Efficiency of the London Stock Exchange

The London Stock Exchange (LSE), founded in 1801, is the fourth largest stock exchange in the world and the largest in Europe (2011 figures). As one of the most international stock exchanges in the world, with approximately 3,000 companies from over 70 countries listed, it is a prime location for companies and investors to consider when looking for new opportunities. However, prior to listing or investing, the efficiency of the market should be determined. To do this we must first ask, what is a stock exchange?

A stock exchange, also known as a stock market, is an organised market in which industrial and financial securities can be sold and purchase. They provide a convenient place for trading securities in a systematic manner, and are indispensable for the smooth and orderly functioning of the corporate sector within a free market economy.

It is argued in the efficient market hypothesis (EMH) that an efficient market is one in which prices fully reflect all available information relating to a particular stock or market. Therefore, no investor would have a competitive advantage over another and there would be no instances in which a return on a stock price can be predicted, as no individual would have access to information that others did not. But is this true of the LSE?

If the EMH is correct then the price of a share on the market should only change when information is made publicly available. To test this theory, let's consider the share price for Tesco in the few weeks prior to, and after, the announcement on 15th January 2013 that horse meat was discovered in beef burgers on sale in Tesco stores.

Tesco PLC Share Price
1st January 2013 - 7th February 2013
(London Stock Exchange, 2013)

As could be expected, Tesco's share price fell to it's lowest (347.1) for the period the day after the announcement was made (16th January 2013). However, what is interesting is the decline in share price from 10th January 2013.

Between Tesco's announcement on 10th January that Christmas sales were the best they had seen in three years, and the announcement of the horse meat discovery, no other announcements were made which should have caused the decline. This suggests the possibility that the information may have been made aware to some investors, prior to the public announcement, therefore causing a premature decrease.

This case isn't the only one which disproves that the LSE does not follow the EMH. HMV's share price fell significantly, prior to the announcement that they were going into administration, again suggesting that some investors knew of the news before the actual announcement was made. So, if the LSE is not efficient according to the EMH, to what extent is it efficient?

It is suggested there are three forms of efficiency within a stock exchange; weak, semi-strong and strong. Within weak form efficient markets, future share prices cannot be predicted by analysing past previous. Share prices are believed to follow a 'random walk', meaning there are no patterns or trends and that future price movements are solely based upon information not contained within the price series. Therefore, within this type of economy an individual investing with no prior research will receive the same level of return as those purchased based upon a recommendation from an analyst who has studied historical data.

A semi-strong efficient market reflect all relevant publicly available information, including past price movements and information relating to changes in management, the issues of dividends and profit levels. Therefore, within these types of market there is no need for an analyst to consider historical information as they have already been absorbed into the market price.

Strong-form efficiency reflects all public and privately available information. This market allows for insider-trading to occur, and can leave external investors feeling cheated.

Although, in the cases discussed, there is some suggestions of a possibility of insider trading there is no evidence to prove this. The majority of movements on the market do follow publicly made announcements with other increases/decreases reflecting previous trends regarding similar issues. Therefore, I believe that the LSE is a semi-strong efficient market. However, I do feel that a shift to strong-form efficient market could be possible if regulations are not effectively enforced.