Professor Ian Giddy's Foundations of Finance
Forecasting and Efficient Markets: Highlights
Forecasting Market Prices
- Forecasting market prices -- stock prices, bond prices and interest rates, currency and commodity prices -- is a major industry. Investors and other market participants devote significant resources to forecasting in the hope of making so-called above-market returns.
- Technical analysis focuses on market price patterns and on proxies for buy or sell pressure in the market.
- Fundamental analysis focuses on the determinants of the underlying value of the security or group of securities.
- Fundamental analysis can be divided into two parts: forecasting broad market aggregates, such as the level of the stock market as measured by the S&P 500, and forecasting the price of individual securities, such as Sony's common stock price.
- Forecasters employ econometric analysis, using methods such as multiple regression analysis, or ratio analysis, such as comparing price-earnings ratios of different firms in the same industry, or informal analysis such as seeking to identify which firms are takeover candidates.
- Technical analysis is the search for recurring patterns in stock market prices. It is based essentially on the notion that market prices adjust slowly to new information and, thus, is at odds with the efficient market hypothesis.
- The Dow theory is the earliest chart-based version of technical analysis. The theory posits the existence of primary, intermediate, and minor trends that can be identified on a chart and acted on by an analyst before the trends fully dissipate. Other trend-based theories are based on relative strength and the point and figures chart.
- Technicians believe high volume and market breadth accompanying market trends add weight to the significance of a trend.
- Odd-lot traders are viewed as uninformed, which suggests informed traders should pursue trading strategies in opposition to their activity. In contrast, short-sellers are viewed as informed traders, lending credence to their activity.
- Value Line's ranking system uses technically based data and has shown great ability to discriminate between stocks with good and poor prospects, but the Value Line mutual fund that uses this system most closely has been only a mediocre performer, suggesting that implementation of the Value Line timing system is difficult.
- New theories of information dissemination in the market suggests there may be a role for the examination of past prices in formulating investment strategies. They do not, however, use methods currently relied on by technical analysts.
The Efficient Market Hypothesis
- Statistical research has shown that stock prices seem to follow a random walk with no discernible predictable patterns that investors can exploit. Such findings are now taken to be evidence of market efficiency, that is, of evidence that market prices reflect all currently available information. Only new information will move stock prices, and this information is equally likely to be good news or bad news.
- Market participants distinguish among three forms of the efficient market hypothesis. The weak form asserts that all information to be derived from past stock prices already is reflected in stock prices. The semistrong form claims that all publicly available information is already reflected. The strong form, usually taken only as a straw man, asserts that all information, including inside information, is reflected in prices.
- Technical analysis reliesfocuses on price patterns and on proxies for buy or sell pressure in the market. Fundamental analysis focuses on the determinants of the underlying value of the stock or security, such as a firm's current profitability and growth prospects. As both types of analysis are based on public information, neither should generate excess profits if markets are operating efficiently.
- Empirical studies of technical analysis do not generally support the hypothesis that such analysis can generate trading profits. Only very short-term filters seem to offer any hope for profits, yet these are extremely expensive in terms of trading costs. These costs exceed potential profits even in the case of floor traders.
- Several anomalies regarding fundamental analysis have been uncovered. These include the P/E effect, the small-firm effect, the neglected-firm effect, and the market-to-book effect.
- Proponents of the efficient market hypothesis often advocate passive as opposed to active investment strategies. The policy of passive investors is to buy and hold a broad-based market index. They expend resources neither on market research nor on frequent purchase and sale of stocks. Passive strategies may be tailored to meet individual investor requirements.
- By and large, the performance record of professionally managed funds lends little credence to claims that professionals can consistently beat the market.
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