Stock Asset Returns Are Predictable Part 1

4. THEORITICAL BACKGROUND
Since the originative works of Fama (1965 and 1970), where an efficient market from the informational execution point of view was defined as one where “stock prices ‘fully reflect’ all available information” (Fama 1970) and market efficiency was categorized into three levels: weak-form, semi-strong form and strong-form. First of all, the information set through weak form efficiency, reflects only the historical prices or returns. Second of all, the information set in semi-strong form efficiency, contains information available to all market participants. Lastly, in strong form efficiency, the information set consists of all information available to any market participant.
Researchable task in this study is whether stock asset returns are predictable, which has been a question of great attention emerged with financial econometrics since the earliest times. Mathematical models of asset pricing have an unusually rich history as compared to every other aspect of economic analysis. For tests of return predictability, information set is defined as the past history of stock prices, company characteristics, market characteristics and the time of the year. The Efficient Market Hypothesis was first introduced by Louis Bachelier, a French mathematician in 1900 in his dissertation. Efficient Market Hypothesis (EMH) means that security prices fully reflect all available information. The efficient market hypothesis has been divided into three categories depending on the information set these are weak, semi-strong and strong form.

These classifications were originally suggested by Fama (1970).
4.1. Weak Form Tests of Market Efficiency
Weak form tests of market efficiency are tests to find out whether all information...

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...d from publicly available information. Other researchers have performed time series analysis on stock returns as well as on the cross sectional distribution of returns of individual stocks to find out if profit opportunities exist (Damodaran, 1996; Reilly and Brown 2003).

4.3. Strong Form Tests of Market Efficiency

Finally, strong form tests of market efficiency are tests of whether the information set consists of all information available to any market participant is fully reflected in asset prices and whether any type of investor can make an excess profit (Elton and Gruber, 1995). In such strong form tests of the efficient market hypothesis no one can earn excess profits. Indeed, in reality laws prohibit trading using insider information.Groups normally tested are corporate insiders, stock exchange specialists, security analysts and professional asset managers.