Chapter Nine
A Basic View of Technical Analysis and Market Efficiency
1
McGraw-Hill/Irwin
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
A Basic View of Technical Analysis
and Market Efficiency






Technical Analysis: The Use of Charting
Key Indicator Series
Efficient Market Hypothesis
Weak Form of the Efficient Market Hypothesis
Semistrong Form of the Efficient Market
Hypothesis
Strong Form of the Efficient Market Hypothesis
2
The Technical Approach to
Investment Timing


A gap exists between the practices of
brokerage houses and Wall Street
(charting and other technical analyses)
and the beliefs held in the academic
community (such as in the efficient
market hypothesis)
Since a consensus does not exist, it may
pay to consider many schools of thought
in valuing a security
3
Technical Analysis



Examines prior price and volume data
and other market-related indicators to
determine past trends hoping this will
help forecast future trends
Emphasis on charts and graphs of
internal market data
Less emphasis on fundamental factors
4
Technical Analysis


Belief that the discovery of fundamental
information may not lead to profitable
trading because of timing
considerations and market
imperfections
Market Imperfections: ability of the
market to adjust rapidly to the supply of
new information in valuing a security
5
Technical Analysis

Efficient Market Hypothesis:
“All securities are correctly priced at any
point in time”
• Implies neither fundamental analysis
nor technical analysis work to profitably
predict security valuation
6
Technical Analysis
assumes:
1. Market value is determined solely by
the interaction of demand and supply
2. Although there are minor fluctuations in
the market, stock prices tend to move in
trends that persist for long periods
Continued
7
Technical Analysis
assumes:
3. Reversals in trends are caused by
shifts in demand and supply
4. Shifts in demand and supply can be
detected sooner or later in charts
5. Many chart patterns tend to repeat
themselves
8
Technical Analysis
Most Significant Assumptions:


Stock prices move in trends that persist for
long periods
These trends can be detected in charts
Thus past trends in market movements can
be used to forecast or understand the future.
The lag between the time a technical analyst
perceives a change in the value of a security
and when the investing public ultimately
assesses this change provides a profit
opportunity to the chartist
9
Technical Analysis
Tools to project future market
movements

Charting

Key indicator series
10
Technical Analysis
Use of Charting


Often linked to development of the
Dow Theory in the late 1890s by
Charles Dow
Generally believed successful in
signaling the market crash of 1929
11
Essential Elements of the Dow Theory
There are 3 major movements in the market:
1. Daily fluctuations
2. Secondary movements (two weeks to a month)
3. Primary trends (long term)
 May be bullish or bearish in nature
 Daily fluctuations and secondary
movements only important to extent they
reflect on the persistence of the long term
primary trend
12
13
Presentation of the Dow Theory:
Example of use to analyze a trend



Chart shows positive
primary trend despite
two secondary
downward trends
Bullish primary trend is
confirmed by the
increases in the levels of
secondary lows and highs
Pattern assumed to
persist long term
but ultimately to end
14
15
Presentation of the Dow Theory:
Market reversal and confirmation
Ultimate end of a bullish trend
detected by a new pattern:

Recovery fails to exceed
previous high (Abortive
recovery) +

New low penetrates a
previous low +

New pattern confirmed by
subsequent movement in
Dow Jones Transportation
Average
16
Support and Resistance Levels
Chartists attempt to define trading levels
where price movements might face a
challenge or barrier
This assumes the existence of

Support levels (lower ends of trading
ranges) and

Resistance levels (upper ends of
trading ranges)
17
Support and Resistance Levels


A breakout above a resistance level or
below a support level is assumed to be
significant in suggesting that a stock is
now trading in a new range and
A breakout suggests higher or lower
trading values outside the previous
range may now be expected
18
19
Support and Resistance Levels
•Support may develop
each time a stock price falls
to a lower level as investors
who previously passed up a
buying opportunity now act
•Resistance may develop
when a stock price rises to
the high side of the normal
trading range as investors
take a profit or try to get
even after having bought at
a previous high
20
Support and Resistance Levels
•Support – at a sufficiently
low price, the quantity
demanded of a security
increases keeping the price
from falling further
•Resistance – at a
sufficiently high price, the
quantity supplied of a
security increases keeping
the price from rising further
Note that the analyst is looking just at the patterns here and is
not really concerned with any fundamentals behind them
21
Support and Resistance Levels
•Breakout – the security
price moves out of the
previous trading range
(breaching the resistance or
support level) suggesting a
new consensus and new
trading levels
22
Volume
The volume of trading supporting a given market
movement is considered significant


A stock price (or the general market) making
a new high on heavy trading volume is
viewed as bullish
A stock price (or the general market) making
a new low on heavy trading volume is viewed
as very bearish
Continued
23
Volume
The volume of trading supporting a given market
movement is considered significant
cont.

