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Chapt 08.doc

  1. 1. Chapter 8 Stock Price Behavior and Market Efficiency Slides 8-1 Fundamentals of Investments 8-2 One of the Funny Things About the Stock Market 8-3 Stock Price Behavior and Market Efficiency 8-4 Technical Analysis 8-5 Dow Theory 8-6 Dow Theory 8-7 Support and Resistance Levels 8-8 Support and Resistance Levels 8-9 Technical Indicators 8-10 Technical Indicators 8-11 Charting 8-12 Charting 8-13 Charting 8-14 Charting 8-15 Charting 8-16 Charting 8-17 Charting 8-18 Charting 8-19 Charting 8-20 Chart Formations 8-21 Chart Formations 8-22 Other Technical Indicators 8-23 Work the Web 8-24 Market Efficiency 8-25 What Does “Beat the Market” Mean? 8-26 Forms of Market Efficiency 8-27 Why Would a Market be Efficient? 8-28 Are Financial Markets Efficient? 8-29 Are Financial Markets Efficient? 8-30 Some Implications of Market Efficiency 8-31 Stock Price Behavior and Market Efficiency 8-32 Stock Price Behavior and Market Efficiency 8-33 Stock Price Behavior and Market Efficiency 8-34 Stock Price Behavior and Market Efficiency 8-35 Chapter Review 8-36 Chapter Review 8-37 Chapter Review
  2. 2. A-62 Chapter 8 Chapter Organization 8.1 Technical Analysis A. Dow Theory B. Support and Resistance Levels C. Technical Indicators D. Charting E. Relative Strength Charts F. Moving Average Charts G. Hi-Lo-Close And Candlestick Charts H. Point-and-Figure Charts I. Chart Formations J. Other Technical Indicators 8.2 Market Efficiency A. What does “Beat the Market” Mean? B. Forms of Market Efficiency C. Why Would a Market be Efficient? D. Are Financial Markets Efficient? E. Some Implications of Market Efficiency 8.3 Stock Price Behavior and Market Efficiency A. The Day-of-the-Week Effect B. The Amazing January Effect C. The October 1987 Crash D. Performance of Professional Money Managers 8.4 Summary and Conclusions Selected Web Sites  
  3. 3. Stock Price Behavior and Market Efficiency A-63 Annotated Chapter Outline 8.1 Technical Analysis Technical analysis: Techniques for predicting market direction based on (1) historical price and volume behavior, and (2) investor sentiment. The previous chapters discussed fundamental analysis; this chapter now addresses technical analysis. Technical analysts search for bullish or bearish signals, or indicators, about stock prices and market direction. The field of technical analysis is huge, with many books written on the subject. This chapter just touches on the highlights of some of the methods. Technical analysis is also very popular in futures markets, so much of this discussion also applies to those markets as well. A. Dow Theory Dow theory: Method for predicting market direction that relies on the Dow Industrial and the Dow Transportation averages. The basis of the Dow theory is that there are three forces at work in the stock market: • Primary direction or trend • Secondary reaction or trend • Daily fluctuations This theory indicates that the primary direction is either bullish or bearish, and reflects the long-run direction of the market. The secondary reactions are temporary departures from the primary direction, and the daily fluctuations are just noise and can be ignored. When the DJIA and DJTA are taken together, the two indexes can confirm each other and the primary trend, or depart from each other and be interpreted as a secondary reaction. Even though this method is not as popular today, its basic principles underlie many modern approaches to technical analysis. B. Support and Resistance Levels Support level: Price or level below which a stock or the market as a whole is unlikely to go. Resistance level: Price or level above which a stock or the market as a whole is unlikely to rise. The basic idea is that most stocks have a support level (price the stock is unlikely to go below) and a resistance level (price the stock is unlikely to go above),
  4. 4. A-64 Chapter 8 which can also be viewed as psychological barriers. When a stock goes down to a minimum level, the "bargain hunters" will view the stock as "cheap," buy the stock and, thereby, support the price. When a stock goes up to a maximum level, investors are likely to consider it "topped out" and sell their stock, which will slow down the price increase. C. Technical Indicators There are many technical indicators available to analysts, including: the advance/ decline line, the closing tick, the closing arms (Trin), and block trades. The advance/decline line shows the cumulative difference between advancing issues and declining issues. The closing tick is the difference between the number of shares that closed on an uptick, and those that closed on a downtick. The closing arms is the ratio of average trading volume in declining issues to average trading volume in advancing issues. Block trades refers to trades in excess of 10,000 shares. Lecture Tip: The closing arms, or Trin, is an interesting indicator to discuss. One easy way for students to remember Trin is from the acronym tr(end) in(dicator). It is useful to do a numerical example of the Trin since we think of declines over advances, but tend to forget the volume in the formula: Trin = (Declining volume/Declines) / (Advancing volume/Advances) D. Charting Technical analysts rely heavily on charts. They study past market prices or information, looking for trends or indicators that may signal the direction of the market or a particular stock. There are many charting techniques—this chapter reviews four of them. E. Relative Strength Charts Relative strength: A measure of the performance of one investment relative to another. Relative strength charts measure the performance of one investment or market relative to another. A common technique is to review how a stock did relative to its industry or the market as a whole. F. Moving Average Charts Moving average: An average daily price or index level, calculated using a fixed number of previous days' prices or level, updated each day.
