Chapter 5

1. Chapter 5 Market Efficiency

2. Fundamental Analysis • Evaluation of firms and their investment attractiveness • Based on • firm’s financial strength, • competitiveness, • earnings outlook • managerial strength, etc. • Technical Analysis • Method of evaluating securities and forecasting future price changes • Based only on past price and volume behavior

3. Efficient Market Hypothesis (EMH) • Theory that market correctly prices securities in light of known relevant information • 3 Forms • Weak • Semistrong • Strong

4. Weak Form EMH • Past stock price return movements cannot be used to predict future price changes • Implies technical analysis cannot consistently provide superior returns

5. Semistrong Form EMH • Market prices quickly and accurately reflect all public information • Suggests fundamental analysis applied to publicly available information and data cannot systematically yield superior returns

6. Strong Form EMH • Market prices quickly and accurately reflect all public and nonpublic information • Suggests even insider information will not consistently result in superior returns

7. Random Walk • Documented by initial research on security returns • Random motion of stock prices as likely to move in one direction as another, regardless of past price behavior • Consistent with the weak form of the efficient market hypothesis (EMH) • If stock prices change randomly, past price movements cannot be used to predict future price movements.

8. Why Stock Prices May Change in Random Manner • Prices based on expectations of future news and events • If expectations unbiased, then: • when actual news and events better than expected, stock prices go up • when actual news and events worse than expected, stock prices go down • Random whether news better or worse than expected!

9. Market Success and EMH • If EMH is true, can anyone can beat the market? • At any point in time, half of investors will have “beaten” market. • If someone beats market, does this automatically invalidate the EMH? • Some will occasionally flip 10 heads in a row.

10. Testing the Weak Form of the EMH • Serial Correlation • Tests for statistically significant relationships between returns • Filter Rules • Form of technical analysis that advocates buying stock when price rises by given percent or selling when price falls by certain percent • Successful with small filters, but only if transaction fees are ignored

11. Conclusions About Technical Analysis • Research does not confirm the consistency of technical analysis techniques • Tools of technical analysis have multiple interpretations • There are so many techniques that definitive statements can not be made

12. Tests of Semi-Strong and Strong EMH: • Anomaly • Condition in security markets that allows for persistent abnormal returns on a consistent basis after adjusting for risk

13. Potential Causes of Market Inefficiency • Small Firm Effect • possible anomaly to the efficient market hypothesis • Tendency for small firms to earn above-rates of return • Not all investors have resources and expertise to properly access stocks • Some misevaluation may only be captured if one is able to take control of a company

14. Potential Causes of Market Inefficiency(Continued) • Dogs of the Dow • Buy top ten stocks with highest dividend yield on a list of 30 picks • Change list at one year time intervals • Has not performed well since 1987

15. Potential Causes of Market Inefficiency(Continued) • January Indicator • January performance is said to forecast the year • Evidence is not impressive

16. Potential Causes of Market Inefficiency(Continued) • Other Potential Causes • Day-of-the-Week Effect • Additions to the S&P 500 • Insider Trader

17. Technical Market Indicators • Data series or combination of data series said to be helpful in forecasting market’s future direction or market indicator • Can be categorized as sentiment indicators, flow of funds indicators and market structure indicators

18. Sentiment Indicators • Assumes sentiment of investors can be ascertained by certain indicators • Sophisticated Investor Rationale: Sophisticated investors right more often than wrong. Seek an indicator that reveals whether sophisticated investors are buying or selling and do same • Contrarian Rationale: Some investors with limited resources are wrong more often than right; seek an indicator of what the “small guys” are doing and do the opposite.

19. Sentiment Indicators(Continued) • Odd-Lot Ratio: measures the amount of odd-lot purchases or sales and assumes that people who trade in odd-lots are inexperienced trades • Mutual Fund Cash Position: assumes that mutual fund managers build up cash at market bottoms • Barron’s Confidence Index: ratio of high-grade to average grade bond yields reflect confidence of smart investors

20. Sentiment Indicators(Continued) • Trin: acronym for trading index and assumes that market movements are more sustainable when accompanied by heavy volume Volume of declining stocks/Number of declining stocks Trin = Volume of advancing stocks/Number of advancing stocks • Put/Call ratio: calculated as ratio of either outstanding puts to calls or volume of puts to calls.

21. Flow of Fund Indicators • Attempts to determine where cash is going or where it might go • Short Interest: assumes that a rise in short interest forecasts a rally • Cash Balances in Brokerage Accounts: viewed as a measure of near term buying

22. Market Structure Indicators • Moving Average • Breadth Indicators • Relative Strength Indicators

23. Market Structure Indicators: Dow Theory • Charting theory originated by Charles Dow • 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 • 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

24. Charting • Attempt to forecast stock price changes from charts of past price and volume data • Form of technical analysis

25. Bar Chart • Type of graph that plots price over time • Typically contains data on high, low, and volume

26. Bar Chart Example

27. Resistance Level • Price range that, according to technical analysis, tends to block further price increases or decreases

28. Support Level • Floor price that, according to technical analysis, tends to restrict downside price moves

29. Head and Shoulders Formation • Pattern of stock price trends that looks like a head and shoulders • Believed by some technical analysts to forecast price decline • Neckline: price at the bottom of the shoulders

30. Point-and-Figure Chart • Technical chart that has no time dimension • X is used to designate an upward price movement of a certain magnitude, while a “0” denotes a similar size down move • X’s are stacked on top of each other as long as the direction of movement remains up • New column is begun when direction changes. • Technical analysts use these charts to predict future price movements

31. Point-and-Figure Example

32. Major Premises for Chartists • Stock prices movements occur in patterns consistent enough to be predictable • Contains resistance and support levels • Volume goes with the trend in some methods