A stock price (or the general market) making a
new high or low on light trading volume may
indicate a temporary move likely to be reversed
24
Types of Charts



Line charts (like the previous ones shown
here to visualize market patterns)
Bar charts
Point and figure charts
25
Types of Charts: Bar Charts
On November
12th, this stock
traded between a
high of $41 and a
low of $38 and
closed at $40 a
share
Bar chart showing the high and low
prices of a stock during trading days in
November with a horizontal dash along
the line to indicate the closing price
26
27
Chart Evaluations
Market technicians
carefully evaluate
charts – looking for
what they perceive to
be significant patterns
of movement
28
Chart Evaluations
Thus in the Figure 9-4 bar chart, the pattern might be
interpreted as the “head-and-shoulders” one (note
the head in the middle) with a lower penetration of
the neckline to the right indicating a sell signal
Chart Representation of a Market Bottom
29
Chart Representations
30
Chart Representations
31
Types of Charts:
Point and Figure Chart (PFC)
•Emphasizes significant
price changes and the
reversal of significant
price changes
•Has no time dimension
•Chartists carefully read
PFCs to observe market
patterns: support,
resistance, breakouts,
congestion, and so on.
32
Types of Charts:
Point and Figure Chart
In Figure 9-7, assume
stock price starts at $30.
Only moves of $2 or more
are plotted
Advances  x
Declines  o
Reversals from advance
to a decline & vice versa
calls for a shift in columns
33
Types of Charts:
Point and Figure Chart
Thus:
The stock price initially
goes from $30 to $42
and then shifts columns
in its subsequent decline
to $36 before moving up
again in column 3.
A similar pattern persists
throughout the chart.
34
Charts
Trendline, published through a division of
Standard & Poor’s
 Provides excellent charting information on
a variety of securities traded on the major
exchanges
 Is available at many libraries and
brokerage houses
35
Charts
 The problem in reading charts has
always been to analyze patterns in such
a fashion that they truly predict stock
market movements before they unfold.
 To justify this effort, one must assume
there are discernible trends over the long
term.
36
Key Indicator Series
A number of technical indicator series
may be watched for bearish ( )and
bullish ( ) trends
• Contrary opinion rules
• Smart money rules
• Overall market indicators
37
Contrary Opinion Rules
Suggest observing unsuccessful market
behavior and choosing a contrary
position:

Odd-lot Theory

Short Sales Position

Investment Advisory Recommendations

Put-Call Ratio
38
Contrary Opinion Rules:
Odd-Lot Theory




An odd-lot trade is one of less than 100
shares — only small investors tend to
engage in odd-lot transactions
This theory suggests watching what the
small investor is doing and then do the
opposite
The weekly Barron’s reports odd-lot trading
on a daily basis in its “Market Laboratory –
Stocks” section
It is easy to construct a ratio of odd-lot
purchases to odd-lot sales
39
Contrary Opinion Rules:
Odd-Lot Theory
Cont.
As shown in Figure 9-8,
the odd-lot trader is on
the correct path as the
market is going up (net
selling position) but
becomes a net buyer
preceding a fall in the
market
40
Contrary Opinion Rules:
Odd-Lot Theory
Cont.


The odd-lot trader is also presumed to be a
strong seller right before the bottom of a
bear market
A corollary to the odd-lot theory says that
Monday odd-lot trades are particularly
suspect
41
Contrary Opinion Rules:
Odd-Lot Theory
Cont.


