Evidence for weak form, Kendall & Alexander (Corhag 1987) shows the relationship of returns in the UK at various periods (1, 2, 4, 8 and 16 weeks) using price as a variable, when examining the data collected, the average correlation coefficient showed at 16 weeks was 0.156 which is the highest correlation from the data suggesting there is little correlation between return and returns in prior periods. If the weak form efficiency were to hold, then technical analysis will produce forecasts on the average of no profits.
Returns are assumed to follow a random walk theory. Burton Malkiel (1973) states that evolve according to a and thus the prices of the stock market cannot be predicted. , , and other have historically accepted the random walk hypothesis. They have run several tests and continue to believe that stock prices are completely random because of the efficiency of the market.
fundamental analysis which is a process of evaluating a security by attempting to measure its fundamental value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (such as the overall economy and conditions) and individually specific factors (such as the financial condition and management of companies). Their goal is to produce a value that an investor can compare with the security's current price in hopes of figuring out what sort of position to take with that security. Fundamental analysis is about using real data to evaluate security's value.
Semi-strong form efficiency, which implies that share prices do not adjust to publicly available new information very rapidly and in a biased fashion, such that excess returns can be earned by trading on that information. It uses event studies involving phenomena occurring at known points in time, such as stock split, or the announcement of corporate earnings in tests of semi-strong form of market efficiency. A method is required when calculating the expected return and when calculating the abnormal return, the typical approach is to use market models such as capital asset pricing model (CAPM) and arbitrage pricing theory (APT). The results show the effect of new information on returns at time of announcement is an abnormal return.
The analysis of results show that if the change significantly lacks behind the announcement date then it implies that investing is not a ‘fair game.’ Tests which give evidence in favour of semi-strong form include, stock splits, Fama, Fisher, Jensen and Roll (1969) believed that splitting shares may improve marketability and also an increase in the dividend paid, moreover, in 80% of the cases when there was a stock split it resulted in an increase in the dividend paid. Ball and Brown (1968) examined ‘residuals (abnormal performance index) for two portfolios: Good News and Bad News, associated with earnings above expectations or below expectations. A positive API was predicted for the Good News portfolio and negative for Bad News. Over 12 months the Good News portfolio increased (5%) and the Bad New portfolio decreased (11%), as expected. as a result, stock price were associated with accounting earnings.
The evidence against semi-strong form is seen in the Analysis of Accounts by George Foster 1979, who researched the effect that published statements by Abraham Brillof (a critic of accounting principles) had on market prices. Brillof published detail analysis of the company’s reports which were audited and had already been released to the public, when a company was criticised the stock fell and the loss from this was not recovered in 30 days. Ball (1974), Watts (1978), Bernard and Seyhun (1997) found that there was a delay in incorporation of earnings announcement to share prices, suggesting the market was not semi-strong efficient. If the semi-strong form were to hold, then fundamental analyst will not be able to produce forecasts that yield excess profits, although it leaves an open possibility for those with inside information to make abnormal profits. Semi-strong form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns.
In a rational market, share price is the present value of future cash flows to the investor. Tests for a rational market involves analysis of, volatility tests which looks at why share prices fluctuate, Shiller (1981), LeRoy and Porter (1981) states markets would be irrational if the volatility of share prices differed from the volatility of the economic fundamentals on which they would expect to be based. Also, tests for over reaction to see if investors overreact to information, Debondt and Thaler (1985) argued investors did over react, they found stocks performing poorly do abnormally well in the long run, whereas stocks performing well do abnormally bad, suggesting investors do over react to information. Stiglitz (1990) defined "if the reason that the price is high today is only because investors believe that the selling price is high tomorrow, when fundamental factors do not seem to justify such a price, a bubble exists. When a bubble exists there is a higher return for investors than the market, the higher return is compensation for the time when the bubble bursts, if investors sell before the bubble bursts they will gain whereas those who do not will lose out.
The market crashes following a bubble, the crash may cause investors to be hesitant to invest in the future. Also noise trading is used to find if uninformed investors buy and sell financial securities at irrational prices and whether they are exploited by informed investors. Shleifer and Summers (1990) look at noise trading however made assumptions which were, some investors are very sentimental and may base their decisions to buy shares on their beliefs or sentiments and therefore are not justified by market fundamentals, also noise traders do not use fundamental information, arbitrageurs traders buy and sell miss-priced shares to make a risk-less profit they are well informed and arbitrageurs see opportunities to make a profit by the way noise traders act. These assumptions can cause volatility as, arbitrageurs sell when the risk is too high, and when the bubble bursts investors who bought at high prices and sold at a lower price will suffer heavy losses.
The EMH became controversial especially after the detection of certain anomalies in the capital markets. Some of the main anomalies are: the day of the week which states that, the day of the week effect, Harris (1986) found on Monday’s a negative return is seen which was not consistent throughout the day, the negative return was seen at the end of Friday, and the first 45 minutes on Monday, however a rise in price happened in the last 30 minutes on Monday. Furthermore, Gibbons and Hess (1981) found while examining stock prices during 1962-1978, there was a significant difference in the expected percentage change for stock prices depending on the day of the week, on Monday the annualised return was 33.5%, the expected change was -7%, positive returns were seen on Wednesday and Friday, therefore the conclusion is to buy on Monday and sell on Friday. French (1980) analysed stocks during 1953-1977 and found there was a tendency for returns to be negative (negative returns are “caused by the weekend effect and not by a general closed-market effect”) on Mondays but positive on all other days of the week.
Also the January effect, Fama (1991) found (studying US stocks) between 1941-1981 small stocks rose by 8.06% and large stocks rose by 1.34% in January both were higher than the average in other months and during 1982-1991 small stocks rose by 5.32% and large stocks rose by 3.2% in January; the periods that were examined show that smaller stocks were affected more, implying the market was not weak form efficient. Possible explanations for the January effect are expressed by Keim (1989) who stated that the microstructure of the market (in December) found investors attempt to sell their shares so prices decrease.
Finally, the strong form efficiency states share prices reflect all information, public and private, and no one can earn excess returns since it is already incorporated into a security’s prices. If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is possible, except in the case where the laws are universally agreed upon.
Therefore, investment analysis and research are worthless as the equity share prices reflect all information that is knowable and relevant. Also due to the tests carried above, evidence support the weak form against technical analyst as their claims are not demonstrated by the available evidence; semi-strong form is also against fundamental analyst as prices react quickly to new information, though some anomalies suggest that all information is not instantly priced in to shares as required by semi-strong EMH. However it acts against the strong form efficiency as private information can provide abnormal profits and insider trading is also illegal.
END OF COURSEWORK
Word count: 1998
Bibliography
PILBEAM, K., 2005. Finance and Financial Markets. 2th ed. New York: Palgrave Macmillan.
LOFTHOUSE, S., 1995. Reading in Investment. England: John Wiley.
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