Investment Management and Capital Markets

Lecture 1: The EMH, Technical and Fundamental Analysis

The efficient market hypothesis

Techniques of Technical analysis
Techniques of Fundamental analysis

Background to the EMH

The Mechanistic Hypothesis (MH):

The EMH is one of the central theories in Modern Finance.

Upto about the end of the sixties, it was believed that the market price of a share
was directly influenced by

- published accounting statements and

- management announcements on operational results

This was called the `Mechanistic hypothesis.’

( Also the `Classical Hypothesis.’)

However, the general difference between Book and Market Values prompted
researchers to develop and test alternative theories.

Two important studies in this connection were the Ball and Brown study (1968)
and the Kaplan and Roll study (1972).

Two important studies in this connection were the Ball and Brown study (1968)
and the Kaplan and Roll study (1972).

(1) Ball and Brown (1968).

Firms were partitioned into good news firms and bad news firms according to whether
the reported earnings was above or below a time series forecast.

(2) Kaplan and Roll (1972):

This study tested the stockmarket’s reading of an accounting change which changed the
reported earnings but had no effect on cash flow.

(3) Sunder (1973) studied the share price performance of companies which changed their
inventory accounting policies from LIFO to FIFO and vice versa. A shift from FIFO to
LIFO improves cashflow and a shift from LIFO to FIFO improves eps. If investors
valued cashflow and not eps then a shift from FIFO to LIFO should result in a share price
increase

KVShenai-ia-07 1
Implications: if the MH is valid then prices should react abnormally upon publicizing the
accounts in each case.

Actual findings:

The Ball and Brown study found:

- good news firms and bad news firms showed abnormally positive or negative returns
(as measured by ei) which started building up upto 12 months before the announcement;
- 80-85% of the abnormal reaction occurred prior to the announcements implying that the
actual announcements had virtually no impact.

The Kaplan and Roll study found:

on study of a 60 week period, 30 weeks before the announcement and 30 weeks after the
announcement:
- the abnormal return immediately after the announcement was insignificant from 0;
- moreover after week 36, a pronounced negative abnormal return was noticed.

The Sunder study found:

That firms shifting to LIFO had shown an abnormal rise of 5% in the 12 month period
before the switch and firms switching to FIFO showed a fall of about 10% in the year
after the switch.

These studies seemed to imply that accounting statements of a company were not the
sole basis on which share prices responded, and thus did not support the Mechanistic
Hypothesis.

What factors could then influence share prices?

These results supported the alternative hypothesis of an efficient market which built in
the economic value of information based on its availability from a variety of other
sources.
such as:

- the state of the entire economy

- the outlook for the specific industry the firm was in

- news on the firm from government reports,

- industry association reports, analysts’ reports

- perceived changes in the firm’s cash flow

KVShenai-ia-07 2
 - market information on the firm’s prospects

all influence share movements.

The Efficient Market Hypothesis

Studies such as the above led to the formal development of the ` Efficient Market
Hypothesis.

In a market economy, the concept of capital market efficiency can be looked at in three
different ways:

- allocative efficiency refers to the ability of the market to allocate resources effectively

- operational efficiency implies the ability of the market to work on low transaction costs

- informational efficiency refers to the ability of the market to correctly reflect via
security prices, the value of information.

The Efficient Market Hypothesis refers to informational efficiency and can be stated as:

“ in an efficient market share prices reflect the value of all relevant information.”

The assumptions to the efficient market hypothesis are the same for perfect capital
markets:
- information freely and instantaneously available to all
- homogeneous products being traded
- no taxes
- perfect competition
- costless transactions

An important part of the concept of Market Efficiency is what type of information

and how quickly the value of relevant information gets reflected in share prices.

Thus three forms of market efficiency have been defined:

KVShenai-ia-07 3
- In the weak form, share prices fully reflect the information content of past historic
price movements.

In the semi-strong form of the EMH, share prices fully reflect the value of all publicly
available information.

In the strong form of the EMH, share prices reflect the value of all relevant
information whether publicly available or not.

The weak form implies that it is impossible to predict future share prices from historic
patterns.

-the` random walk hypothesis.’ Or a state where the `market has no memory’.

Tests for the weak form are based on the random walk hypothesis, and now take the
general form of `predictability of returns.’

The semi-strong form implies that share prices already include the value of all relevant
information which is publicly available.

Thus there is no benefit to be obtained by analysing the financial statements of companies

or other information.

Tests for semi-strong form are based on the speed with which prices adjust to new
information.

It is recommended that such tests be based on `event studies.’

The strong form implies that share prices in the strong form already take into account
all relevant information.

Thus in the strong form all information which affects the prospect for the share
is already included in share prices including that which has not yet been made public.

Tests for the strong form are based on whether `insiders’ who are privy to inside (private)
information are able to generate abnormal returns as judged by their actions.

Tests for the strong form of market efficiency have focused on estimating abnormal
returns from Insider trading, Security analysts’ announcements and Portfolio Managers.

According to the theory:

KVShenai-ia-07 4
 - even in the weak form of the EMH, technical analysis would not be effective,

- in the semi strong form fundamental analysis would not be effective.

The strong form does not hold as insider knowledge can still achieve better returns.