The theory actually suggests the small trader
does all right most of the time but badly
misses on key market turns
While the odd-lot theory appeared to have
some validity in the 1950s and 1960s, it was
not particularly valuable in more recent
decades.
However, odd-lot traders outguessed many
professional traders in the mid-1970s and
late 1980s as well as in October 1997 and
in the fall of 2003
42
Contrary Opinion Rules:
Short Sales Position
A rule based on the volume of short sales in
the market
[A short sale represents the selling of a security
you do not own with the anticipation of
purchasing the security in the future to cover
your short position]
The contrary opinion stems from two sources:


Short seller are sometimes emotional and may
overreact to the market, and more importantly
There is now a built-in demand for stocks that
have been sold short by investors who will
have to repurchase shares to cover their short
positions
43
Contrary Opinion Rules:
Short Sales Position Cont.


When the number of short sellers is
large (i.e., they are bearish), this is
thought to be a bullish signal
Daily short sale totals for the NYSE are
reported in the Wall Street Journal as
well as midmonth figures for the two
major exchanges and securities traded
on those exchanges
44
Contrary Opinion Rules:
Short Sales Position Cont.

Technical analysts compute a ratio of
total short sales positions on an
exchange to average daily exchange
volume for the month
• Normal ratio is between 2.0 and 3.0
• A ratio of 2.5 indicates current short
sales are equal to 2 ½ times the day’s
average trading volume
45
Contrary Opinion Rules:
Short Sales Position Cont.
 As the ratio (called the short
interest ratio) approaches the
higher end of the normal range, this
would be considered bullish
 Use of the ratio has produced
mixed results
46
Contrary Opinion Rules:
Investment Advisory Recommendations
A further contrary opinion rule:
Watch the predictions
of investment advisory services
and do the opposite

Investors Intelligence has formalized this into an Index of
Bearish Sentiment:
When 60% or more of advisory services are
bearish, expect a market upturn
When only 15% or fewer are bearish,
expect a decline in the market
47
Contrary Opinion Rules:
Investment Advisory Recommendations
Cont.
In Figure 9-9, a summary of
bullish and bearish
sentiments from the “Market
Laboratory—Economic
Indicators” section of
Barron’s, the AAII Index
(American Assoc. of
Individual Investors Index)
shows the percentage of
bears in the 15% range
suggesting a possible sell
under contrary opinion rules
48
Contrary Opinion Rules:
Put-Call Ratio
ILL-CONCEIVED speculation in the options
market suggests that a “put-call” ratio may tell
you to do the opposite of what option traders
are doing

Puts and calls represent options to buy or
sell stock over a specified period of time at a
given price:
• A put is an option to sell
• A call is an option to buy

Put-call ratio data is found in the “Market
Week – Options” section of Barron’s
49
Contrary Opinion Rules:
Put-Call Ratio
Cont.


The ratio of put (sell) to call (buy) options
is normally about 0.60 – there are
generally fewer traders of put options than
call options
When the ratio gets up to 0.65 to 0.70 or
higher, this indicates increasing pessimism
by option traders and the contrary rules
suggests a buy signal
Continued
50
Contrary Opinion Rules:
Put-Call Ratio
Cont.


When the ratio goes down to 0.40,
decreasing pessimism (increasing
optimism) may indicate that it is time
to sell if you are a contrarian
The put-call ratio has a better than
average record for calling market
turns.
51
Smart Money Rules
Market technicians have long attempted
to track the pattern of sophisticated
traders in the hope that they might
provide unusual insight into the future:
 Theories related to bond market traders
(e.g., Barron’s Confidence Index), and
 Theories related to stock market
specialists (e.g., short sales by
specialists)
52
Smart Money Rules:
Barron’s Confidence Index
Barron’s
=
Confidence Index
Yield on 10 top-grade corporate bonds
x 100
Yield on 40 intermediate-grade bonds
53
Smart Money Rules:
Barron’s Confidence Index Cont.
 This index is used to observe the trading
pattern of investors in the bond market on
the premise that they are more
sophisticated than stock traders and pick
up trends more quickly
 The theory suggests that a person who
can figure out what bond traders are doing
today may be able to determine what
stock market investors will be doing in the
near future
54
Smart Money Rules:
Barron’s Confidence Index
Cont.
 As top-grade bonds pay smaller yields than
intermediate-grade bonds, the Confidence
Index is always below 100%
 Normal trading range is between 80 and 96
55
Continued
Smart Money Rules:
Barron’s Confidence Index