  5. 5. Stock Price Behavior and Market Efficiency A-65 Moving averages are used to identify short- and long-term trends. The moving average lines can be computed for various time periods, and compared to a graph of the actual stock prices, or to other moving averages for the stock. Lecture Tip: A fun exercise for students is to gather stock price data for a company, download it into a spreadsheet, compute several period's moving averages, and then graph the results. If the student collects daily stock prices, they can compute 30-day and 90-day moving averages, and then plot these moving averages against the daily stock prices. It is then very interesting to discuss the interpretation of these moving average graphs, and it's an easy way for the students to become involved in technical analysis. G. Hi-Lo-Close and Candlestick Charts Hi-Lo-Close chart: Plot of high, low, and closing prices Candlestick chart: Plot of high, low, open, and closing prices that shows whether the closing price was above or below the opening price. A hi-lo-close chart is a bar chart showing the high price, low price, and closing price each day for a stock or index. The Wall Street Journal presents these charts daily for the Dow averages. Technical analysts use these charts to look for patterns. Candlestick charts have been used in Japan for several centuries to chart rice prices. They are a very compact method of showing the open, high, low, and closing prices of a stock or index. In addition, the analyst can tell quickly if the stock was moving up or down in price. There are many patterns that analysts use to predict trends in the market. H. Point-and-Figure Charts Point-and-figure charts: Technical analysis chart showing only major price moves and their direction. Point-and-figure charts show only major price moves and directions. These charts ignore time periods, and some technical analysts feel they provide a better indication of important trends. They are constructed using Xs for upward price moves of $X, and Os for downward price moves of $X. Note that there is no time dimension, simply a price move of a certain number of dollars (say $2 per X). A buy or sell signal is created when new highs or lows are reached. I. Chart Formations There are hundreds of chart formations and patterns that chartists look for. One of the most popular is the "head-and-shoulders" pattern, shown in Figure 8.5 in
  6. 6. A-66 Chapter 8 the text. The real difficulty with using these chart formations is trying to identify the patterns, and then interpreting when they actually appear. J. Other Technical Indicators There are many other technical indicators. A few presented in the text include: odd-lot indicator, hemline indicator, and the Super Bowl indicator. These last two indicators show how far some people go to try to predict market trends. 8.2 Market Efficiency Market efficiency: Relation between stock prices and information available to investors indicating whether it is possible to "beat the market;" if a market is efficient, it is not possible except by luck. Efficient market hypothesis (EMH): Theory asserting that, as a practical matter, the major financial markets reflect all relevant information at a given time. The primary question is: Can you, or can anyone, consistently "beat the market?" A. What Does "Beat the Market" Mean? Excess return: A return in excess of that earned by other investments having the same risk. To judge if an investment "beat the market," we need to know if the return was high or low relative to the risk involved. We need to determine if the investment has earned a positive excess return in order to say it "beat the market." B. Forms of Market Efficiency Weak-form efficient market: A market in which past prices and volume figures are of no use in beating the market. Semistrong-form efficient market: A market in which publicly available information is of no use in beating the market. Strong-form efficient market: A market in which information of any kind, public or private, is of no use in beating the market. "A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return." So a market can
  7. 7. Stock Price Behavior and Market Efficiency A-67 only be determined to be efficient with respect to specific information. The three forms include: • Weak-form efficiency, with respect to information reflected in past price and volume figures. • Semistrong-form efficiency, with respect to any publicly available information. • Strong-form efficiency, with respect to any information, both public and private. To be clear, if the information allows an investor to earn excess returns on an investment, the market is not efficient with respect to that information. Therefore, if an investor uses past price information to earn an excess return, then the market is not weak-form efficient. If an investor uses a firm's financial statements to earn an excess return, the market is not semistrong-form efficient. Finally, if an investor uses inside information to earn an excess return, the market is not strong-form efficient. C. Why Would a Market Be Efficient? The fundamental characteristic of an efficient market is that prices are correct in that fully reflect all relevant information. When new information becomes available, prices change quickly to reflect the new information. In an efficient market, price is a consensus opinion of value, based on the information and knowledge of millions of investors. D. Are Financial Markets Efficient? There are four reasons why market efficiency is difficult to test: • The risk-adjustment problem • The relevant information problem • The dumb luck problem • The data snooping problem There are three generalities based on research that are relevant to market efficiency: • Short-term stock price and market movements are very difficult to predict with accuracy. • The market reacts quickly and sharply to new information. There is little evidence that a market under (or over) reaction can be profitably exploited. • If the stock market can be beaten, it is not obvious, so this implies that the market is not grossly inefficient. E. Some Implications of Market Efficiency If markets are efficient:
