The efficient market hypothesis is starting to lose favour with many in the investment industry, but still remains as a cornerstone of diversification strategy and is the justification used by technical analysts for not doing any fundamental research.
Simply, the efficient market hypothesis states that every little morsel of information that is knowable to anyone in the investment industry is already included in the share price, and that all analysis is futile. A basket of randomly chosen stocks is as good as any portfolio because the market has already rationally priced each stock according to all possible calculations one could care to make using every piece of available information. Only someone with inside information privy to data no one else has seen can do better on a consistent basis than a random portfolio.
Technical analysts hang their hopes on this theory because it provides justification to the approach of hanging on trends and riding upswings, the market as a perfect pricing machine means that anyone following the price of security already knows the entire impact of any changes on a company's operations, even if he can't explicitly state what those changes are.
Proof of the efficient market hypothesis is the posit that no one has ever been able consistently to beat the market year after year. Opponents of the efficient market hypothesis point out that approximately 70% of all amateur stock picking clubs do tend to beat the market by a respectable margin, and those using the techniques of Buffett, Keynes, Fisher and Graham have been beating the market most years for the better part of a century, only very recently have other paradigms been considered.
While the efficient market hypothesis does state that forecasting of any kind, based on any analysis whatsoever is futile, this does not mean that for optimal returns in terms of risk and return that a truly random mix of securities is used. Portfolio theory, discussed in the section on diversification involves lining up securities that have a historical tendency to move in a contrary manner (like buying shares of importer companies as well as exporters, knowing that currency shifts that hurt one group usually work in the favour of the other).
Warren Buffett's view of the efficient market hypothesis is an absolute screamer. "Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it's an enormous advantage to have opponents who have been taught it's useless even to try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT."
The jury is still out as to exactly how efficient the market really is. It appears to be true that there is no point listening too closely for news about companies in an attempt to gain a trading advantage. Certainly there is no way known that an amateur investor or speculator could get anywhere with this as the floor traders and specialists would have that base pretty well covered. Thus it is clear that in the very short term you could call it "efficient" because no form of analysis you could use would give you any edge over market insiders.
In the very long term it is clear that markets are quite efficient. Stock prices do reflect the fortunes of a company over the very long term.
Where the market is least efficient is in the medium term. Traders make the short term market efficient because they trade on rumours and news and are very close to the source of this information. They move the market rapidly upward or downward when something is announced. However traders seem to be quite inept at pricing stocks properly. They move stocks up or down, but they don't settle on any correct judgement of intrinsic value. Most traders don't care about intrinsic value anyway, seeing "truth" in prices. Thus in the medium term, that is with regard to the real economic situation of companies on a time frame of months to several years the market is not efficient. Stock prices are quickly moved by sentiment, but they aren't accurately valued by it.
Here lie opportunities for both speculators and investors. The short term speculator can profit by following trends in prices and trading only on that basis. They should not concern themselves with news or rumours as these are probably already in the price of the stock before they even got in. Long term investors have an opportunity to take a more leisurely bite out of the market, identifying undervalued quality stocks and holding them is a form of arbitrage where you benefit from market inefficiency in the medium term and efficiency in the long term.