Stock Market Efficiency – Can the market be predicted?

In my previous blog, I briefly discussed the concept of stock market efficiency; this topic will be my next focus, considering the somewhat controversial subject in more depth by comparing the effects of a recent profit announcement from Centrica to an older example from Royal Dutch Shell. Stock market efficiency divides people in opinion, with some believing that share price movements are completely random and others of the view that share price increases and decreases can be predicted.

Both academics and investors have questioned pricing efficiency – the concept that prices of securities fully and fairly reflect  all information regarding both past events and future events the market expects to occur and therefore that the prices  of securities are priced fairly (Watson & Head, 2013). The testing of markets for efficiency led to the recognition of three different forms of market efficiency. Fama (1970) identified these as follows:

·         Weak-form efficiency

·         Semi-strong form efficiency

·         Strong-form efficiency

The concept of market efficiency will be discussed through the examples mentioned above.

In February, Centrica (the owner of British Gas) hit the news regarding their reported drop in profits. Their full year operating profits fell by 35% with profits at British Gas falling by 23% (BBC News, 2015). Centrica also announced that they had taken the decision to cut dividend payments to shareholders by 30% (Ficenec, 2015). Shares in Centrica ended on the day of the announcement (19^th February) 8.5% lower than the previous day (BBC News, 2015) as shown in the share price graph constructed below. I believe this demonstrates a semi-strong form efficient market because the share price reflects all relevant publicly available information, not just past price movements (Fama, 1970). It is no surprise that investors would sell their shares upon news of a significant dividend cut.

(Share Price figures sourced from http://www.centrica.com/index.asp?pageid=28&type=chart_)

Fama (1970) also suggests that you cannot beat the market by analysing publicly available information after it has been released as the market has already absorbed it into the price. The graph shows that the share price dropped considerably on the day of the announcement and therefore investors would have nothing to gain by acting on the news in the following days.

Centrica are suffering because of the drop in oil prices and the warmer weather in the UK this winter. Global oil prices have halved as supplies increased but demand slumped (BBC News, 2015). The Telegraph’s Questor column which publishes share and stock market tips strongly advised investors to avoid investing in Centrica after the announcement, due to the impact of these factors on Centrica’s profits (Ficenec, 2015). This will have further encouraged investors to sell their shares and contributed to the reduction in share price as this information was readily available to the market.

In contrast, I believe a lack of efficiency was demonstrated in 2012 when Royal Dutch Shell announced a 54% rise in full year profits (Macalister, 2012). Shell were benefiting from higher oil prices even though production had fallen, which also contributed to an increase in net income from $5.7bn to $6.5bn (BBC News, 2012). In an efficient market you would expect the market to react positively to this news as it suggests improved performance. Therefore you would assume the share price would increase. However, this news was met with a reduction in share price as shown in the graph I have constructed below. The significant rise in both profit and income was reported on 2nd February but as you can see the share prices dropped considerably on this day.

(Share Price figures sourced from http://www.shell.com/global/aboutshell/investor/share-price-information/historical-share-prices/london-rdsb.html_)

This could suggest that markets are completely random as you would expect security prices to increase after positive news announcements. This supports Kendall’s (1953) theory of Random Walks - the idea that share prices change in a random fashion, indicating there is no systematic link between one price movement and subsequent ones.

However, Kendall (1953) also suggested that prices were random because they reflect all known information and changes only occur when new information enters the market. The case of Royal Dutch Shell does not seem to support this. Does this then display a lack of efficiency from the market as they are not acting rationally to known information? Or alternatively, do investors simply not value this information regarding profit and income rises? I suppose an investor is most concerned with what return they can expect from a company and therefore value dividend announcements more highly as demonstrated in the recent example of Centrica.

Nevertheless, I believe one critique of Kendall’s theory would be the existence of chartists and investment analysts. I believe this should be considered when thinking about my original question. If analysts are continuing to make considerable returns in their line of work, how can share price movement be totally random? 

To conclude, I believe you cannot predict the stock market and share price movements are completely random because you do not know what will happen day to day and therefore what news will come to light. Analysts can make educated guesses and predictions; however you will never truly know how the market will react for definite. Additionally, the release of news has varying levels of effect on the share price depending on how the market values this information. Investors must value the news as significantly important to act upon the announcement.

Furthermore, to create value for shareholders, I believe it is essential that stock markets are efficient. An efficient market will correctly price shares therefore providing managers with the necessary signals to make good financial decisions (Arnold, 2013). If the market gets the price wrong, managers will find it hard to know what they have to do to increase shareholder wealth, as demonstrated by the example of Royal Dutch Shell. Shell’s managers would have predicted that a rise in profits would result in positive gains in relation to the share price. Therefore, they may have been left confused as to what strategy to implement in order to please their shareholders.

On the other hand, managers also have a responsibility to disclose information. Shares will only be priced efficiently if all relevant information has been released to the market (Arnold, 2013). However, managers may consider holding back information they believe could result in a negative effect. This could also lead to managers manipulating information to produce more favourable news as we saw in the case of Tesco that I discussed in my previous blog post. These actions could also have a detrimental effect on stock market efficiency as a whole.

References

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

BBC News. (2012, February 2). Shell plans production expansion as profits rise. BBC News. Retrieved from http://www.bbc.co.uk/news/business

BBC News. (2015, February 19). British Gas owner Centrica sees profits fall steeply. BBC News. Retrieved from http://www.bbc.co.uk/news/business

Fama, E. (1970). Efficient capital markets: a review of theory and empirical work. Journal of Finance, 25(2), 383-417. Doi: 10.1111/j.1540-6261.1970.tb00518.x 

Ficenec, J. (2015, February 19). Questor says Avoid. The Telegraph. Retrieved from http://www.telegraph.co.uk

Kendall, M. (1953). The analysis of economic time series, part 1: prices. Journal of the Royal Statistical Society, 96, 11-25. Doi: 10.2307/2980947

Macalister, T. (2012, February 2). Shell profits up 54% to £2m an hour. The Guardian. Retrieved from http://www.theguardian.com

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.