This essay critically discusses’ A market Is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions. ‘(With respect to Technical & Fundamental Analysis). In this essay, firstly, the Efficient Market Hypothesis (MME) Is given an appraisal In relation to random walk, as well as its definition, revealing theories in context of empirical evidence. A brief explanation of the 3 forms of MME is highlighted alongside a brief description of its tests for validity.
The mall focus of discussion Is whether or not Technical & Fundamental Analysis can determine abnormal returns by investors strategically using a set of information to formulate buying and selling sections to beat the efficient market. (Graphs and sets of equations may be applied). Following general empirical studies, the theory of Efficient Market typically asserts that, It would be Impossible to consistently outperform the market by means of technical & fundamental analysis, consequently, in the light of this assertion, technical, fundamental and other anomalies are revealed that may suggest some levels of market inefficiencies.
Finally, a conclusion, subjectively underlining the relevant points expressed above, putting to perspective facts conveyed through the topic of critical discussion. Appraisal of the Efficient Market Hypothesis and Random Walk The efficient market hypothesis Is a financial theory widely accepted by most academic financial economists. It was generally believed that securities markets were extremely efficient in reflecting Information about individual stocks and about the stock market as a whole.
The accepted view was that when information arises, the news spreads very quickly and Is incorporated into the prices of securities without delay. Thus, when the term ‘efficient market’ was Introduced Into the economics literature In the sass , It as defined as a market in which prices at any time “fully reflect” and ‘adjusts rapidly to new available information’ (Eugene F. Fame, 1970, p 383. ).
In the context of this hypothesis, “efficient” empirically, means that the market Is capable of quickly digesting new information on the economy, an Industry, or the value of an enterprise and accurately impounding it into securities prices. In such markets, participants can expect to earn no more, nor less, than a fair return for the risks undertaken, hence ‘OFF Theory closely associated with the efficient market hypothesis, was originally created y Louis Bachelor (1900), and developed by Kendall, in sass.
Kendall (1953) found that stock and commodity prices follow a random walk. Random walk varies with regard to the time parameter. According to capital markets theory, the expected return from a security is primarily a function of its risk. The price of the security reflects the present value of its expected future cash flows, which incorporates many factors such as volatility, liquidity, and risk of bankruptcy. However, while prices are rationally based, changes in prices are expected to be random and unpredictable, cause new information, by its very nature, is unpredictable.
Therefore stock prices are said to follow a Random Walk. Versions of the Efficiency Market Hypothesis and tests Following the concept of information, as stated in the above paragraph, it is useful to distinguish among three versions of the MME, Fame (1970) identified as: the weak, semi-strong, and strong forms of the hypothesis. These versions differ by their notions of what is meant by the term “all available information. ” The tests for each form, summarized in brief, empirically shows evidence in favor of MME:
According to Fame (1970), Weak form efficiency claims that all past prices of a stock are reflected in today’s stock price. Therefore, technical analysis cannot be used to predict and beat a market. The Weak Form Tests. The test of the weak form of the MME is generally taken to comprise of; an autocorrelation test, a runs test and filter rule test. An autocorrelation test investigates whether security returns are related through time. On the other, a runs test, for example, measures the likelihood that a series of two variables is a random occurrence.
A filter rule (or trading test) is a trading rule grading the actions to be taken when shares rise or fall in value by x%. Filter rules should not work if markets are weak form efficient. Overall, the tests highlighted, statistically tests for independence, to establish the weak-form holds, thereby invalidating strategic rules for technical analysis, to obtain abnormal profits. Following the weak-form MME, is the Semi-Strong form efficiency in which Fame (1970) states that security prices reflect all publicly available information.
The Semi-Strong Test. Tests for the semi-strong, significantly and reveals Event Study. The iris event study was undertaken by Fame, Fisher, Jensen and Roll (1969), though the first to be published was by Ball and Brown (1968). An event test analyzes the security both before and after an event, such as earnings announcements, stock splits and analyst’s recommendations. The idea behind the event test is that an investor will not be able to reap an above average return by trading, on an event including the Fundamental Analysis strategy.
