This essay is going to discuss the efficient market hypothesis theory against the technical and fundamental analysis. It is going to discuss what the efficient market hypothesis is all about and the way it is related to the current situation, the tests ca

University Degree Business and Administrative studies

AC2005C/N FINANCE 1

LECTURER NAME: CHRISTOPHER ESSIEN

By spring 2007/2008

This essay is going to discuss the efficient market hypothesis theory against the technical and fundamental analysis. It is going to discuss what the efficient market hypothesis is all about and the way it is related to the current situation, the tests carried out and finally the evidence shown. It will also compare and contrast the theory of the technical analysts and fundamental analysis with the efficient market hypothesis. It will examine the arguments among people who carried out different tests and have got opposite views on the same issues.

The efficient market hypothesis (EMH) claims that, security prices reflect the information that is known and therefore are unbiased in the sense that they reflect the joint beliefs of all investors about future outlooks. EMH also states that, except through luck it is not always possible to outperform the market by using any information or news that the market already knows. This is to say, when financial markets are in equilibrium, the prices of financial instruments reflect all readily available information. This has been seen recently in the case of northern Rock. Once the news was told its share price dramatically went down. This is because current prices of financial instruments reflect the optimal forecast using all available information when markets are in equilibrium. For instance if good news is printed in the evening standard about a certain company, by the time investors read the news and buy the financial instrument the next morning, its price has already adjusted so that no one would make an excess return. Commonly there are three forms of market efficiency:

Weak-form states that no excess returns can be earned by using investment tactics based on historical share prices; it has two certain types of testing, these are correlation tests and runs tests. By doing correlation tests we are trying to determine whether there is a direct relationship, by looking if the relationship is linear or not, between past information and current returns. But correlation test work on the assumption that the market is in equilibrium. Runs tests look at analysing large observations of past share prices to see whether there are runs of positive or negative returns; a positive run or negative run is determined by increase and decrease in share price respectively. Weak form EMH is all about current share prices reflecting information, but assumes that the market is in equilibrium and also doesn’t look at efficiency of information. This is in total contrast to a technical analysis approach to investment because basing trading rules on share price history would not be sensible as the future cannot be predicted like that.

Technical analysis: This is the forecasting of market prices from the analysis of data generated by the process of trading. By definition: ‘It refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals. Technical Analysis is the science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in “the Averages” and then deducing from that pictured history the probable future trend’. Technical analysis relies on the assumption that markets discount everything except information generated by market action.

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Price Discounts Everything, Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. Technical analysis uses the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.

Prices Movements are not Totally Random, Technicians believe that prices trend. However, most technicians acknowledge also that there are periods where prices do not trend. If it were true that prices were always random, it would be too difficult to make money using technical analysis.

Therefore if the weak form of EMH stands, then technical analysis has no value. Because current price will be reflected by past information therefore using past prices and charting them to forecast future prices is irrelevant. There are more studies to back EMH than technical analysis but this doesn’t mean that technical analysts and chartists work is immaterial. The information is works best in the currency market rather than the stock market because share prices are affected by so many factors and past share price doesn’t take into consideration future news and announcements but investors do. And it is clear by past studies that information directly affects share price. This evidence suggests that only a very small element of historic return can explain current return. The implication is that technical analysis is not useful.

The holds the idea that prices already reflect all such influences before investors are aware of them. In the contrast, technicians say that EMH ignores the way markets work, in that many investors base their expectations on past earnings, track record, etc. Because future stock prices can be strongly influenced by investor expectations, they claim it only follows that past prices influence future prices. They also point to research in the field of , specifically that people are not the rational participants EMH makes them out to be. Technicians have long said that irrational human behavior influences stock prices, and that this behaviour leads to predictable outcomes. EMH disagrees, and states that past prices cannot be used to profitably predict future prices. EMH advocates say that if prices quickly reflect all relevant information, there will not be any method including technical analysis which can beat the market. argues back to say, "Technical analysis is anathema to the academic world. He further argues that, under the weak form of the efficient market hypothesis, future stock prices can not be predicted from past stock prices.

Fundamental Analysis, Fundamental analysis is the examination of the underlying factors that affect the economy, industry groups, and companies. As with most analysis, the goal is to make a forecast. At the company level, fundamental analysis may involve the examination of financial data, management, business concept and competition. For the national economy, fundamental analysis might look at economic data to make an assessment on the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately draw towards fair value. Fundamentalists believe that markets are weak-form efficient.

Fundamental analysis will also help identify companies that represent a good value. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet and stable earnings. Another reward for fundamental analysis is the development of a thorough understanding of the business.

According to the economist Eugene Fama who published the seminal paper on the EMH in the journal of finance in 1970, EMH advocates agree in that, individual market participants do not always have complete information (act Rationally), however their collective decisions balance each other which results in a rational outcome. This means that optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which keeps the price in equilibrium. In some instances, the efficient market hypothesis also appears to be inconsistent with many events in stock market history. This would tend to indicate that rather irrational behaviour can sweep stock markets at random. Tests of the random-walk hypothesis have been extensively used as a test for weak-form efficiency. Returns are generally assumed to follow a random walk (Bachelier (1900)). A follower of the random walk theory believes it's impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time - in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity .

Semi-strong form states that share prices adjust within randomly small but limited amount of time and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information. is all about publicly available information but also incorporates past share prices. It states that information that is publicly available to investors will reflect in share prices. According to semi-strong if there is a release of bad news then share price will fall and investors will lose interest in that company and likewise if good news is released then share price will go up and investors will gain interest in the company, it also states that you can only beat the market by insider trading. CAPM model that describes the relationship between risk and expected return.

There are anomalies to the EMH include: The day of the week effects both Fran Cross (1973) and Gibbons and Hess (1981) have found statistically significant evidence that share prices tend to fall on Mondays and rise on Fridays.

One of the biggest challenges facing the EMH has been discovery of the so called January effect, noted by Keim (1983) from a study of the US stock-market covering the years 1963 to 1979. The is a pattern that shows higher returns tend to be earned in the first month of the year. The January effect is the finding that not only are returns on stocks in January relatively high compared to other months of the year, but more importantly the returns on small company stocks happen to significantly out-perform the performance of the market as a whole in January . This difference is significant even if one controls for risk factors as measures by the firms’ betas small firms tending to be more risky with high betas. For instance, a study by Fama (1991) covering the period 1941 to 1981 found that not only is January the month with the highest average return. The effect is not confined exclusively to the U.S. market; in fact Gultekin and Gultekin (1983) found the effect to be even more pronounced than in the United States in 16 other countries.

Market rationality is concerned with the extent that prices reflect expectations about the present value of future cash flows. Tests for the rational market involve analysis of: Volatility test (Shiller 1981 and LeRoy and Porter1981) find that actual prices vary considerably more than theoretical prices and reject market rationality. And also Marsh and Merton (1986) assume that dividends are a positive function of past prices and conclude that the market is rational. Overreaction (Debondt and Thaler) found that: Poorly performing stocks subsequently do abnormally well and high performing do abnormally badly, this is not consistent with the EMH. While bubble exists investors get a return greater than the market. Stock market crashes; A crash fellows a bubble. Shliefer and Summers (1990) describe the noise traders do not use fundamental information.

Fundamental analysis can be valuable, but it should be approached with caution, because it does not capture the company's aspects or risks that cannot be measured by a number. So it is therefore not useless but cannot be used independent of everything else. So overall the statement made is quite bias because it suggests that both technical analysis and fundamental analysis are useless however it is clear from studies that have been undertaken that these types of analysis are not only very useful in forecasting and investing but are needed to make precise judgments.

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