Violation of Efficient Market Hypothesis: Mean Reversion

B

The Efficient Market Hypothesis (EMH) is a theory that suggests financial markets are efficient and that all available information is quickly and accurately reflected in security prices. It has three forms: weak, semistrong, and strong.

The weak form of the EMH states that security prices fully reflect all past market data, including historical prices and trading volume. In other words, according to the weak form, it is not possible to earn abnormal returns by analyzing historical data. This form assumes that prices follow a random walk pattern and do not exhibit any predictable trends or patterns. If stock prices are mean reverting over a three to five year period, it suggests that there is some predictable pattern or trend in the market, which violates the assumptions of the weak form of the EMH.

The semistrong form of the EMH goes a step further and asserts that security prices reflect all publicly available information, including not only historical data but also fundamental information such as financial statements, news, and economic indicators. If stock prices are mean reverting, it implies that there is some information or fundamental factor that investors can use to predict future price movements and earn abnormal returns. This violates the assumptions of the semistrong form of the EMH.

The strong form of the EMH is the most stringent form and asserts that security prices reflect all relevant information, including both public and private information. If stock prices are mean reverting, it suggests that even private information, not available to the public, can be used to predict future price movements. This violates the assumptions of the strong form of the EMH.

Given the information provided, the violation of the mean reversion pattern over a three to five year period implies that both the weak form and semistrong form of the EMH are violated. Therefore, the correct answer is C. Semistrong and weak forms only.