The Strong-Form Efficiency is the most extreme version of the MME states that security prices fully reflect all relevant public and private information. Strong Form Test. Noteworthy of a mention (although irrelevant to this essay), the test in the strong form efficiency, empirically suggests insiders to a company, such as senior managers, have access to inside information. Empirical evidence does not support the strong form OHM as Securities and Exchange Commission (SEC) regulations forbid insiders for using this information to achieve abnormal returns.
Technical and Fundamental analysis, is empirically viewed as market strategies traders, and investors alike employ, in a bid to search for under-valued stocks, hence to outperform the efficiency market. But, what is Technical and Fundamental analysis? What is the aim and objective of the Technical and Fundamental analyst? A brief definition of Technical Analysis, represents “a research on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market” (Bodied et al. , 2003).
Technical analysis assumes a slow response of stock prices to fundamental supply and demand factors, which is diametrically opposed to the notion of an efficient market. Technical analysis uses mostly chart-based techniques (by way of time- series) in order to evaluate the future potential trend of financial markets and of individual securities; hence, technical analysts are called chartists. Chart-based technique means the study of price time series trend and of indicators obtained using past prices and volumes.
A summary of some Chart-based methods include; Rounding Bottom, Triple Tops and Bottoms, Gaps, Wedge, Flag and Pennant, Triangles, Moving Averages, Trading Range Break, as well as Double tops and bottom and Heads and shoulders illustrated in diagrams below Double tops and bottoms Heads and shoulders The aim of the technical analysis is to identify the increasing and decreasing trends f the market, and, most of all, to identify as early as possible the signals of trend changes, considered sell- or buy-action signals.
The basic principle of their analysis that prices move in trends and thus they buy when prices increase and sell when prices decrease. Therefore, the information set necessary to develop the analysis contains only past prices and transaction volumes. Fundamental Analysis, is described as ” the research on determinants of stock value, such as earnings and dividends prospects, expectations for future interest rates, and risk of the firm”(Bodied et al. 2003).
The main goal of fundamental analysis is to generate insights that are not already reflected by market prices. In other words, fundamental analysts pursue to enhance the ability to predict future security price movements and use such predictions to design equity portfolio. Fundamental analysts usually start with a study of past earnings and an examination of company financial statements, then supplementing this analysis with further detailed economic analysis. There is not a single set of well defined tools that constitutes a fundamental analysis.
Some of the valuation assure it uses, to assess a given company’s intrinsic values are; Earnings, Earnings-per-share (PEPS) Price-to-earnings (PIE) Ratio, Projected-earnings-growth (PEG), Dividend Yield, Dividend Payout Ratio, Book Value, Price-to-book (P/B) Ratio, Price-to-sales (P/S) Ratio, Return-on-equity (ROE), to name Just a few. The essence of evaluating technical analysis (TA) and fundamental analysis (FAA) postulates question that verify how effective or ineffective, the analyses of information contradict Efficient Market Hypothesis.
Firstly, in recalling the weak form efficiency, that challenges the underpinnings of technical analysis, the sing fundamental analysis, empirical finance literature evidently implies that TA and FAA is without merit, from a Random Walk point of view. To establish the fact from a Random Walk theory, it follows that Fame (AAA), explained how the theory of random walks in stock market prices presents important challenges to the proponents of both technical analysis and fundamental analysis.
Fame (Bibb), further in this perspective, upholder random-walk theory as an accurate description of reality. During sass, the technical or fundamental analyses were the commonly used and supported methods in predicting the stock prices by the market rebellions. As part of Fame’s doctoral dissertation (AAA), he declares, the logic behind the technical (chartist) theories is that history tends to repeat itself. That is, if the past behavior of an individual security or a stock market is taken to account, it may be foreseen their future path by analyzing past sequence of price changes.
According to Fame, ‘it is impossible to gain abnormal profit by looking at the history of the price change series’ because successive price changes are independent (chartist theories says dependent), exactly what random walk theory says. Furthermore, the assumption of the Fundamental analysis approach depends on the belief that security has an intrinsic value other than actual price. Intrinsic value is the value of a security potential earnings.
