lt;hr align=center color=#d1d1e1 noshade=noshade size=1 width=100%gt; The http://www.investopedia.com/terms/e/...hypothesis.asp (EMH) is a highly controversial topic among financial academics for a long time, and CNBC's Jim Cramer is adding fuel to the fire. Volumes of journal articles, research and other types of scholarly works have been churned out by supporters and critics of the hypothesis and the topic is still debated. Read on to learn how Cramer's in-your-face stock recommendations on CNBC's Mad Money supply proof that the market behaves inefficiently.


lt;! --printable = OFF-Impliions of EMHlt;ogt;lt;/ogt;

The efficient market hypothesis contends that all equities are priced in a way that reflects all appropriate information about the stocks and/or the market. One impliion of EMH indies that since market prices should instantly reflect information as it happens, performing research via http://www.investopedia.com/terms/f/...alanalysis.asp should not yield any new information which could permit an investor to make market-beating investment choices. (For more information, read http://www.investopedia.com/articles.../04/022004.asp and http://www.investopedia.com/articles/02/101502.asp) lt;ogt;lt;/ogt;

Based on EMH, market efficiency also causes prices to be unpredictable and, thus, http://www.investopedia.com/terms/t/...alanalysis.asp should not have the ability to yield indiors and chart patterns which function predictive functions.

Keep in mind that these impliions are based just on EMH theory; there's much debate concerning the degree to which markets are effective - or whether they are effective at all. By way of instance, counter to EMH, there are cases of investment egies where fundamental analysis has proven to be successful. In fact, the http://www.investopedia.com/terms/o/oracleofomaha.asp, Warren Buffett, has made consistantly market-beating returns for several decades using fundamental analysis to stabilize underpriced businesses. (For more about that, visit http://www.investopedia.com/articles/01/071801.asp, http://www.investopedia.com/articles/05/012705.asp and http://www.investopedia.com/universi...entalanalysis/.)


The research

Researchers in lt;st1lace w:st=ongt;lt;st1lacename w:st=ongt;lt;st1lace u1:st=ongt;lt;st1lacename u1:st=ongt;Northwesternlt;/st1lacenamegt;lt;/st1lacegt; lt;st1lacetype w:st=ongt;lt;st1lacetype u1:st=ongt;Universitylt;/st1lacetypegt;lt;/st1lacetypegt;lt;/st1lacenamegt;lt;/st1lacegt;'s Kellogg School of Management published a study called Is your Market Mad? Proof from'Mad Money' in March of 2006, which showed how Jim Cramer's recommendations on Mad Money have generated a predictable tendency, which some investors have used to create fairly high returns in a relatively short time period.

For those who aren't acquainted with Mad Money, the show's host, http://www.investopedia.com/terms/j/jimcramer.asp is a former http://www.investopedia.com/terms/h/hedgefund.asp manager. On Mad Money, Jim Cramer provides his buy/sell recommendation to numerous featured stocks, such as stocks suggested by viewers' phone calls or emails. The show has gotten quite popular - its own entertaining nature about financial issues attracted more than 300,000 viewers nightly in 2006.

In this study, researchers had accumulated stock returns, daily volume data, http://www.investopedia.com/terms/i/intraday.asp quotes and other sorts of financial information on buy recommendations which Cramer made between July 28 and October 14, 2005. One of the key findings provides proof of the occurrence of the http://www.investopedia.com/terms/c/cramerbounce.asp. According to the study, Cramer's buy recommendation triggers a statistically significant short-term rise in the stock's price on the afternoon directly following the afternoon it's recommended. This rise is the most apparent for smaller stocks, where the increase is just over 5 percent compared to the previous close. For the whole sample, the average rise is nearly 2%.

Does this study imply that Cramer has a knack for finding undervalued stocks at the right moment? No. Instead, the investigators in this study theorize that stocks become overpriced since a large number of Mad Money viewers blindly buy stocks based on Cramer's recommendation. In other words, these climbs weren't attributed to some new news that companies had published and, above all, they weren't sustained for long. In fact, the study demoned that these increases faded away within 12 days. The inflation in stock prices that happens as a result of Cramer's recommendations enables intelligent investors to gain higher returns and, thus, serves as proof against the efficiency of the market.

