Chapter #5All Rights Reserved1 Market Efficiency Chapter 5 Market Analysis Methodologies Forms of Market Efficiency Testing Market Efficiency Technical

Chapter #5 All Rights Reserved 1

Market EfficiencyChapter 5

Market Analysis MethodologiesForms of Market EfficiencyTesting Market EfficiencyTechnical Market Analysis


Market Analysis Methodologies

Fundamental Analysis Evaluation of firms and their investment attractiveness Based on

firm’s financial strength competitiveness earnings outlook managerial strength

Technical Analysis Method of evaluating securities and forecasting future

price changes Based largely on price and volume behavior


Market Efficiency

Efficient Market Hypothesis (EMH) Security prices reflect all known information

You cannot use past, present of inside information to consistentlyconsistently beat the market

Three Forms of Efficiency Weak (historic prices) Semi-Strong (new information) Strong (inside information)


Weak Form Efficiency

Past stock price return movements cannot be used to predict future price changes

Implies technical analysis cannot consistently provide superior returns


Semi-Strong Form Efficiency

Market prices quickly and accurately reflect all public information

Suggests fundamentalfundamental analysis applied to publicly available information and data cannot systematically yield superior returns


Strong Form Efficiency

Market prices quickly and accurately reflect all public and nonpublic information

Suggests even insider information will not consistently result in superior returns


Random Walk Hypothesis

Stock prices wander about like a drunken monkey Burton Malkiel’s “Random Walk Down Wall St”

You really don’t know where prices will be tomorrow Alternative Description: Brownian motion Best thing to do is buy and hold an efficient portfolio

RWH consistent with EMT


A Partial Explanation for RWH

Some non-random observations… Quarterly reports arrive at the beginning of the

next quarter. Stock analysts tend to predict next [quarter]

earnings on a regular basis What we don’t know…

How will investors (& speculators) react news? Are positive reports necessarily good news? Why? Non-homogeneity of player expectations


Testing the Weak Form

Filter Rules (mostly statistics-based models) Deviations exceeding plus or minus 2 Rule: price up or down more than 5% (Yale

Rule) Fly in the Ointment

Serial Correlation Price changes exhibit positive correlation over time Remove trends using first differences

Markets tend to be weak form efficient


Testing the Semi-Strong Form

Anomalies Literature Small firm effect January effect Low P/E effect Day-of-week effect (Friday-Monday) Listing on big board effect Being added to S&P 500 list effect

Bottomline: markets not exactly semi-strong efficient


Testing the Strong Form

SEC Rules notwithstanding… Insiders consistently earn abnormal risk adjusted

returns A Research Artifact: insiders typically receive

options that let them buy stocks at below market prices – locking in positive returns

Insider buying is considered a positive sign.


Non-EMH Analysis

Technical Market Indicators Sentiment Flow of Funds Contrarian Put-Call ratio Mutual Fund cash position Confidence indexes Short interest Moving Averages


Non-EMH Analysis

Charting Point and figure Candlesticks O-H-L-C Heads/Shoulders Resistance/Support (breakouts


Non-EMH Analysis

Some final words on Chartists Believe that stock price movements occur in

patterns consistent enough to be predictable Analysis indicates resistance and support levels Importance of volume – adds weight to trend Japanese futures market original source of

candlestick method (12-13 century CE)


Dow Theory Market uptrend is confirmed if primary market index hits

new high that is soon followed by high in secondary index Downtrend signaled in similar fashion Transports Index is favored confirmatory signal

To make profit in stock market investors should take advantage of primary market trend Whenever primary trend is up, each secondary trend will produce

peak higher than last one – reverse true for down trend Any true indicator of primary market trend confirmed

relatively quickly by similar action in different stock price averages

Documents

Chapter #5All Rights Reserved1 Market Efficiency Chapter 5 Market Analysis Methodologies Forms of Market Efficiency Testing Market Efficiency Technical