Some fundamental factors such as quality of management, the overall situation of the industry in which the firm operates and the economic condition itself can affect a security potential earnings. Thus, an analyst can predict the future price of a security by evaluating these fundamental factors by finding out the intrinsic value and comparing it with the security actual price. If actual price of the security is lower than its intrinsic value, sooner or later the actual price will go up through its intrinsic value and vice versa.
Against the logic behind the opponents of fundamental analysis and Fame (Bibb:3-4), for the first time in literature, defined an efficient market as: “a market where there are large numbers of rational profit maximizes actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants”. This benefiting implies that a multitude of rational participants who compete with one another lead to the elimination of discrepancies between the actual prices and intrinsic values even though the latter are hard to estimate.
The naturalization process of discrepancies between the actual price and the intrinsic values will cause the actual price fluctuates randomly around its intrinsic value. The actual or expected new information can change the intrinsic value. According to Fame, in this situation, the actual prices will be immediately changed by absorbing the new information and rye to find the new level of intrinsic value because of high competition between many intelligent participants.
Around the same time, Samuelsson (1965:41) demonstrated that the series of successive price changes are independent by claiming that: “in a competitive market there is a buyer for every seller and if somebody is sure that a price would rise, it would have already risen”. He inferred that the unpredictability of prices was the sign of efficient working of the stock markets. Fame (1970) presented a landmark paper on the efficient market empirical work. He defines market efficiency very clearly (Fame,1970:383): A market in which prices always fully reflect all available information is called efficient. According to the definition of the efficient market hypothesis, an efficient market can exist if the following conditions hold Cones, 1993:626; Shellfire, 2000:2): I. A large number of rational profit maximizing investors exists who actively participate in the market, hence value securities rationally. Some investors are not rational, their irrational trades are canceling each other out or rational arbitrageurs eliminate their influence without affecting prices. Participants at fully to the new accordingly. Iii.
Information is costless and widely available to market approximately same time. Investors react quickly and information, causing stock prices to adjust The discussions stated above, have in effect, demonstrated the ineffectiveness of FAA and TA in an Efficient Market. However, it is noted, as seen in Shades (1990), who documented strong evidence of predictable behavior of security returns and therefore, rejects the random walk hypothesis. Additionally, LeRoy and Porter (1981), implied these anomalies exhibit to an extent, excess volatility in the stock market.
In he existence of these anomalies, the trading rules of technical analysis, and research approaches of fundamental analysis, may be capitalized upon to possibly outperform the efficiency market. A brief list of relevant anomalies is highlighted below: Low PEE effect- Some evidence indicates that low PEE stocks outperform higher PEE stocks of similar risk Low-priced stocks- This arises from a believe that the price of every stock has an optimum trading range. Small firm effect- Small firms seem to provide superior risk-adjusted returns. Neglected firm effect- Neglected firms seem to offer period returns with surprising regularity.
Market overreaction- It is observed that the market tends to overreact to extreme news. So, systematic price reversals can sometimes be predicted. January effect- In January, stock returns are inexplicably high, and small firms’ stocks do better than large firms’. Day-of-the-week/end effect- It is observed that security price changes tend to be negative on Mondays and positive on the other days of the week, with Friday being the best of all. Persistence of technical analysis- If them is true, technical analysis should be useless. Each year over, an immense amount of literature based in varying degrees on the subject is printed.
Conclusions As Milkier (2003) examined the attacks on the OHM and concludes that stock markets are far more efficient and far less predictable (against the notion ‘predictability of technical analysis). Furthermore G. William Chewer showing that when anomalies anomalies subsequently weaken or disappear, consequently research findings cause the market to become more efficient (Chewer, 2003). Subsequently, it is observed, Fame (1991), following the second of his three review papers, accepted the existence f anomalies that contradict his ‘efficiency market’ theory.
It was concluded by Fame and French (1998), claiming that the resulting problems from anomalies are caused by asset pricing theories, or they can be attributed to chance, rather than the skillful functions of the Technical and Fundamental Analyst. The study of MME, is seen to be a somewhat controversial area under discussion, hence, conclusion to whether the strategy of Technical Analysis or Fundamental Analysis, can outperform the efficient market, to obtain abnormal profit, is not ascertained. Therefore, the MME Theory, is subject to ongoing debate. References
