Chapter 5
Market Efficiency
Fundamental Analysis
• Evaluation of firms and their investment
attractiveness
• Based on
– firm’s financial strength,
– competitiveness,
– earnings outlook
– managerial strength, etc.
Technical Analysis
• Method of evaluating securities and forecasting
future price changes
• Based only on past price and volume behavior
Efficient Market Hypothesis (EMH)
• Theory that market correctly prices
securities in light of known relevant
information
• 3 Forms
– Weak
– Semistrong
– Strong
Weak Form EMH
• Past stock price return movements cannot
be used to predict future price changes
• Implies technical analysis cannot
consistently provide superior returns
Semistrong Form EMH
• Market prices quickly and accurately reflect
all public information
• Suggests fundamental analysis applied to
publicly available information and data
cannot systematically yield superior returns
Strong Form EMH
• Market prices quickly and accurately reflect
all public and nonpublic information
• Suggests even insider information will not
consistently result in superior returns
Random Walk
• Documented by initial research on security returns
• Random motion of stock prices as likely to move
in one direction as another, regardless of past price
behavior
• Consistent with the weak form of the efficient
market hypothesis (EMH)
– If stock prices change randomly, past price movements
cannot be used to predict future price movements.
Why Stock Prices May Change
in Random Manner
• Prices based on expectations of future news and
events
• If expectations unbiased, then:
– when actual news and events better than expected,
stock prices go up
– when actual news and events worse than expected,
stock prices go down
• Random whether news better or worse than
expected!
Market Success and EMH
•
If EMH is true, can anyone can beat the
market?
–
•
At any point in time, half of investors will
have “beaten” market.
If someone beats market, does this
automatically invalidate the EMH?
–
Some will occasionally flip 10 heads in a row.
Testing the Weak Form of the EMH
•
Serial Correlation
–
•
Tests for statistically significant relationships
between returns
Filter Rules
–
–
Form of technical analysis that advocates
buying stock when price rises by given percent
or selling when price falls by certain percent
Successful with small filters, but only if
transaction fees are ignored
Conclusions About Technical Analysis
• Research does not confirm the consistency
of technical analysis techniques
• Tools of technical analysis have multiple
interpretations
• There are so many techniques that definitive
statements can not be made
Tests of Semi-Strong and Strong EMH:
• Anomaly
– Condition in security markets that allows for
persistent abnormal returns on a consistent
basis after adjusting for risk
Potential Causes of Market Inefficiency
• Small Firm Effect
– possible anomaly to the efficient market
hypothesis
– Tendency for small firms to earn above-rates of
return
– Not all investors have resources and expertise to
properly access stocks
– Some misevaluation may only be captured if one
is able to take control of a company
Potential Causes of Market Inefficiency
(Continued)
• Dogs of the Dow
– Buy top ten stocks with highest dividend yield on
a list of 30 picks
– Change list at one year time intervals
– Has not performed well since 1987
Potential Causes of Market Inefficiency
(Continued)
• January Indicator
– January performance is said to forecast the year
– Evidence is not impressive
Potential Causes of Market Inefficiency
(Continued)
• Other Potential Causes
– Day-of-the-Week Effect
– Additions to the S&P 500
– Insider Trader
Technical Market Indicators
• Data series or combination of data series
said to be helpful in forecasting market’s
future direction or market indicator
• Can be categorized as sentiment indicators,
flow of funds indicators and market
structure indicators
Sentiment Indicators
• Assumes sentiment of investors can be ascertained
by certain indicators
• Sophisticated Investor Rationale: Sophisticated
investors right more often than wrong. Seek an
indicator that reveals whether sophisticated
investors are buying or selling and do same
• Contrarian Rationale: Some investors with limited
resources are wrong more often than right; seek an
indicator of what the “small guys” are doing and
do the opposite.
Sentiment Indicators
(Continued)
• Odd-Lot Ratio: measures the amount of odd-lot
purchases or sales and assumes that people who
trade in odd-lots are inexperienced trades
• Mutual Fund Cash Position: assumes that mutual
fund managers build up cash at market bottoms
• Barron’s Confidence Index: ratio of high-grade to
average grade bond yields reflect confidence of
smart investors
Sentiment Indicators
(Continued)
• Trin: acronym for trading index and assumes that
market movements are more sustainable when
accompanied by heavy volume
Volume of declining stocks/Number of declining stocks
Trin = Volume of advancing stocks/Number of advancing stocks
• Put/Call ratio: calculated as ratio of either
outstanding puts to calls or volume of puts to calls.
Flow of Fund Indicators
• Attempts to determine where cash is going or
where it might go
– Short Interest: assumes that a rise in short interest
forecasts a rally
Short Interest Ratio 
Total Short Interest
Average Daily Trading Volume
– Cash Balances in Brokerage Accounts: viewed as a
measure of near term buying
Market Structure Indicators
• Moving Average
• Breadth Indicators
• Relative Strength Indicators
Market Structure Indicators: Dow Theory
• Charting theory originated by Charles Dow
• 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
• 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
Charting
• Attempt to forecast stock price changes
from charts of past price and volume data
• Form of technical analysis
Bar Chart
• Type of graph that plots price over time
• Typically contains data on high, low, and
volume
Bar Chart Example
Resistance Level
• Price range that, according to technical
analysis, tends to block further price
increases or decreases
Support Level
• Floor price that, according to technical
analysis, tends to restrict downside price
moves
Head and Shoulders Formation
• Pattern of stock price trends that looks like
a head and shoulders
• Believed by some technical analysts to
forecast price decline
• Neckline: price at the bottom of the
shoulders
Point-and-Figure Chart
• Technical chart that has no time dimension
– X is used to designate an upward price movement of a
certain magnitude, while a “0” denotes a similar size
down move
– X’s are stacked on top of each other as long as the
direction of movement remains up
– New column is begun when direction changes.
• Technical analysts use these charts to predict
future price movements
Point-and-Figure Example
Major Premises for Chartists
• Stock prices movements occur in patterns
consistent enough to be predictable
• Contains resistance and support levels
• Volume goes with the trend in some
methods