Efficient Markets:

An efficient market is one in which security prices fully reflect all available information. New information is information that investors did not previously have and could not anticipate. In other words, because prices respond to new information and new information is itself unpredictable, stock prices will move in a seemingly random fashion as well.

The followers of the random walk hypothesis believe that price movements are unpredictable and therefore security analysis will not help predict future market behavior.When financial experts say that stock prices follow a random walk, they mean that no matter what patterns seem to appear when we examine the behavior of past stock pattern, prices move essentially at random.

Levels of Market Efficiency:

The efficient markets hypothesis (EMH) is concerned with information - not only the source of information, but also the quality and speed with which it is disseminated among investors and reflected in asset prices. The more information that is incorporated into stock prices, the more efficient the market becomes. The levels of market efficiency are the weak form, the semi-strong form, the strong form.

The weak form of the EMH holds stock prices fully reflect any relevant information that can be obtained from an analysis of past price movements.

The semi-strong form of the EMH asserts that stock prices fully reflect all relevant information that investors can obtain from public sources. The investors cannot consistently earn abnormally high returns using publicly available information.

The strong form of EMH holds that there is no information, pubic or private, that allows investors to consistently earn abnormal returns. It states that stock prices rapidly adjust to any information, even if it isn't available to every investor.

Market Anomalies:

Despite considerable evidence in support of the EMH, researchers have uncovered some patterns that seem inconsistent with the theory. These market anomalies are calendar effects, small-firm effect, post earnings announcement drift, and the value effect.

Calendar effect holds that stock returns may be closely tied to the time of the year or the time of the week. That is, certain months or days of the week may produce better investment results than others.

Small-firm effect states that the size of the firm has a bearing on the level of stock returns.Several studies have shown that small firms earn higher returns than large-cap stocks.

Another anomaly is post earnings announcement drift. The stock prices may only react the "surprise" part of the earnings announcement.

According to the value effect, the best way to make money is to buy stocks that have relatively low prices relative to some measure of fundamental value such as book value or earnings. An investor following a value strategy might calculate the P/E ratio or the ratio of market value to book value for many stocks, then buy the stocks with the lowest ratios.

The most common explanation for market anomalies is that the stocks that earn abnormally high returns are simply riskier than other stocks, so the higher returns on these stocks reflect a risk premium rather than mispricing by the market.

Another explanation is that even in an efficient market where prices move essentially at random, some trading rules may appear to earn abnormally high returns simply as a matter of chance.

The discovery of these abnormalities led to the development of an entirely new way of viewing the workings of financial markets that is known as behavioral finance.Traditional finance assumes that investors, managers, and other actors in financial markets are rational. In contrast behavioral finance assumes that market participants make systematic mistakes, and those mistakes are inextricably linked to cognitive biases that are hard-wired into human nature.

Behavioral Finance: A Challenge to the Efficient Markets Hypothesis:

Researchers in behavioral finance believe that investors' decisions are affected by a number of psychological biases that lead investors to make systematic, predictable mistakes that, in turn, may lead to predictable patterns in asset prices that create opportunities for other investors to earn abnormally high profits without accepting abnormally high risk.

Beyond firm fundamentals, behavioral finance advocates believe that investors' decisions are affected by a number of personal beliefs and preferences. Consequently, investors will overreact to some types of financial information and underreact to others, resulting in pricing that cannot be justified on the basis of the firm itself. An understanding of these behavioral factors can improve stock price prediction, resulting in an inefficient market and lack of support for the EMH.

Some of the behavioral factors that might influence the actions of investors are overconfidence and self-attribution bias, loss aversion and representativeness.

Loss aversion is the tendency for individuals to dislike losses more than they like gains. As a consequence, investors hold on to losing stocks in hopes that they will bounce back.

Representativeness reflects an individual's tendency to make strong conclusions from limited samples. A successful stock analyst over the past three years is not necessarily going to be correct again. Across the thousands of stock analysts, there are some that make good decisions by random chance.

Investors guilty of narrow framing analyze an investment on its own merits without considering how that security correlates with the other investments in their portfolio. They might end up with an undiversified portfolio.

Investors might become overconfident in their judgments. Three consequences are that they might underestimate the amount of risk, make unduly positive forecasts, and participate in excessive trading.

Investors guilty of biased self-attribution will take undue credit for good selections and blame others for bad decisions. If these investors pick an above-average mutual fund, it is to their supposed credit, but if the mutual fund does poorly, these individuals will blame the portfolio manager for bad selection and/or timing. These individuals place more value on information that agrees with their selections.

Technical Analysis:

Technical analysis involves the study of the various forces at work in the marketplace. Technical analysts argue that internal market factors, such as trading volume and price movements, often reveal the market's future direction before the cause is evident in financial statistics. Thus, by revealing the market's future direction, technical analysis provides insight that is supposed to be helpful to investors in timing their investment decisions. If technical analysis indicates the market is about to move up, it signals a good time to buy; if it indicates the market is about to turn down, it signals a good time to sell.

The market can definitely have an impact on the prices of individual securities, and a significant one at that. In fact, studies have indicated that between 20 and 50% of stock price behavior can be traced to market forces. When the market is bullish, stock prices rise in general. When market participants become bearish, most prices fall. This is because stock prices are simply the result of supply and demand forces in the market. Since the demand for and supply of securities depend on the general condition of the market, stock prices are affected by the general behavior of the marketplace.

