markets, financeWhat is the relationship between the efficiency of a market and its predictability? One might initially assume that they are inverse properties. Conversely, there’s no advantage of knowing something about tomorrow’s market, if everyone else already knows the same, because that knowledge will already be priced in. What roles do strong and weak efficiencies play in this relationship with predictability?
What you say is in theory correct according to the Efficient market hypothesis(EMH). the weak form of EMH states that all previous information is priced into the asset, the semi-strong form states that all previous known information is priced into the asset and the price instantly changes when new information is made public. Knowing information that is not released yet would be valuable to you in predicting tomorrow’s price in case the strong form of EMH is rejected. The strong form of EMH states that even hidden information is priced in.
So according to the efficient market hypothesis in an efficient market you can not profit from information since all information is already priced.
However the theory itself is very much questionable. Do all market participants have the same information? and more importantly, do they all interpret this information the same way? i dont think so. Besides if markets were really efficient and rational we would not have boom and bust cycles (bubbles).
Grossman and Stiglitz (1980) make a theoretical argument that fully efficient markets are impossible because it is the ability to profit from making predictions off of specialized information that provides the incentive for markets to become more efficient in the first place.
In essence, the brief answer to your question is that market efficiency and predictability are strongly negatively correlated, and it is precisely this correlation that prevents markets from becoming fully efficient.
As for strong vs. weak efficiency, the Grossman-Stiglitz argument implies that the informational efficiency of a market will be correlated with the costs of obtaining the information. In markets where even basic pricing information is not cheap (e.g. certain OTC derivatives), weak-form efficiency is not guaranteed. In markets where a great deal of fundamental information is essentially free (e.g. US public equities), strong form efficiency may be a reasonable approximation.
There doesn’t have to be any particular relationship between predictability and the efficiency of a market. There are efficient markets with high predictability; and there are efficient markets with low predictability. Ditto for inefficient markets.
The one thing we can say, from the definition of efficient markets, is that in an efficient market with some predictability, the predictions are known to enough market players for them to be priced in already; hence no one can deliberately & consistently make above-average returns from it.
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