Cont.
If bond investors are bullish about
future economic prosperity, they are
rather indifferent between holding topgrade and intermediate-grade bonds
the yield differences between the two
categories will be relatively small
 Confidence Index near 96
56
Smart Money Rules:
Barron’s Confidence Index Cont’d
 10 Top Grade Bonds yielding 8.4% while
40 Intermediate Grade Bonds yield 9.1%:
8.4%
Barron’s Confidence Index =
x 100 = 92%
9.1%
 Investors become quite concerned about the
economy’s future health and will invest in lowerquality bond issues only at a sufficiently high yield
differential to justify the risk – the gap widens:
8.9%
Barron’s Confidence Index =
x 100 = 83%
10.7%
57
Smart Money Rules:
Barron’s Confidence Index Cont’d
 Market technicians assume there are a
few months of lead time between what
happens to the Confidence Index and what
happens to the economy and stock market
 The Confidence Index has a mixed record
of predicting future events
 This mixed record may partly be due to
the fact that the supply of new bond issues
can influence yields as much as investor
attitudes (demand)
58
Smart Money Rules:
Short Sales By Specialists


Because of the uniquely close position
of specialists to the action on Wall
Street, market technicians ascribe
unusual importance to their decisions
Frequently monitored is
the ratio of specialists’ short sales to the
total amount of short sales
59
Smart Money Rules:
Short Sales By Specialists



The normal ratio of specialists’ short
sales to the total amount of short sales
on an exchange is about 45%
If the ratio goes above 50%, technicians
interpret this as a bearish signal
If the ratio falls below 40%, technicians
consider this bullish
60
Overall Market Rules

Breadth of the Market
Attempts to measure what a broad range
of securities are doing compared to a
market average
• Advance-declines are often compared with
movement of a popular market average
•

Cash Position of Mutual Funds
• Indicates their buying potential
• Is generally representative of the
purchasing potential of other large
institutional investors
61
Overall Market Rules

Breadth of the Market
•
Compare advance-declines:
The number of stock prices which are
rising compared to those declining
relative to movements in a stock
market average as a potential signal
of a turning point in the market
62
Continued
Overall Market Rules

Breadth of the Market
•
Cont’d
E.g., if the Dow-Jones Industrial
Average (DJIA) is rising while the
number of daily declines consistently
exceeds the number of daily
advances, this might signal the end of
a bull market. Why? Although
conservative investors are investing in
blue-chip stocks, there is a lack of a
broad-based confidence in the market
63
Overall Market Rules

Breadth of the Market
Cont.
In Table 9-1,
future weakness
in the market is
signaled by a
strength in the
DJIA that is not
reflected in the
advance-decline
data
64
Overall Market Rules

Breadth of the Market
Cont.
When the DJIA is going down but
advanced consistently lead declines, the
market may be posed for recovery
 Weighted averages calculated of daily
advances/declines are also used
 Daily data on the DJIA and advancing &
declining issues may be found in the
“Stock Market Data Bank” section of the
Wall Street Journal

65
Overall Market Rules

Breadth of the Market
Cont.
 Comparisons may provide insights but
also false signals – care in
interpretation should include a look at
a wide range of variables
 Decimalization of stock prices in 2001
may have caused the advance-decline
measure to lose some of its usefulness
as an advance or decline of only a
penny is all that is now needed to
make the list
 (You could, with effort, make up your
own measures)
66
Overall Market Rules

Cash Position of Mutual Funds
 Between 5 - 20% as a percent of total assets
 At the lower end of this range, mutual funds
appear to be fully invested and can provide
little in the way of additional purchasing
power
 As their cash position goes to 15% or higher,
this might represent significant purchasing
power that might help trigger a market
upturn
 While the overall premise is valid, problems
arise in identifying significant cash positions
for mutual funds in a given market cycle
67
The real world of investing

Behavioral finance
• Based on cognitive psychology
• Suggests individuals may view or “frame”
economically equivalent events differently
if presented in different contexts even after
adjusting for risk and other rational
considerations
• What is viewed by an individual as a
rational choice in a context may seem
irrational to an outside observer
68
The real world of investing