The Dow Theory:

Dow theory is a technical approach based on the idea that the stock market's behavior can be best described by the long-term price trend of the Dow Jones Industrial Index and the Dow Jones Transportation Index. If the values of both indexes are rising, we say that we are in a bull market. If the Dow Jones Industrial Average declines and the Transportation Index follows suit, we say that the markets have entered into a bearish period. The Confidence Index is the ratio of the average yield on high-grade corporate bonds to the average yield on low-grade corporate bonds. Low-rated bonds always provide a higher yield than high-grade bonds. If investors are pessimistic about the future, they will require a much higher yield on low-rated bonds, resulting in a decline in the Confidence Index. The unique feature of this index is that it uses bond yields to judge stock market performance.

Technical Conditions within the Market:

Four market forces that may influence market prices are (1) market volume, (2) breadth of the market, (3) short interest, and (4) odd-lot trading.

Market volume is an obvious reflection of the amount of investor interest. The market is considered strong when volume goes up in a rising market or drops off during market declines. It is considered weak when volume rises during a decline or drops during rallies.

The breadth of the market measure contrasts the number of firms with share price advancing to the number of firms with share price declining. When investors are optimistic, the number of advances will generally outnumber the frequency of declining share prices.

Short interest is a measure of the number of shares in the stock market that have been sold short. Because shares sold short will have to be purchased by the short sellers in order to cover their positions, the short sale measure is an indicator of future demand for the shares. Hence, the short interest measure provides insight to the current expectations regarding share prices and future potential demand.

Odd-lot trading is based on the cynical assumption that small investors will be the last to invest in a bull market and last to sell in a bear market. Hence, as the number of odd-lot purchases increases, there is supposedly an increasing chance of a market decline. If the number of odd-lot sales exceeds the number of odd-lot purchases by an increasing amount, it is an indication that the least knowledgeable group is giving up. The supply of additional shares will reduce price to sellers, but increase the likelihood that subsequent prices will be higher.

Trading Rules and Measures:

Market technicians are the analysts who believe it is chiefly (or solely) supply and demand that drive stock prices. They use a variety of mathematical equations and measures to assess the underlying condition of the market.

Some of the widely used technical indicators are: (1) advance-decline lines, (2) new highs and lows, (3) the arms index, (4) the mutual fund cash ratio, (5) on-balance volume, and (6) the relative strength index (RSI).

An advance-decline line is the difference between the number of shares going up in price and the number going down in price. The NYSE, Amex, and Nasdaq publish statistics on how many of

their stocks closed higher and lower than the previous day. Each day's net number is added to (or subtracted from) the running total, and the result is plotted on a graph. If the graph is rising, then advancing issues are more numerous than declining issues, and the market is considered strong.

New highs and lows measure is similar to the advance-decline line, but looks at price movements over a longer period of time.A stock is defined as reaching a new high if its current price is at the highest level it has been over the past year. A stock makes a new low if its current price is at the lowest level it has been over the past year.

The Arms Index, also known as the TRIN, for trading index, builds on the advance-decline line by considering the volume in advancing and declining stocks. The higher the TRIN is, the worse the market condition. A bullish market would have more advances than declines and greater volume in the rising stocks than falling ones.

TRIN = (Number of up stocks/Number of down stocks) / (Volume in up stocks/Volume of down stocks)

Mutual fund cash ratio (MFCR) looks at the cash position of mutual funds as an indicator of future market performance, and measures the percentage of mutual fund assets that are held in cash.The higher the MFCR is, the stronger the market.

MFCR = Mutual fund cash position / Total assets under management

On balance volume (OBV) is a momentum indicator that relates volume to price change. When the security closes higher than the previous day, all the day's volume is considered up volume and added to the running total. If it closes lower, all of the day's volume is considered down volume and subtracted from the running total. If prices are rising and OBV measures are rising, it is very bullish. A bearish measure would consist of both prices and OBV values declining. If they are going in opposite directions, even if share prices are rising, technical analysts would be concerned.

The relative strength index (RSI) is a measure of the average price change on up days to the average price change on down days. If the average price change is the same on up and down days, the RSI value will be 50. High values actually suggest that there is more buying than the fundamentals will justify.

Charting:

Charts are popular because they provide a visual summary of activity over time. Bar charts and point-and-figure charts are the most popular charts.Bar charts show market or share prices on the vertical axis and time on the horizontal axis. Prices are recorded as vertical bars that depict the high, low, and closing prices. Point-and-figure charts are used strictly to keep track of emerging price patterns.There is no time dimension, and only significant price changes are recorded on these charts.

Chart formations are said to result because of certain supply and demand forces in the marketplace. Some investors argue that history repeats itself, and so chart formations indicate

the course of events to come. Of course, the formations are often not very clear, so identification and interpretation can be a most difficult job.

Moving averages compare current share price to the average share price over a specified period. The period might, for instance, be 200 days. Every new day is added to the average, and the oldest day is dropped from the average. When current share prices advance above their 200-day moving average, share prices are expected to continue to rise, whereas when stock prices drop below their moving average, they are expected to continue to decline.

Having reviewed these topics please answer the following questions:

1. Briefly define random walk hypothesis.

2. Explain the three forms of market efficiency.

3. What are market anomalies? Briefly describe the January effect, the size effect, and the value effect.