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8
Stock Price Behavior
and Market Efficiency
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
“If you see a bandwagon, it’s too
late.”
-Sir James Goldsmith
“Don’t try to buy at the bottom
and sell at the top. It can’t be
done except by liars.”
-Bernard Baruch
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Controversy, Intrigue, and Confusion
• Our goal in this chapter is first to discuss bull markets
and bear markets, as well as market psychology.
• Then, we will consider if anyone (i.e., you) can
consistently “beat the market.”
• Finally we will examine some baffling market
phenomena.
– The “Day of the Week” Effect
– The “January” Effect
– The puzzling performance of professional money managers
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Technical Analysis
• Technical analysis differs significantly from
fundamental analysis.
• Technical analysis is a controversial set of techniques
for predicting market direction based on
– Historical price and volume behavior
– Investor sentiment
• Technical analysts essentially search for bullish
(positive) and bearish (negative) signals about stock
prices or market direction.
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Dow Theory, I.
• The Dow theory is a method that attempts to interpret
and signal changes in the stock market direction.
• Historically, quite popular.
• The Dow theory identifies three forces:
– a primary direction or trend,
– a secondary reaction or trend, and
– daily fluctuations
• Daily fluctuations are essentially noise and are of no
real importance.
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Dow Theory, II.
Dow Jones Industrial Average,
January 2, 2001 to October 3, 2003
12,000
The primary direction is either bullish or bearish,
and reflects the long-run direction of the market.
11,000
Level
10,000
9,000
8,000
Secondary
trends,
temporary
departures
Corrections,
reversions to the
primary direction
7,000
01/01
04/01
07/01
10/01
01/02
04/02
07/02
10/02
01/03
04/03
07/03
10/03
Date
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Dow Theory, III.
• Purpose: to signal changes in the primary direction.
• Must monitor two indexes:
– Dow Jones Industrial Average
– Dow Jones Transportation Average
• If ONE index departs from the primary direction, this is
not a signal.
• However, if a departure in one is followed by a
departure in the other, this is viewed is confirmation
that the trend has changed.
The trend is your friend…
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Support and Resistance Levels
• A support level is a price or level below which a stock
or the market as a whole is unlikely to go, while a
• Resistance level is a price or level above which a stock
or the market as a whole is unlikely to rise.
• Resistance and support areas are usually viewed as
psychological barriers
– Bargain hunters help “support” the lower level.
– Profit takers “resist” the upper level.
• A “breakout” occurs when a stock (or the market)
passes through either a support or a resistance level.
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Market Diaries,
A Collection of Technical Indicators
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Technical Indicators, Notes
• The “advance/decline line” shows, for some period, the cumulative
difference between advancing and declining issues.
• “Closing tick” is the difference between the number of shares that
closed on an uptick and those that closed on a downtick.
• “Closing arms” or “trin” (trading index) is the ratio of average
trading volume in declining issues to average trading volume in
advancing issues. Using data from the "Previous Close:"
Arms 
754,540,57 0/1,734 435,144

 1.6944
384,700,63 0/1,498 256,809
• “zBlock trades” are trades in excess of 10,000 shares.
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Charting, Relative Strength
• Relative strength charts measure the performance of
one investment relative to another.
• Comparing stock A to stock B, through relative strength.
Stock A
(4 Shares)
Stock B
(2 Shares)
Relative
Strength
1
$100
$100
1.00
2
96
96
1.00
3
88
90
0.98
4
88
80
1.10
5
80
78
1.03
6
76
76
1.00
Month
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Charting, Moving Averages
• Moving average charts are average daily prices or index
levels, calculated using a fixed number of previous days’
prices or levels, updated each day.
• Because daily price fluctuations are “smoothed out,”
these charts are used to identify trends.
• Example: Suppose the technical trader calculates a 15day and a 50-day moving average of a stock price.
– If the 15-day crosses the 50-day from above, it is a bearish
signal—time to sell.
– If the 15-day crosses the 50-day from below, it is a bullish
signal—time to buy.
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Example: 15-Day and
50-Day Moving Averages
Dow Jones Industrial Average,
15-Day and 50-Day Moving Average
11,000
10,500
10,000
Index Level
15-Day
50-Day
9,500
9,000
8,500
8,000
7,500
1/2/02
3/6/02
5/7/02
7/9/02
9/9/02
11/7/02 1/10/03
3/14/03 5/15/03
7/17/03
9/17/03
Date
Note the "whipsaw" action—i.e., plenty of buying and selling signals.
This happens because 15 and 50 may be too "close" together in time.
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More Chart Types
• A hi-lo-close chart is a bar chart showing, for each day,
the high price, low price, and closing price.
• A candlestick chart is an extended version of the hi-loclose chart. It plots the high, low, open, and closing
prices, and also shows whether the closing price was
above or below the opening price.
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Candlestick Making, Basics
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Candlestick “Formations”
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Point and Figure Charts, I.
• Point-and-figure charts attempt to show only major price
moves and their direction.
– The point and figure chart maker decides what price move is
major.
– That is, it could be $2, $5, or any other level.
• A major up-move is marked with an “X”
• A major down-move is marked with an “O”
• Start a new column when there is a direction change.
– Buy and sell signals are generated when new highs or new lows
are reached.
