Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 9 Market Efficiency, Behavioral Finance, and Technical Analysis

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-2 Random Walks and Efficient Markets Random Walk: the theory that stock price movements are unpredictable, so there is no way to know where prices are headed –Studies of stock price movements indicate that they do not move in neat patterns –This random pattern is a natural outcome of markets that are highly efficient and respond quickly to changes in material information

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-3 Random Walks and Efficient Markets (cont’d) Efficient Market: a market in which securities reflect all possible information quickly and accurately To have an efficient market, you must have: –Many knowledgeable investors actively analyzing and trading stocks –Information is widely available to all investors –Events, such as labor strikes or accidents, tend to happen randomly –Investors react quickly and accurately to new information

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-4 Efficient Market Hypothesis Efficient Market Hypothesis (EMH): information is reflected in prices—not only the type and source of information, but also the quality and speed with which it is reflected in prices. The more information that is incorporated into prices, the more efficient the market becomes. Levels of the EMH –Weak Form EMH –Semi-strong Form EMH –Strong Form EMH

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-5 Levels of EMH Weak Form EMH –Past data on stock prices are of no use in predicting future stock price changes –Everything is random –Should simply use a “buy-and-hold” strategy Semi-strong Form EMH –Abnormally large profits cannot be consistently earned using public information –Any price anomalies are quickly found out and the stock market adjusts Strong Form EMH –There is no information, public or private, that allows investors to consistently earn abnormally high returns

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-6 Market Anomalies Calendar Effects –Stocks returns may be closely tied to the time of year or time of week –Questionable if really provide opportunity –Examples: January effect, weekend effect Small-Firm Effect –Size of a firm impacts stock returns –Small firms may offer higher returns than larger firms, even after adjusting for risk

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-7 Market Anomalies (cont’d) Earnings Announcements –Stock price adjustments may continue after earnings adjustments have been announced –Unusually good quarterly earnings reports may signal buying opportunity P/E Effect (Value Effect) –Uses P/E ratio to value stocks –Low P/E stocks may outperform high P/E stocks, even after adjusting for risk

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-8 Technical vs. Fundamental: So Who is Right? There is growing consensus that markets may not be perfectly efficient, but they may be at least reasonably efficient Individual investor must determine which approach has merits for their investing decisions

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 9-9 Investor Behavior and Security Prices Overconfidence –Investors tend to be overconfident in their judgment, leading them to underestimate risks Biased Self-Attribution –Investors tend to take credit for successes and blame others for failures –Investors will follow information that supports their beliefs and disregard conflicting information

Copyright © 2011 Pearson Prentice Hall. All rights reserved Investor Behavior and Security Prices (cont’d) Loss Aversion –Investors dislike losses much more than gains –Investors will hang on to losing stocks hoping they will bounce back Representativeness –Investors tend to draw strong conclusions from small samples –Investors tend to underestimate the effects of random chance

Copyright © 2011 Pearson Prentice Hall. All rights reserved Investor Behavior and Security Prices (cont’d) Narrow Framing –Investors tend to analyze a situation in isolation, while ignoring the larger context Belief Perseverance –Investors tend to ignore information that conflicts with their existing beliefs

Copyright © 2011 Pearson Prentice Hall. All rights reserved Behavioral Finance at Work in the Markets Stock Return Predictability –It maybe profitable to buy underperforming stocks when they are out-of-favor –Momentum of stock prices up and down tends to continue over 6- to 12-month time horizons –Value stocks may outperform growth stocks

Copyright © 2011 Pearson Prentice Hall. All rights reserved Behavioral Finance at Work in the Markets (cont’d) Investor Behavior –Investors who believe they have superior information tend to trade more, but earn lower returns –Investors tend to sell stocks that have risen in value rather than declined –Investors acting on emotions instead of facts may reduce market efficiency

Copyright © 2011 Pearson Prentice Hall. All rights reserved Behavioral Finance at Work in the Markets (cont’d) Analyst Behavior –Analysts may be biased by “herding” behavior, where they tend to issue similar recommendations for stocks –Analysts may be overly optimistic about a favorite stock’s future

Copyright © 2011 Pearson Prentice Hall. All rights reserved Using Behavioral Finance to Improve Investment Results (Table 9.1) Don’t hesitate to sell a losing stock Don’t chase performance Be humble and open-minded Review the performance of your investment on a periodic basis Don’t trade too much

