3. Literature Review
3.3. The Efficient Market Hypothesis: EMH
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psychological ones. The notion of investors’ sentiment is raised. In our situation, with presidential elections for example, it seems that investors tend to be more optimistic during the second part of the presidential term as the new election could be a base to change and improvement of the economy and financial markets. It would then explain the presence of higher stock returns during the two last years of the term. On the contrary, this is during the second year of the term that investors would usually be disappointed at the government in power as their expectations are not fulfilled and the sentiment of anticipation is less present as the upcoming elections is in a longer time.
3.3. The Efficient Market Hypothesis: EMH
General introduction to the EMH
The efficient market hypothesis is a theory that has been developed by Eugene Fama in the early 1960s at the University of Chicago Booth School Business. His empirical studies led him to conclude that an efficient market is characterized as a market in which prices of assets are an accurate reflection of all available information. Therefore, the efficient market hypothesis states that it is impossible to “beat the market”, in other words, impossible for investors to buy stocks over or undervalued as they are always traded at a fair-value on stock exchanges unless investors are willing to ‘bear’ more risk. Thus, according to this theory, it is not accurate to use both fundamental and technical analysis to predict the future trend in the stock markets:
The fundamental analysis is a method to determine the intrinsic value of an asset. Different factors are analyzed to reach a value as accurate as possible. Internal factors of the company are taken into account so as external ones. The range of factors is by consequence large and includes information from financial ratios to macroeconomic data.
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The technical analysis does not intend to estimate the intrinsic value of a company’s stock as the fundamental analysis does; but instead analyze, through different ways and means of calculations, historical data generated by market activity in order to predict the future pattern (trend) of the market and invest in consequence.
Both fundamental and technical analyses are used with the same purpose to predict the upcoming pattern of the market activity, in order to realize the most profitable investments. The defenders of these analyses are the main opponents to the efficient market hypothesis as they base their investments on them. As many investors use both fundamental and technical analyses, this theory has been really controversial since its creation. Regarding our own study, the findings of abnormal returns around the presidential election date would go against the efficient market hypothesis if we wanted to use them with the purpose of investment.
This first approach of the efficient market hypothesis can be extended to three different forms.
This is still Fama who divided his first hypothesis into these three different categories, in 1970.
They are now classified as followed:
The strong form or strong-form efficiency
This type of market efficiency does not only take into consideration the public information but also the private one. It extends the assumption of the semi-strong efficiency stating that the market reacts actually immediately to all kind of information, public or private. It also includes the theory applicable for the weak-form of efficient market hypothesis. According to the different assumptions of the strong-form efficiency, no investors would possibly make any profit compared to an “average” investor, even if new information was given to him (public or private).
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The semi-strong form or semi-form efficiency:
This form of efficiency is related to how the market reacts to public information. It suggests that the market price reacts in an almost immediate, better to say very quick, way to the information available to the public. If the security price completely reflects the public information, it is not possible to use any analysis (fundamental or technical) to try to beat the market exploiting public information as markets do not underreact or overreact when the information is released.
The weak form or weak-form efficiency:
This type of market efficiency states that it is not possible to use historical data to forecast the future pattern of the market activity. Stock prices are independent from a day to another and they are not impacted by their history. In this way, investors cannot make any forecast of stock market prices. This is by definition contradictory with the technical analysis and the reason why these two theories are not compatible.
To conclude, it is important and relevant in our literature review to underline the concept of efficient market hypothesis as it has been a major breakthrough in the contemporary market finance and it is directly related with our topic in the way that, the results we will find after our two different studies might show abnormal returns. Nevertheless, we cannot be worried about our future results as this theory has been among time, very controversial and challenged by investors averse to use technical analysis and fundamental analysis to prepare their investment strategies. The aim of the research question is not to refute or support the efficient market hypothesis but instead to show evidence that the risk might be reduced and stock returns increased when we consider the presidential election in both Taiwan and France. The findings of market cycles in the two countries combined with the presence of abnormal returns around
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the presidential elections period would suggest a lower risk for a potential investor to allocate his money.
3.4. Previous Findings on Abnormal Returns around Presidential Election