– Congestion area, the area between buy and sell signals—a time
of market indecision concerning its trend.
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Point and Figure Charts, II.
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Point and Figure Charts, III.
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Chart Formations
• Once a chart is drawn, technical analysts examine it for
various formations or pattern types in an attempt to
predict stock price or market direction.
• One example is the head-and-shoulders formation.
– When the stock price “pierces the neckline” after the right
shoulder is finished, it is time to sell.
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Chart Formations, The Head and Shoulders
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Other Technical Indicators
• The “odd-lot” indicator looks at whether odd-lot
purchases are up or down.
• Followers of the “hemline” indicator claim that hemlines
tend to rise in good times.
• The Super Bowl indicator forecasts the direction of the
market based on who wins the game.
– Two Conference representatives play in the Super Bowl: one
from the National Football Conference and one from the
American Football Conference.
– A win by the National Football Conference (or one of the original
members of the National Football League) is bullish.
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Market Efficiency
• The Efficient Market Hypothesis (EMH) is a theory
that asserts: As a practical matter, the major financial
markets reflect all relevant information at a given time.
• Market efficiency research examines the relationship
between stock prices and available information.
– The important research question: Is it possible for investors to
“beat the market?”
– Prediction of the EMH theory: If a market is efficient, it is not
possible to “beat the market” (except by luck).
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What Does “Beat the Market” Mean?
• The excess return on an investment is the return
in excess of that earned by other investments that
have the same risk.
• “Beating the market” means consistently earning
a positive excess return.
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Forms of Market Efficiency,
(i.e., What Information is Used?)
• A Weak-form Efficient Market is one in which past prices and
volume figures are of no use in beating the market.
– If so, then technical analysis is of little use.
• A Semistrong-form Efficient Market is one in which publicly
available information is of no use in beating the market.
– If so, then fundamental analysis is of little use.
• A Strong-form Efficient Market is one in which information of any
kind, public or private, is of no use in beating the market.
– If so, then “inside information” is of little use.
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Why Would a Market be Efficient?
• The driving force toward market efficiency is simply
competition and the profit motive.
• Even a relatively small performance enhancement can
be worth a tremendous amount of money (when
multiplied by the dollar amount involved).
• This creates incentives to unearth relevant information
and use it.
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Are Financial Markets Efficient?
• Market efficiency is difficult to test.
• There are four basic reasons for this:
–
–
–
–
The risk-adjustment problem
The relevant information problem
The dumb luck problem
The data snooping problem.
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Are Financial Markets Efficient?
• Nevertheless, three generalities about market efficiency
can be made:
– Short-term stock price and market movements appear to be
difficult to predict with any accuracy.
– The market reacts quickly and sharply to new information, and
various studies find little or no evidence that such reactions can
be profitably exploited.
– If the stock market can be beaten, the way to do so is not
obvious.
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Some Implications if Markets are Efficient
• Security selection becomes less important, because
securities will be fairly priced.
• There will be a small role for professional money
managers.
• It makes little sense to time the market.
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Stock Price Behavior and Market Efficiency
The day-of-the-week effect refers to the tendency for
Monday to have a negative average return.
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The Amazing January Effect, I.
• The January effect refers to the tendency for small
stocks to have large returns in January.
• Does it exist for the S&P 500?
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The Amazing January Effect, II.
• The January effect refers to the tendency for small
stocks to have large returns in January. What do we
see when we look at returns on small stocks?
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The Market Crash in October 1987
• On October 19, 1987 (Black Monday), the Dow
plummeted 500 points to 1,700.
– Investors lost about $500 billion in share value.
– The market lost over 20% of its value.
– The volume was a record at the time: 600 million shares.
• Today the NYSE has circuit breakers.
– Rules that kick in to slow or stop trading when the DJIA
decreases (or increases) by more than a pre-set amount in a
trading session.
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The Performance of
Professional Money Managers
• From 1963 to 1998, the S&P 500 index outperformed
general equity mutual funds 22 times (out of 36).
• Why can’t the pros beat the averages? (You can hold a
market average very easily—SPDRs)
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Useful Internet Sites
• Technical Analysis Websites:
– Dow Theory:
– Glossary of terms:
– Drawing charts:
www.thedowtheory.com
www.e-analytics.com
www.stockcharts.com
www.bigcharts.com
http://finance.yahoo.com
• Charts and other indicators:
www.prophet.net
www.stockta.com
• Chart patterns:
www.chartpatterns.com
• Market Efficiency: Is astrology useful? (ed. No.)
www.afund.com
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Chapter Review, I.
• Technical Analysis
–
–
–
–
Dow Theory
Support and Resistance Levels
Technical Indicators
Charting
•
•
•
•
Relative Strength
Moving Average
Hi-Lo-Close and Candlestick
Point-and-Figure
– Chart Formations
– Other Technical Indicators
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Chapter Review, II.
• Market Efficiency
–
–
–
–
–
What Does “Beat the Market” Mean?
Forms of Market Efficiency
Why would a Market be Efficient?
Are Financial Markets Efficient?
Some Implications of Market Efficiency
• Stock Price Behavior and Market Efficiency
–
–
–
–
The Day-of-the-Week Effect
The Amazing January Effect
The October 1987 Crash
Performance of Professional Money Managers
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