Copyright © 2011 Pearson Prentice Hall. All rights reserved Technical Analysis Before financial data/financial statements were required to be disclosed, investors could only watch the stock market itself to determine buy-or-sell decisions Investors began keeping “charts” of stock market movements to look for patterns, or “formations” that indicated whether to buy or sell Studies have shown that anywhere from 20% to 50% of the price behavior of a stock can be traced to overall market forces

Copyright © 2011 Pearson Prentice Hall. All rights reserved Technical Analysis (cont’d) Technical Analysis is the study of the various forces at work in the marketplace and their affect on stock prices. –Focus is on trends in a business’ stock price and the overall stock market –Stock prices are a function of supply and demand for shares of stock –Used to get a general sense of where the stock market is going in the next few months –Several technical indicators may be used together

Copyright © 2011 Pearson Prentice Hall. All rights reserved Big Picture Technical Indicators The Dow Theory –Market’s performance is based upon long-term price trend (primary trend) in overall market –Used to signal end of both bull and bear markets –An after-the-fact measure with no predictive power

Copyright © 2011 Pearson Prentice Hall. All rights reserved Figure 9.1 The Dow Theory in Operation

Copyright © 2011 Pearson Prentice Hall. All rights reserved Big Picture: Technical Indicators (cont’d) Trading Action –Looks at minor trading characteristics in market over long periods of time –Assumes the market moves in cycles and these cycles repeat themselves –Trading rules are formed from patterns: January indicator Presidential election indicator Super Bowl indicator

Copyright © 2011 Pearson Prentice Hall. All rights reserved Big Picture Technical Indicators (cont’d) Confidence Index –Looks at ratio between yields on high-grade corporate bonds compared to low-grade corporate bonds –Optimism and pessimism about the future outlook is reflected in the bond yield spread –Trend of “smart money” is revealed in bond market before it shows up in stock market

Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Technical Indicators Market Volume –Pure supply and demand analysis for common stocks –Strong market when volume goes up –Weak market when volume goes down

Copyright © 2011 Pearson Prentice Hall. All rights reserved Volume The volume of trading supporting a given market movement is important A stock price (or the general market) making a new high on heavy trading volume is viewed as bullish A stock price (or the general market) making a new low on heavy trading volume is viewed as very bearish A stock price (or the general market) making a new high or low on light trading volume may indicate a temporary move likely to be reversed

Copyright © 2011 Pearson Prentice Hall. All rights reserved Key Indicator Series A number of technical indicator series may be watched for bearish ( )and bullish ( ) trends –Contrary opinion rules React opposite to the indicator Reflection of individual investors –Wrong most of the time –Smart money rules “best info” gathered by these “experts” –Overall market indicators

Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Technical Indicators (cont’d) Breadth of the Market –Looks at number of stock prices that go up (advances) versus number of stock prices that go down (declines) –Strong market when advances outnumber declines –Weak market when declines outnumber advances

Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Technical Indicators (cont’d) Short Interest –Looks at number of stocks that have been sold short at any given time –Can give two different interpretations: Measure of Future Demand for Stock –Strong market when short sales are high since guarantees future stock sales to cover the short positions Measure of Present Market Optimism or Pessimism –Weak market when short sales are high since professional short sellers think stocks will decline

Copyright © 2011 Pearson Prentice Hall. All rights reserved Short Sales Position A rule based on the volume of short sales in the market –Short sell when you think the stock price will fall The contrary opinion stems from two sources: Short seller are sometimes emotional and may overreact to the market, more importantly; there is now a built-in demand for stocks that have been sold short by investors who will have to repurchase shares to cover their short positions Daily short sale totals for the NYSE are reported in the Wall Street Journal Wall Street Journal

Copyright © 2011 Pearson Prentice Hall. All rights reserved Short Sales Position Technical analysts compute a ratio of total short sales positions on an exchange to average daily exchange volume for the month –Normal ratio is between 2.0 and 3.0 –A ratio of 2.5 indicates current short sales are equal to 2 ½ times the day’s average trading volume  As the ratio (called the short interest ratio) approaches the higher end of the normal range, this would be considered bullish  Use of the ratio has produced mixed results