Behavioral finance continued:
• A poor or a favorable personal experience
with a particular investment may color an
individual’s attitude toward choices among
alternatives including that investment even
if they are economically equivalent
• Financial behaviorists suggest people
overreact to both good and bad news
 This “may well portray the high tech
fervor and debacle of the last decade”
69
The real world of investing

Behavioral finance suggests:
• Focus less on computing expected values,
standard deviations, and betas
• Spend more time examining the “irrational”
human being making investment decisions
70
Efficient Market Hypothesis (EMH)



New information is very rapidly
processed so that securities are
properly priced at any given time
The large number of profit-maximizing
participants concerned with analysis
and valuation of securities promotes this
Any relevant news is likely to be
absorbed and acted upon very rapidly
by these profit-maximizing individuals
71
Efficient Market Hypothesis




No stock price can be in disequilibrium or
improperly priced for long
Instantaneous adjustment to new information
Information travels in a random, independent
fashion
Prices are an unbiased reflection of all
currently available information
72
Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) is
stated and tested in three forms:
1. The weak form
2. The semi-strong form
3. The strong form
73
Weak Form of the EMH



No relationship between past and future
prices of securities
Prices of securities are presumed to be
independent over time
Because EMH maintains that current
prices reflect all available information,
and information travels in a random
fashion, it is assumed that little or
nothing is to be gained from studying
past stock prices
74
Weak Form EMH

Has been tested in two ways:
• Tests of independence
• Trading rule tests

Both tests seem to uphold the weak
form of the EMH:
• Security prices do appear to be
independent over time or move in the
pattern of a random walk
75
Weak Form EMH
 Tests imply prices move independently over
time
 Past trends cannot be used easily to predict
the future
 Charting/technical analysis may have limited
value
 No exceptional returns can be earned by
using investment strategies based on
historical stock prices or other financial data
76
Tests of Independence


The serial correlation between stock
prices over time has been consistently
small and not statistically significant –
they follow a “martingale”
“Securities are priced in an unbiased
fashion at any given time” – the only
factor that affects stock prices is the
introduction of previously unknown
news or information
77
Tests of Independence

A further test based on the frequency and
extent of runs in stock price data –
sequences of two or more price changes
in the same direction – also tends to
indicate that stock price movements are
independent over time
(+ + + + - + - + - + - - - + - +) Price changes
run
run
over time
78
Trading Rule Tests


Try to determine whether a given
trading rule based on past price data,
volume, and so forth, can be used to
beat a naïve buy-and-hold approach
Simulates conditions under which a
given trading rule is used to determine if
superior returns were produced after
considering transaction costs and the
risks involved
79
Trading Rule Tests

Stock price moves up 5% or more, “buy”
• Assumes this represents a “breakout” and
should be considered bullish


If price drops 5%, “sell”
This is a follow-the-market-trend strategy
rather than a buy low-sell high strategy
Since stock prices move randomly,
such rules
do not consistently achieve exceptional results
80
Implications for
Technical Analysis


Any trading rule that relies on historical
data and information will be of little
value
Security prices do appear to be
independent over time, or, more
specifically, move in the pattern of a
random walk
81
Semistrong Form EMH


All public information is already
impounded into the value of a security
There is no learning lag in the
dissemination of public information
• This may depend upon the size of the
firm which issued the stock and the
attention being paid to it by analysts and
others in the marketplace
82
Semistrong Form of EMH

Tests of this form of the EMH attempt
to see if investors acting on the basis of
newly released public information are
able to earn superior returns adjusting
for risk and transaction costs
83
Semistrong Form of EMH
Assume a stock goes up 15% and
the stock is 20% riskier than the market.
Assume the overall market rises by 10%.
On a risk-adjusted basis, the stock would
need to go up in excess of 12% [10% mkt
return x 1.2 risk factor] to beat the market.
Since the stock rose by more than 12%, it
is said to have beaten the market on a
risk-adjusted basis.
84
Semistrong Form of EMH


Tests examining the effects of such
events as stock splits, stock dividends,
and changes in accounting policy indicate
that the market is generally efficient in a
semistrong sense.
Almost all the market impact of a stock
split appears to occur before the public
announcement.  Little is gained from
acting on the announcement
85
Semistrong Form of EMH