Stock market anomalies:

January effect

Monthly returns on NYSE listed stocks ( covering the period 1904-1974) have shown
that the average return in January was higher than in any other month: in later years the
return in January was approximately 3% higher than the average return in other months.

Day of the week effect

A study covering the period 1953-1978 ( NYSE stocks) has shown that in the first few
hours of Monday trading, returns have been negative.

Holiday effect

Average stock returns on days just before public holidays have been seen to be higher.

Briloff Effect

Firms analysed by Briloff fall in price following publication.

His analysis is based on publicly available information.

Timing effect

Shares which had done badly in one year were more likely to do better in the next

Value Line (tips)

Value Line Groupings have over the period 1965-85 shown continued and consistent
performance relative to the market indicating that VL has been able to ‘beat the market’
consistently.

Book Value to market value, B/V; Earnings Price ratio, E/P; Size effects

KVShenai-ia-07 5
`Value Stocks’ ( higher BV/MV or E/P) have outperformed `Growth stocks’
( low Earnings/ Price (E/P)) or lower Book to Market Value ratios (BV/MV).

The study also showed that there is an inverse relationship between size and return. This
is also called the `small firm effect.’

Stock Market Crash

On Oct. 19 stockmarkets across the world fell 25-30%, following the fall in the price of
US stocks.
There had been no visible economic phenomenon which could have prompted this.

Bond Market anomalies:

January effect

On average, corporate bonds have shown notably higher returns during January than in
other months of the year, across all classes of bonds.

Day of the week effect

The return on Monday has been negative as with shares (but here the effect was less
pronounced as it was negative on most other days, except Thursday).

To what extent are markets efficient in your opinion?

KVShenai-ia-07 6
Technical Analysis

- the study of past share price movements to identify recurring patterns and predict the in
a share's price behaviour, the two main branches being

- Chartism
- Mechanical Rule usage

Technical Analysts do not concern themselves with the fundamental ( earnings forecasts,
technology factors ) and other characteristics of a share.

Chartism:

Here technical analysts identify cycles and trends and on this basis make predictions of
buy/hold/purchase for clients. Typical patterns identified are ‘Head and Shoulders’.
‘Double Top’ as below:

Double Top Head and Shoulders

- self –destruction feature as investors rush in to buy shares.

Mechanical Rules:

Here technical analysts recommend purchase or sale of shares based on predtermined

rules such as:

- Momentum and Contrarian Strategies

- Moving average, trading range breakout, filter rules.

KVShenai-ia-07 7
In a momentum strategy, investors are advised to buy shares that have just started rising
in price on the assumption that it will continue to rise in the next period; sell shares on
which returns have just fallen on the assumption that such shares will continue to fall.
(`incomplete adjustment.’)

In a contrarian strategy, investors are advised the opposite: to sell shares that have just
started rising in price on the assumption that it will fall in the next period; buy shares on
which returns have just fallen on the assumption that such shares will rise. ( `market
overreaction’)

In a moving average strategy, a buy signal is generated when the short term average
(daily price, few days average) crosses the long term moving average ( typically 50-200
days) from below; a sell signal vice versa.

In the trading range breakout strategy, a trading range based on the past say, 200 days
is noted
and buy and sell signals are generated if the current share price crosses the upper or lower
range.

Similarly, followers of filter rules specify buy and sell signals if the share price rises
above a low by a certain % or falls below a high by a certain %.

Sell
Daily Share Price

Buy Sell
Buy
Moving average

Fundamental Analysis

Fundamental Analysis on the other hand uses all publicly available information such as
financial statements, new information on prospects, profitability, to value a stock
and make forecasts on earnings, dividends and returns.

The techniques used in fundamental analysis are:

- Financial Analysis
- Top-down / Bottom-up approaches
- Equity Valuation Models

KVShenai-ia-07 8
Financial Analysis

Here an analyst would study the profitability, liquidity, activity,

gearing, investor ratios and the accounting policies of the company to make necessary
forecasts.

Ratio analysis enables the company performance to be compared with the industry best,
the and the industry average.

Top-down / Bottom-up approaches

In top-down approaches, the analyst forecasts the economy’s gross domestic product,
industry outlook and such items which are market/country specific.

In a bottom up approach, analysts look at company specific factors.

Studies have shown that a top-down bottom-up approach yields better returns.

Equity Valuation Models.

Finally, equity valuation models can also be used to measure the value of
shares. The common methods used are:
- Net Asset Value (Break up value)
- Dividend Valuation Models
- the Dividend Valuation Model and the
- the Dividend Growth Model
- Earnings based Valuations
- Free Cash flow methods

What is the implication for market efficiency if Technical Analysis is successful?

What is the implication for market efficiency if Fundamental Analysis is successful?

KVShenai-ia-07 9
What are the implications of the EMH for Investors and Corporates:

- stocks are generally priced in line with their risk characteristics.

- information on the share’s prospects becomes very quickly incorporated into share
prices.

- if markets are wfe then historic data cannot be used to generate abnormal returns.

- if markets are sse then it is not possible to consistently identify underpriced or

overpriced stocks.

- Accounting changes cannot boost share prices – the market acts according to the
perceived implications for cashflow.

- the yield curve has information on the market’s future expectations of inflation and
interest rates.

KVShenai-ia-07 10