BKM 11 Part 1

Random Walks and the Efficient Market Hypothesis: There are three forms of the EMH

(1) Weak-form EMH (2) Semistrong-form EMH (3) Strong-form EMH

Random Walks and the Efficient Market Hypothesis: As a real-world example, suppose a company...[2]

-As a real-world example, suppose a company announces higher than expected earnings to the public. -Assuming the EMH holds, the stock price should immediately jump up to a new level and then move randomly without drift (i.e. it should rotate randomly around some fixed level).

Implications of the EMH: Technical Analysis (As an example of a resistance level...)[5]

-As an example of a resistance level, suppose a stock traded for several months at $50 and then declined to $40. -If the stock price begins to increase at some point, $50 becomes a resistance level. This is because many investors who held onto the stock during the price decline will look to sell it once it reaches $50. -Although this makes sense, it's a bit of a circular argument. -If $50 was truly a resistance level, then investors might be unwilling to purchase the stock at $49 because there is little room for the stock price to increase. But this creates a new resistance level at $49. -Using this logic, this cycle would continue indefinitely. This undermines the idea of resistance levels as investors will most certainly buy and sell this stock at $49. Those who purchase the stock expect a fair rate of return.

Random Walks and the Efficient Market Hypothesis: Empirical evidence shows that stock prices follow [3]

-Empirical evidence shows that stock prices follow no discernible pattern. The prevailing reason for why this occurs is known as the efficient market hypothesis (EMH). -The EMH states that stock prices reflect all available information at any given point in time. -In other words, as soon as information becomes available suggesting a stock is underpriced or overpriced, investors will immediately bid up the price or force down the price

Random Walks and the Efficient Market Hypothesis: For example, smaller firms or firms in [4]

-For example, smaller firms or firms in emerging markets are not always analyzed at the level of main-stream firms. -Thus, if an investor is willing to put in the time to research and analyze those firms, they could potentially find mis-priced stocks and exploit that mis-pricing. -That being said, investment analysts are paid large amounts of money to uncover as much information as possible by their investment company employers. -This competition between investment firms supports the notion that stock prices reflect nearly all available information.

Implications of the EMH: Technical Analysis (One component of technical analysis is...)[3]

-One component of technical analysis is resistance levels. -These are values at which it is difficult for stock prices to rise above or fall below. -They are driven by market psychology

Implications of the EMH: Technical Analysis (Resistance occurs when...)

-Resistance occurs when supply exceeds demand -The opposite is known as support and is where investors will want to buy since stock is not anticipated to decrease from there

Random Walks and the Efficient Market Hypothesis: Since stock prices should reflect all available...[3]

-Since stock prices should reflect all available information, only new information should cause stock prices to change. -These future stock price changes must be unpredictable - if they were predictable, it would suggest the current stock price does not reflect all known information. -The end result is that stock prices should follow a random walk, which means they are random and unpredictable

Random Walks and the Efficient Market Hypothesis: There are three forms of the EMH - (3) Strong-form EMH [4]

-Stock prices reflect all information relevant to a firm, including information only available to company insiders -This EMH version is difficult to justify because it makes sense that corporate insiders would have information long enough to profit from it. This is the reason why we have insider trading laws -Strong-form EMH implies semistrong-form EMH and weak-form EMH -No one can earn excess returns

Random Walks and the Efficient Market Hypothesis: There are three forms of the EMH - (1) Weak-form EMH [3]

-Stock prices reflect all information that can be derived by examining historical data -This form implies that trend analysis is not worthwhile -Requires that investors cannot systematically profit from market inefficiencies (technical + fundamental analysis will not work)

Random Walks and the Efficient Market Hypothesis: There are three forms of the EMH - (2) Semistrong-form EMH [4]

-Stock prices reflect all publicly available information related to the prospects of a firm -This information includes historical data as well as fundamental data such as balance sheet strength and earnings forecasts -Semistrong-from EMH implies weak-form EMH -Again neither fundamental or technical analysis can consistently produce excess returns

Implications of the EMH [5]

-Technical Analysis -Fundamental Analysis -Active vs. Passive Portfolio Management -The Role of Portfolio Management in an Efficient Market -Resource Allocation

Implications of the EMH: Technical Analysis (Technical Analysis is the search....)[4]

-Technical Analysis is the search for recurrent and predictable patterns in stock prices. -Technical analysis only works if stock prices are slow to respond to market forces (i.e. markets not efficient) -If they are slow to respond, then technical analysis can exploit and profit from trends in the data. -If markets are truly efficient, then technical analysis will not work because stock prices already reflect all available information (including insights gained from historical trends)

Random Walks and the Efficient Market Hypothesis: The assumption that stock prices reflect...[2]

-The assumption that stock prices reflect "all" available information is significant. -It's possible that an investor could gain an edge by searching for information overlooked by other investors.

Implications of the EMH: Technical Analysis (The key takeaway around technical analysis is that....)[3]

-The key takeaway around technical analysis is that it shouldn't work in an efficient market. -Even if a new pattern is discovered that one can profit from, it will eventually yield little benefit once other investors notice the pattern. -Prices will be bid up or forced down until equilibrium is reached. If and when that same pattern shows itself, prices should quickly respond leaving little opportunity to exploit it.

Implications of the EMH: Technical Analysis (Technical analysts are sometimes called...)

-chartists -An example of this approach is the relative strength approach

Random Walks and the Efficient Market Hypothesis: The random walk theory dictates...

The random walk theory dictates that past movement of stock price cannot be be used to predict future movement. Thus, it'd be impossible to outperform the market over time