Copyright © 2011 Pearson Prentice Hall. All rights reserved Market Technical Indicators (cont’d) Contrary Opinion and Odd-Lot Trading –Measures the volume of small traders –Assumes that small traders will do just the opposite of what should be done Panic and sell when market is low Speculate and buy when market is high –Bull market when odd-lot sales significantly outnumber odd-lot purchases –Bear market when odd-lot purchases significantly outnumber odd-lot sales

Copyright © 2011 Pearson Prentice Hall. All rights reserved Odd-Lot Theory An odd-lot trade is one of less than 100 shares — only small investors tend to engage in odd-lot transactions –The odd-lot trader is presumed to be a strong seller right before the bottom of a bear market –A corollary to the odd-lot theory says that Monday odd-lot trades are particularly suspect –If purchases > sales, a bad signal watch what the small investor is doing and then do the opposite The weekly Barron’s reports odd-lot trading on a daily basis in its “Market Laboratory – Stocks” sectionBarron’s

Copyright © 2011 Pearson Prentice Hall. All rights reserved Put-Call Ratio ILL-CONCEIVED speculation in the options market suggests that a “put-call” ratio may tell you to do the opposite of what option traders are doing Puts and calls represent options to buy or sell stock over a specified period of time at a given price: –A put is an option to sell (expect prices to fall) –A call is an option to buy (expect prices to rise) Put-call ratio data is found in the “Market Week – Options” section of Barron’sBarron’s

Copyright © 2011 Pearson Prentice Hall. All rights reserved Put-Call Ratio The ratio of put (sell) to call (buy) options is normally about 0.60 –there are generally fewer traders of put options than call options When the ratio gets up to 0.65 to 0.70 or higher, this indicates increasing pessimism by option traders and the contrary rules suggests a buy signal When the ratio goes down to 0.40, decreasing pessimism (increasing optimism) may indicate that it is time to sell if you are a contrarian The put-call ratio has a better than average record for calling market turns.

Copyright © 2011 Pearson Prentice Hall. All rights reserved Trading Rules and Measures Advance-Decline Line –Measures the difference between stocks closing higher and stocks closing lower than previous day –Difference is plotted on graph to view trends –Used as signal to buy or sell stocks –Bull market when advances outnumber declines –Bear market when declines outnumber advances

Copyright © 2011 Pearson Prentice Hall. All rights reserved Trading Rules and Measures (cont’d) New Highs–New Lows –Measures the difference between stocks reaching a 52-week high and stocks reaching a 52-week low –10-day moving average is plotted on graph to view trends –Used as signal to buy or sell stocks –Bull market when highs outnumber lows –Bear market when lows outnumber highs

Copyright © 2011 Pearson Prentice Hall. All rights reserved Trading Rules and Measures (cont’d) The Arms Index or Trading Index (TRIN) –Combines advance-decline line with trading volume –Used as signal to buy or sell stocks –Bull market when TRIN values are lower –Bear market when TRIN values are higher

Copyright © 2011 Pearson Prentice Hall. All rights reserved Trading Rules and Measures (cont’d) Mutual Fund Cash Ratio (MFCR) –Tracks cash position of mutual funds –High cash positions in mutual funds provides liquidity for future stocks purchases or protection from future mutual fund withdrawals –Bull market when MFCR values are higher –Bear market when MFCR values are lower

Copyright © 2011 Pearson Prentice Hall. All rights reserved Trading Rules and Measures (cont’d) On Balance Volume –Tracks the volume to price change relationship as a running total –Up-volume occurs when stock closes higher and is added to running total; down-volume occurs when stock closes lower and is subtracted from running total –Direction of indicator is more important than actual value –Used to confirm price trends –Bull market when OBV values are higher –Bear market when OBV values are lower

Copyright © 2011 Pearson Prentice Hall. All rights reserved Using Technical Analysis (cont’d) Moving Averages –Tracks data (usually stock price) as average value over time –Used to “smooth out” daily fluctuations and focus on underlying trends –Usually calculated over periods ranging from 10 to 200 days

Copyright © 2011 Pearson Prentice Hall. All rights reserved Figure 9.7 A 100-Day Moving Average Line

Copyright © 2011 Pearson Prentice Hall. All rights reserved ailpage&v=L3EzXzofRtI How The Pros Use Moving Averages. detailpage&v=7PY4XxQWVfM What are Bollinger Bands