Market Efficiency Chapter 5 Market Analysis Methodologies Forms

Market Analysis Methodologies o Fundamental Analysis n n Evaluation of firms and their investment

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

Weak Form Efficiency o o Past stock price return movements cannot be used to

Semi-Strong Form Efficiency o o Market prices quickly and accurately reflect all public information

Strong Form Efficiency o o Market prices quickly and accurately reflect all public and

Random Walk Hypothesis o Stock prices wander about like a drunken monkey n Burton

A Partial Explanation for RWH o Some non-random observations… n n o Quarterly reports

Testing the Weak Form o Filter Rules (mostly statistics-based models) n n o Deviations

Testing the Semi-Strong Form o Anomalies Literature n n n o Small firm effect

Testing the Strong Form o SEC Rules notwithstanding… n n n Chapter #5 Insiders

Non-EMH Analysis o Technical Market Indicators n n n n Chapter #5 Sentiment Flow

Non-EMH Analysis o Charting n n n Chapter #5 Point and figure Candlesticks O-H-L-C

Non-EMH Analysis o Some final words on Chartists n n Chapter #5 Believe that

Dow Theory o Market uptrend is confirmed if primary market index hits new high

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Market Analysis Methodologies o Fundamental Analysis n n Evaluation of firms and their investment attractiveness Based on o o o firm’s financial strength competitiveness earnings outlook managerial strength Technical Analysis n n Chapter #5 Method of evaluating securities and forecasting future price changes Based largely on price and volume behavior All Rights Reserved 2

Market Efficiency o Efficient Market Hypothesis (EMH) n Security prices reflect all known information o o You cannot use past, present of inside information to consistently beat the market Three Forms of Efficiency n n n Chapter #5 Weak (historic prices) Semi-Strong (new information) Strong (inside information) All Rights Reserved 3

Weak Form Efficiency o o Past stock price return movements cannot be used to predict future price changes Implies technical analysis cannot consistently provide superior returns Chapter #5 All Rights Reserved 4

Semi-Strong Form Efficiency o o Market prices quickly and accurately reflect all public information Suggests fundamental analysis applied to publicly available information and data cannot systematically yield superior returns Chapter #5 All Rights Reserved 5

Strong Form Efficiency o o Market prices quickly and accurately reflect all public and nonpublic information Suggests even insider information will not consistently result in superior returns Chapter #5 All Rights Reserved 6

Random Walk Hypothesis o Stock prices wander about like a drunken monkey n Burton Malkiel’s “Random Walk Down Wall St” o o o n Chapter #5 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 All Rights Reserved 7

A Partial Explanation for RWH o Some non-random observations… n n o 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… n n n Chapter #5 How will investors (& speculators) react news? Are positive reports necessarily good news? Why? Non-homogeneity of player expectations All Rights Reserved 8

Testing the Weak Form o Filter Rules (mostly statistics-based models) n n o Deviations exceeding plus or minus 2 s 5% Rule: price up or down more than 5% (Yale Rule) Fly in the Ointment n Serial Correlation o o o Price changes exhibit positive correlation over time Remove trends using first differences Markets tend to be weak form efficient Chapter #5 All Rights Reserved 9

Testing the Semi-Strong Form o Anomalies Literature n n n o 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 Chapter #5 All Rights Reserved 10

Testing the Strong Form o SEC Rules notwithstanding… n n n Chapter #5 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. All Rights Reserved 11

Non-EMH Analysis o Technical Market Indicators n n n n Chapter #5 Sentiment Flow of Funds Contrarian Put-Call ratio Mutual Fund cash position Confidence indexes Short interest Moving Averages All Rights Reserved 12

Non-EMH Analysis o Some final words on Chartists n n Chapter #5 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) All Rights Reserved 14

Dow Theory o Market uptrend is confirmed if primary market index hits new high that is soon followed by high in secondary index n n o To make profit in stock market investors should take advantage of primary market trend n o Downtrend signaled in similar fashion Transports Index is favored confirmatory signal 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 Chapter #5 All Rights Reserved 15