Investors are assumed to not only digest
information very quickly, but also to be
able to see through mere changes in
accounting information that do not have
economic consequences
• Changing depreciation schedules for
financial reporting (but not tax purposes)
makes earnings per share look higher but
provides no economic benefit to the firm
and research shows it has no positive
impact on valuation
86
Semistrong Form of EMH
• Mere accounting changes related to
inventory policy, reserve accounts,
exchange transactions, and other
items that appear to have no
economic benefits do not appear to
deceive investors
• The effect on stocks of such changes
thus may be neutral or even negative
87
Implications for
Fundamental Analysis


One cannot use fundamental analysis to
determine whether a stock is
undervalued or overvalued
The collective wisdom of the
marketplace in which everyone is trying
desperately to come out ahead will
dominate any individual’s judgment on
the value of a stock
88
Implications for
Fundamental Analysis Cont.

Ironically, although many suggest that
fundamental analysis may not lead to superior
profits, it is fundamental analysis itself that
makes the market efficient:
Because everyone is doing fundamental
analysis, there is little in the way of
unabsorbed or undigested information.
 One extra person doing fundamental analysis is
unlikely to achieve superior insight
89
Implications for
Fundamental Analysis, Cont’d

Anomalies or deviations from the basic
proposition that the market is efficient still do
occur.
• E.g., stocks with low price/earnings ratios
consistently provide better returns than stocks
with high price/earnings ratios. Perhaps fewer
institutional investors in smaller firms make for a
less-efficient market and superior potential
opportunities
90
Strong Form of EMH
Stock prices fully reflect all information,
whether public or otherwise
 Requires that no group of investors have
a monopoly on access to any information
 Perfect markets exist where all
information is available to everyone at
the same time (full transparency)
 No group of investors can be expected to
show superior risk-adjusted returns
under any circumstances

91
Strong Form of EMH

Major test results of this form of the EMH
do not support it
• Specialists on security exchanges have
been able to earn superior rates of return
on invested capital. The “book” they keep
on unfilled limit orders appears to provide
monopolistic access to information.
• Corporate insiders consistently earn
higher returns than would be expected in
a perfect capital market
92
Strong Form of EMH
• Although there is evidence to not
accept the strong form of the EMH, the
range of participants with access to
superior information is not large
• Those who act illegally with insider
information may initially achieve higher
returns from their special access to
information, but the price of their
actions (forfeiture of gains, payment of
fines, jail time) may be high
93
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94
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95
Summary
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While fundamental analysis deals with
financial analysis and determinants of
valuation, technical analysis is based on
the study of past price and volume data as
well as associated market trends to predict
future price movements.
Technical analysis relies heavily on
charting and the use of key market
indicators to make forecasts.
96
Summary
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Technical Analysis also observes support and
resistance levels in the market as well as data
on volume.
Line, bar, and point & figure graphs are used to
spot turns in the market
Market technicians also follow a number of key
indicator series to predict the stock market –
contrary opinion indicators, smart money
indicators, and general market indicators.
97
Summary

Although arguments have traditionally
been made about the relative importance
of fundamental and technical analysis,
current attention is directed to the efficient
market hypothesis and its implications for
all types of analysis.
98
Summary

The efficient market hypothesis maintains
that the market adjusts very rapidly to the
supply of new information, and, because
of this, securities tend to be correctly
priced at any given time (or rapidly
approaching this equilibrium value).
99
Summary

The efficient market hypothesis has been
stated and tested in three different forms:
1. The weak form states that there is no
relationship between past and future prices
(they are independent over time).
2. The semistrong form suggests all public
information is currently impounded in the
price of a stock.
3. The strong form suggests all information,
public or otherwise, is included in the value
of a security.
100
Summary

Research tends to support the weak form
of the efficient market hypothesis which
causes many researcher to seriously
question the overall value of technical
analysis. However, many Wall Streeters
vigorously debate this position
101
Summary
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The semistrong form is also reasonably
supported by research and this fact
would tend to question the value of
fundamental analysis by the individual
investor. (It is the collective wisdom of all
fundamental analysis that leads to the
efficient market hypothesis in the first
place). There are some contradictions to
the semistrong form and much research
is aimed at supplying additional such
data.
102
Summary

The strong form of the efficient market
hypothesis is not generally accepted.
103