1. Market Efficiency Chapter 5
Market Analysis Methodologies
Forms of Market Efficiency
Testing Market Efficiency
Technical Market Analysis
Chapter #5
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2. Market Analysis Methodologies
Fundamental Analysis
Evaluation of firms and their investment attractiveness
Based on
firm’s financial strength
competitiveness
earnings outlook
managerial strength
Technical Analysis
Method of evaluating securities and forecasting future price changes
Based largely on price and volume behavior
Chapter #5
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3. Market Efficiency Efficient Market Hypothesis (EMH)
Security prices reflect all known information
You cannot use past, present of inside information to consistently beat the market
Three Forms of Efficiency
Weak (historic prices)
Semi-Strong (new information)
Strong (inside information)
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4. Weak Form Efficiency
Past stock price return movements cannot be used to predict future price changes
Implies technical analysis cannot consistently provide superior returns
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5. Semi-Strong Form Efficiency
Market prices quickly and accurately reflect all public information
Suggests fundamental analysis applied to publicly available information and data cannot systematically yield superior returns
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6. Strong Form Efficiency
Market prices quickly and accurately reflect all public and nonpublic information
Suggests even insider information will not consistently result in superior returns
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7. Random Walk Hypothesis
Stock prices wander about like a drunken monkey
Burton Malkiel’s “Random Walk Down Wall St”
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
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8. A Partial Explanation for RWH
Some non-random observations…
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…
How will investors (& speculators) react news?
Are positive reports necessarily good news?
Why? Non-homogeneity of player expectations
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9. Testing the Weak Form Filter Rules (mostly statistics-based models)
Deviations exceeding plus or minus 2 s
5% Rule: price up or down more than 5% (Yale Rule)
Fly in the Ointment
Serial Correlation
Price changes exhibit positive correlation over time
Remove trends using first differences
Markets tend to be weak form efficient
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10. Testing the Semi-Strong Form
Anomalies Literature
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
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11. Testing the Strong Form
SEC Rules notwithstanding…
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.
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12. Non-EMH Analysis Technical Market Indicators Sentiment Flow of Funds
Contrarian
Put-Call ratio
Mutual Fund cash position
Confidence indexes
Short interest
Moving Averages
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13. Non-EMH Analysis Charting Point and figure Candlesticks O-H-L-C
Heads/Shoulders
Resistance/Support (breakouts
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14. Non-EMH Analysis Some final words on Chartists
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)
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15. Dow Theory
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
Transports Index is favored confirmatory signal
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
Chapter #5
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