Perfect Market Efficiency: Reality or an idealistic view?

The recent fall in crude oil prices has created large disruption to global oil companies, including Exxon Mobil who experienced a 21% fall in profits during Q4 2014 (Carroll 2015, Krauss 2015 & Driver 2015). This led me to question how efficiently the market is responding to such changes and what, if any, there impact is on Exxon’s share price.

There are 3 different types of stock market efficiency; Operational, Allocational and Pricing. The focus of this blog will be pricing; assessing how well a market responds to new information. In an efficient capital market share prices accurately reflect all information that is publically available, rendering it impossible to develop trading rules to ‘beat the market’. The efficient market hypothesis (EMH) states any new information revealed about a company will be incorporated into the share price rapidly and logically. Therefore, stock market efficiency means share prices reflect their true economic value. Would it not, therefore, be rational to expect the 21% drop in Exxon’s profit to be reflected by a reduced market value?

EMH argues news is unpredictable making future price changes impossible to forecast. Kendall (1953) provided evidence of a random walk hypothesis, finding no logical link between one price movement and succeeding ones. It follows that share prices will be random, since they reflect new information which is unpredictable. On the basis of this, it could be argued statistical, technical analysis of share prices is effectively irrelevant. Conversely, a counter argument could be presented in the fact that many large companies still employ technical analysts implying they find their skills to be useful.

Fama (1970) developed Kendall’s initial findings, proposing three forms of market efficiency. The first was weak form, proposing share prices reflect all historical movements and information. Any profits generated in excess of the market return will be done so by chance. There is an array of evidence strongly supporting this theory. In terms of Exxon, the announcement of a 21% fall in profits during the fourth quarter of 2014 should not be immediately incorporated into their share price. Supporting this, on 2^nd February, the day of the announcement, Exxon’s shares ended the day’s trading 2.5% higher, outpacing the gain in the overall market. Does this lack of immediate reflection in the share price imply a slow reaction from the market? 

                                                                                                                 Figure 1. Exxon Mobil share price. 
                                                                                                                 Note. NASDAQ, 2015

Perhaps, but as displayed in figure 1, Exxon’s share price fell by almost 5% in the 6 days leading up to the announcement. This premature impact on the share price could lead some to conclude investors had an indication about the fall in profits, seemingly possessing some level of insider knowledge. This would provide support for strong form market efficiency, in which share prices reflect all information regardless of whether it is publically available. In this situation no one can make abnormal returns. However, in instances involving insider dealing, in which an insider or group has access to information that is not publically available, abnormal returns have been seen. This form is best viewed as a benchmark against which market inefficiency can be judged.

A much more credible explanation, at least in my opinion, is that investors were aware of the impact the falling oil industry would have in the forthcoming profit announcement from Exxon. Oil markets are oversupplied whilst demand is declining, resulting in falling prices. The price of crude oil, seen as the international benchmark, fell by more than a third in the final quarter of 2014. It surely then came as no surprise that Exxon’s fourth quarter profits were negatively impacted, arguably explaining the drop in share price in the days leading up to the announcement.

This argument provides support for the semi-strong form of market efficiency; share prices reflect all historic movements as well as publically available information. Semi-strong market efficiency supports EMH, arguing share prices react quickly and logically to new information. The 2.5% increase on the day Exxon announced their profit, and the subsequent increase the following day, could be a result of the company’s statement regarding dividends. They announced the 9.5% increase in dividends remains unaffected, which may have restored investor confidence. It may also be worth noting that due to the current uncertainty of the oil industry, in which prices plummeted further in January, share prices are likely to be volatile for the coming months.

The efficient market theory has been heavily criticised for various reasons, including behavioural issues. Investors may not always make rational decisions, but may be overruled by cognitive reflexes such as overconfidence. However, stock market efficiency is vital for shareholder wealth maximisation; an important aspect of most businesses, discussed in my previous blog. Market efficiency makes this seem like a realistic goal, although some have claimed it may tempt managers to hold back negative information. It is clear the market is not perfectly efficient, as it is impossible for market values to reflect all information. Rather, investors rely on a flow of information to the market to allow share prices to incorporate new information and reflect their true value. In my opinion Kendall’s Random walk hypothesis provides the best account of share prices. Information cannot be predicted, nor can the way in which investors will react to this news. Therefore, accurate forecasts cannot be made, suggesting share prices are in fact ‘random’.

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson Education.

Carroll, J. (2015). Exxon Profit Declines After Oil Market Collapse. Retrieved 18 February 2015, from http://www.bloomberg.com/news/articles/2015-02-02/exxon-profit-declines-as-oil-industry-reels-from-market-collapse

Driver, A. (2015). Exxon fourth-quarter profit tops estimate, share buyback slasher in half. Retrieved 18 February 2015, from http://www.reuters.com/article/2015/02/02/us-exxon-results-idUSKBN0L618820150202

Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance, 25(2), 383-417. Retrieved from JSTOR http://www.jstor.org/

Kendall, M. (1953). The Analysis of Economic Time-Series – Part 1: Prices, Journal of the Royal Statistical Society, 116(1), 11-34. Retrieved from JSTOR http://www.jstor.org/

Krauss, C. (2015). Exxon Mobil Revenue and Profit off 21% on Oil Decline. Retrieved 19 February 2015, from http://www.nytimes.com/2015/02/03/business/energy-environment/exxon-mobil-q4-earnings-decline.html?_r=0

NASDAQ. (2015). Exxon Mobil share price. Retrieved 18 February 2015, from http://www.nasdaq.com/symbol/xom/interactive-chart

Watson, D. & Head, A. (2013). Corporate Finance: principles and practices. (6^th ed.), Harlow: Pearson Education.