The study also discovered that trading http://www.investopedia.com/terms/v/volume.asp on the stocks which Cramer recommended also spiked dramatically. For smaller stocks, the trading volume rose by as much as 900% on the day following the recommendation. The most interesting consequence is that, in some instances, the level of mortality stayed significantly elevated for as long as 16 days after the recommendation was made. Additionally, it seems that Cramer's recommended stocks generally receive much higher buyer-initiated trades on the afternoon following a recommendation to buy. This may reflect a flood of purchase orders from regular Mad Money viewers. This summit in the percentage of buyer-initiated trades ultimately drops back to pre-recommendation levels after about 12 days. This suggests that Cramer's recommendations have a direct impact on stocks' prices.


Other Effects

The Northwestern researchers also looked at two other facets of Cramer's recommendations: their effects on the http://www.investopedia.com/terms/b/bid-askspread.asp and the amount of http://www.investopedia.com/terms/s/shortselling.asp in the market.

Based on the study, short sales tended to spike dramatically within the opening minutes of the trading day following Cramer's recommendation. Since successful short sellers borrow stocks to market when prices are high and then buy back them to pay their positions once the prices are low, it might be inferred that at least some investors know about the Cramer bounce and are attempting to profit from what they see as an overvalued stock. (For related reading, check out the http://www.investopedia.com/university/shortselling/.)

It was also determined that the bid-ask spread for stocks that were recommended failed to alter at any point in time. This is significant since a lack of change in the bid ask spread indies that http://www.investopedia.com/terms/m/marketmaker.asp don't dread the prospect of http://www.investopedia.com/terms/a/...nformation.asp as a result of Cramer's guidelines. This is because nothing new concerning the stock has surfaced during that time and, as a result, the current bid-ask spread should still reflect the stocks' fundamentals following Cramer's recommendation, even if the market value of the stock does not.


Why Is This Important?

One of the biggest assumptions (and potentially the biggest flaw) of the EMH is that investors are rational. This study offers proof that the absurd behaviors of individual participants in the financial world can produce predictable, collective actions that can have no less than a short-term impact on stock prices. For the most part, it can be presumed that the investors which are contributing to the Cramer bounce phenomenon are making stock purchases as a result of Jim Cramer's impact, instead of as a product of logical thought.

As a rule of thumb, emotional investors that buy stocks without doing their homework tend to lose out on good returns. In this circumstance, Cramer's recommendations are costly in the days after being featured on Mad Money and, all things being equal, will tend to eliminate value since their prices repay to pre-Cramer bounce levels.


Social Learning Theory

In plogy, the observational, or social learning theory details certain conditions which need to be met prior to an observer's behavior changes as a result of observing a product's behavior. One of the critical points of the theory is that an observer is more likely to pay attention and follow another individual's behavior if that person possesses qualities which the observer finds out to be desirable. Jim Cramer's recommendations can easily sway the more emotional investors into performing trades without conducting a fantastic amount of research, since many may feel that he's an authority on stocks and that his word ought to be good enough.

This study also found a way for particular traders to practically consistently create a steady stream of returns. More specifically, this describes how short sellers can regularly make the most of the Cramer bounce and short sell stocks on the afternoon following the recommendations and then buy them back two or three days later to earn an nearly http://www.investopedia.com/terms/a/arbitrage.asp-such as profit. According to the EMH, consistently predicting and capitalizing on the market's moves ought to be impossible since the market moves in an unpredictable manner.

On the flip side, we ought to note that the stocks' prices did finally return for their true worth. Therefore, while the behavior of stocks featured on Mad Money is not consistent with EMH, this study also demones that stocks are (eventually) driven by fundamentals. While in this case the stocks returned to their original values In a short time span, http://www.investopedia.com/terms/b/bubble.asp of this sort can also last for years, as was the case using the http://www.investopedia.com/terms/d/dotcom.asp bubble of the late'90s. (For more information, see http://www.investopedia.com/features/crashes/.)


Don't Go Mad Yourself

EMH relies on the premise that the main players in the market are rational. This analysis is a good illuion of how irrational behavior can lead to stock prices to change in a manner that's contrary to EMH theory. Investors shouldn't discount the role that emotion and investor plogy play in how the market behaves. Even though there is no formula or indior which could account for or assess the emotional areas of investing, traders can rescue themselves from being trapped in madness by investing prudently, instead of simply following the crowd.

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