Session 5 Topics to be Covered: –Market Efficiency –Random Walk –Fundamental Analysis –Speculation –Technical Analysis

Market Efficiency In theory, a company’s stock price is based on investor expectations about future dividends and stock prices. Expectations are based on information about –the company –the industry, or –the economy. Can investors with superior information or valuation skills identify profitable investments?

An Academic Perspective The Efficient Markets Hypothesis: If markets are efficient, then –information is widely and cheaply available to investors. –all available information is already reflected in security prices. –unexploited profitable trading opportunities using this information should not persist.

Efficient Markets Academic articles examine efficiency of the football, baseball, or horse race betting markets. For football betting, market efficiency means that –the closing point spread should not differ systematically from the actual difference in scores. According to one study –NFL bettors systematically underestimate the relative strengths of underdogs and home teams. –The college betting market is more efficient than the NFL market.

Random Walk Market efficiency arose from the recognition that stock prices seemed to wander, or follow a random walk. A random walk means successive changes in value are independent. Consider the following game: –You are given $100 to play. –At the end of each week, a coin is tossed. Heads: you win 3% Tails: you lose 2.5% –After 1 week, you will either have $103 or $97.50

Random Walk Tests of the Efficient Markets Hypothesis look for all types of patterns in stock price changes: –daily, weekly, or monthly –cross-country –patterns for different time periods –correlations, runs and technical trading rules.

Efficient Markets Some contradictions to the theory are not surprising. –Company insiders do well when they deal in their own stock. Others take more explaining. –On average, stocks of small companies have outperformed those of large companies, particularly during the first week of January.

Levels of Market Efficiency Three levels of market efficiency have been defined: –Weak Form: Prices reflect all information contained in the record of past prices. –Semi-Strong Form: Prices reflect past prices and all other public information. –Strong Form: Prices reflect all public and private information.

Investment Strategies There are several different strategies investors adopt to choose investments, that differ with respect to the amount of confidence they have in the Efficient Markets Hypothesis. –The Dart Board –Fundamental Analysis –Speculation –Technical Analysis

The Dart Board If markets are perfectly efficient, then –all stocks are fairly priced, and –you may just choose stocks randomly. Alternatively, you may choose broad market indices like the Standard and Poor’s 500. Market index strategies have been remarkably successful.

Fundamental Analysis Fundamental analysts study a company’s business and financial records trying to uncover information about future profitability. Fundamental analysts say things like: –“Given their position within the industry, the outlook for long-term earnings growth for this company is good.” –“Based on the price-to-earnings ratio of this company, this stock apprears overvalued.”

Fundamental Analysis If markets were perfectly efficient, then analysts should not be able to earn abnormal profits. In reality, it takes time and money to get and understand information. Occasionally, we see superior investment performance. –skill or luck?

Speculation Prices may have nothing to do with market efficiency or information. Instead it may all come down to psychology. Perhaps it is OK to pay too much for a stock if you can in turn sell it to a greater fool who will pay even more.

Speculation Historically, we have seen many famous exceptions to market efficiency that are often attributed to speculators: –The Tulip Bulb Craze –The South Sea Bubble –The “Tronics” Boom –Conglomerates –The Nifty Fifty –Internet Stocks ???

Speculation How do we reconcile speculative fads with market efficiency? Possibly: –Markets are usually efficient and driven by fundamentals. –Markets experience occasional periods of speculative frency focused on certain stocks. The trick is to know what is happening now.

Technical Analysis Technical analysis is the making and interpreting of stock charts. Its practitioners are also called chartists. They study a past for a clue about the future. Technical analysts do not believe in market efficiency. They believe markets follow trends and sustainable patterns.

Technical Analysis Technical analysts do not believe in market efficiency. They believe markets follow trends and sustainable patterns.