  8. 8. A-68 Chapter 8 • Security selection is less important; investors may as well hold index funds to minimize their costs. • There is little need for professional money managers. • Investors should not try to time the market. In fact, market timing is very difficult to achieve and is not recommended, even ignoring market efficiency. Lecture Tip: It may be helpful to restate the implications of market efficiency with respect to the forms of market efficiency, as follows: • Weak-form efficiency: If weak-form efficiency holds, then technical analysis is a waste of time, and the whole industry of technical analysts are of no benefit. • Semistrong-form efficiency: If semistrong-form efficiency holds, then fundamental analysis is of no benefit, and most of the financial analysts and mutual fund managers are not providing any value. • Strong-form efficiency: If strong-form efficiency holds, then inside information is of no value, further indicating there should be no restrictions on insider trading. 8.3 Stock Price Behavior and Market Efficiency This section discusses several stock market anomalies. A. The Day-of-the-Week Effect Day-of-the-week effect: The tendency for Monday to have a negative average return. Table 8.3 shows the day-of-the-week effect, which indicates that Monday is the only day with a negative average return. Notice that Friday has a high positive return. This effect is statistically significant, but it is difficult to exploit it to earn a positive excess. About all we can do is use this in our trading decisions; purchase a stock late on Monday and sell our stocks late on Friday. B. The Amazing January Effect January effect: Tendency for small stocks to have large returns in January. Figures 8.6a and 8.6b show the results of the January effect. Small stocks tend to have much higher returns in January, whereas larger stocks (S&P 500) do not show this result. The bulk of the return occurs in the first few days of January and is more pronounced for stocks that have significant declines. This effect exists in most major markets around the world. Two factors are important in explaining the
  9. 9. Stock Price Behavior and Market Efficiency A-69 January effect: tax-loss selling, and institutional investors rebalancing their portfolios. C. The October 1987 Crash NYSE circuit breakers: Rules that kick in to slow or stop trading when the DJIA declines by more than a preset amount in a trading session. On October 19, 1987 (Black Monday) the Dow plummeted 500 points to 1,700 with about $500 billion in losses that day. There are several explanations for what happened: • Irrational investors bid up stock prices and the bubble popped. • Markets were volatile, the economy was shaky, and Congress was in session considering antitakeover legislation. • Program trading quickly created very large sell orders. Interestingly, the market recovered very quickly. The market was up in 1987 and the bull market continued for many years after the crash. As a result of the crash, NYSE circuit breakers were introduced. These circuit breakers required trading halts based upon 10, 20, and 30 percent declines in the DJIA. The trading halts vary from 30 minutes, to two hours, to the rest of the trading day. D. Performance of Professional Money Managers There have been a number of studies that compare the performance of mutual fund managers with market indices. The results of almost every study indicate that the market indices outperform the mutual fund managers. This is further evidence in favor of market efficiency. Mutual fund managers should be experts in technical and fundamental analysis, and should be able to use these tools to earn excess returns, if anybody can. Lecture Tip: An interesting study by Fortin and Michelson [Journal of Financial Planning, February 1999] compares the performance of a large sample of mutual funds categorized by investment objective, to their respective market indexes. For example, growth funds were compared to the S&P 500, corporate bond funds were compared to the Lehman Brothers Corporate Bond index, international funds were compared to the MSCI EAFE, and small company equity funds were compared to the Wilshire 2000. This study found that, on average, the indices significantly outperformed the mutual funds for all fund categories but one. The one category that the funds outperformed the index was small company equity funds. Apparently the fund managers are able to exploit enough market inefficiencies in the small firm equity market to allow excess returns to accrue. Current Topics: "Fund vs. Indexes: Data are Misleading," by Jonathan Clements, The Wall Street Journal, June 15, 1999. This article indicates that stock fund managers aren't performing as well or as poorly as they appear.
  10. 10. A-70 Chapter 8 "Whenever you see funds regularly beating or badly trailing their benchmark index, you ought to be suspicious." This is because investors can do no better or worse than the market, since collectively they are the market. As a group they should lag the market by a few percentage points, since the mutual funds have fees and investment costs. If this is not happening, then something is wrong. The author indicates that many studies of mutual funds are using the wrong indexes for comparison. Rather than using the S&P 500 for U.S. stock funds, the Wilshire 500 should be used, since it is a broader based index. In the past Morgan Stanley's EAFE index has been used as a foreign stock benchmark, which performed poorly relative to foreign stock funds due to its over-weighting of Japanese stocks. This index is now a better comparison with the funds since the Japanese market has declined, lowering the weighting of the Japanese stocks. 8.4 Summary and Conclusions