The efficient market hypothesis (EMH), also known as efficient market theory, suggests that markets are informationally efficient. This hypothesis is incompatible with technical analysis because of EMH's assumptions about the availability of information and the rationality of the market. By assuming that markets are informationally efficient, and that historical prices and expectations are already priced into investments, efficient market hypothesis operates on the assumption that it's impossible to exceed market-average returns by looking at past price data. According to EMH, stocks always trade at their fair value on exchanges.

Key Takeaways

  • The efficient market hypothesis is incompatible with technical analysis because of the theory's assumptions about the availability of information and the rationality of the market.
  • Technical analysts argue that prices and investors tend to follow predictable patterns and once identified, those patterns can be used to anticipate future trading opportunities for above market-average returns.
  • According to the efficient market hypothesis, security prices already reflect all available information.
  • Following the efficient market hypothesis's claim that the market is totally random, the best course of action for investors is to invest in a low-cost, passive portfolio.

Technical analysis is a form of financial analysis that is completely predicated on the concept of using past data to anticipate future price movements. Technical analysis uses patterns in market data from the past to identify trends and make predictions for the future. As a result, EMH is conceptually opposed to technical analysis. Proponents of EMH are also of the belief that it's pointless to search for undervalued stocks or predict trends in the market through fundamental analysis.

The Role of Historical Data

The main disagreement between EMH and technical analysis is the role of historical data. Technical analysts argue that prices and investors tend to follow predictable patterns. Once identified, those patterns can be used to anticipate future trading opportunities for above market-average returns.

According to EMH, security prices already reflect all available information. This includes investor sentiment about possible price trends and all recurring phenomena that might produce those trends again. In addition, according to the EMH, past price and volume data may not have any relationship with future movements.

Proponents of EMH claim that if enough traders are using similar technical valuation techniques, technical analysis can create results that resemble a self-fulfilling prophecy. Large numbers of speculative traders can push the price of a security beyond its market-clearing level.

For example, suppose that a large number of technical traders believe the price of a stock is likely to go up. As a result, they enter the market as bulls. This bids up the price of the stock. Through their collective bias, they are able to override efficient market information.

Active vs. Passive Strategies

Although it underlies most modern financial theory, EMH is a highly controversial theory and is not readily accepted by all financial professionals. If EMH is to be accepted, the only way to produce outsized risk-adjusted returns is through accessing insider information.

According to EMH, because of the randomness of the market, the best course of action for investors is to invest in a low-cost, passive portfolio. In reality, data shows that active managers do not consistently outperform passive managers over time, even though in the short-term, active strategies can provide some success.