficient market is one in which the market price of a security is an unbiased estimate of its intrinsic value. Market efficiency is defined in relation to information that is reflected in security prices. Eugene Fama suggested that it is useful to distinguish three levels of market efficiency.
- Weak Form Efficiency – It asserts that the current price fully incorporates information contained in the past history of prices only. That is, nobody can detect mispriced securities and “beat” the market by analysing past prices. The weak form of the hypothesis got its name for a reason – security prices are arguably the most public as well as the most easily available pieces of information. Thus, one should not be able to profit from using something that “everybody else knows”. On the other hand, many financial analysts attempt to generate profits by studying exactly what this hypothesis asserts is of no value – past stock price series and trading volume data. This technique is called technical analysis.
- Semi-strong Form Efficiency – It suggests that the current price fully incorporates all publicly available information. Public information includes not only past prices, but also data reported in a company’s financial statements (annual reports, income statements, filings for the Security and Exchange Commission, etc.), earnings and dividend announcements, announced merger plans, the financial situation of company’s competitors, expectations regarding macroeconomic factors (such as inflation, unemployment), etc. In fact, the public information does not even have to be of a strictly financial nature. For example, for the analysis of pharmaceutical companies, the relevant public information may include the current (published) state of research in pain-relieving drugs. The assertion behind semi-strong market efficiency is still that one should not be able to profit using something that “everybody else knows” (the information is public).
- Strong Form Efficiency – The strong form of market efficiency hypothesis states that the current price fully incorporates all existing information, both public and private (sometimes called inside information). The main difference between the semi-strong and strong efficiency hypotheses is that in the latter case, nobody should be able to systematically generate profits even if trading on information not publicly known at the time.