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Session 5

Session 5. Topics to be Covered: Market Efficiency Random Walk Fundamental Analysis Speculation Technical Analysis. Market Efficiency. In theory, a company’s stock price is based on investor expectations about future dividends and stock prices. Expectations are based on information about

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Session 5

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  1. Session 5 • Topics to be Covered: • Market Efficiency • Random Walk • Fundamental Analysis • Speculation • Technical Analysis

  2. Market Efficiency • In theory, a company’s stock price is based on investor expectations about future dividends and stock prices. • Expectations are based on information about • the company • the industry, or • the economy. • Can investors with superior information or valuation skills identify profitable investments?

  3. An Academic Perspective • The Efficient Markets Hypothesis: If markets are efficient, then • information is widely and cheaply available to investors. • all available information is already reflected in security prices. • unexploited profitable trading opportunities using this information should not persist.

  4. Efficient Markets • Academic articles examine efficiency of the football, baseball, or horse race betting markets. • For football betting, market efficiency means that • the closing point spread should not differ systematically from the actual difference in scores. • According to one study • NFL bettors systematically underestimate the relative strengths of underdogs and home teams. • The college betting market is more efficient than the NFL market.

  5. Random Walk • Market efficiency arose from the recognition that stock prices seemed to wander, or follow a random walk. • A random walk means successive changes in value are independent. Consider the following game: • You are given $100 to play. • At the end of each week, a coin is tossed. • Heads: you win 3% • Tails: you lose 2.5% • After 1 week, you will either have $103 or $97.50

  6. Random Walk • Tests of the Efficient Markets Hypothesis look for all types of patterns in stock price changes: • daily, weekly, or monthly • cross-country • patterns for different time periods • correlations, runs and technical trading rules.

  7. Efficient Markets • Some contradictions to the theory are not surprising. • Company insiders do well when they deal in their own stock. • Others take more explaining. • On average, stocks of small companies have outperformed those of large companies, particularly during the first week of January.

  8. Levels of Market Efficiency • Three levels of market efficiency have been defined: • Weak Form: Prices reflect all information contained in the record of past prices. • Semi-Strong Form: Prices reflect past prices and all other public information. • Strong Form: Prices reflect all public and private information.

  9. Investment Strategies • There are several different strategies investors adopt to choose investments, that differ with respect to the amount of confidence they have in the Efficient Markets Hypothesis. • The Dart Board • Fundamental Analysis • Speculation • Technical Analysis

  10. The Dart Board • If markets are perfectly efficient, then • all stocks are fairly priced, and • you may just choose stocks randomly. • Alternatively, you may choose broad market indices like the Standard and Poor’s 500. • Market index strategies have been remarkably successful.

  11. Fundamental Analysis • Fundamental analysts study a company’s business and financial records trying to uncover information about future profitability. • Fundamental analysts say things like: • “Given their position within the industry, the outlook for long-term earnings growth for this company is good.” • “Based on the price-to-earnings ratio of this company, this stock apprears overvalued.”

  12. Fundamental Analysis • If markets were perfectly efficient, then analysts should not be able to earn abnormal profits. • In reality, it takes time and money to get and understand information. • Occasionally, we see superior investment performance. • skill or luck?

  13. Speculation • Prices may have nothing to do with market efficiency or information. • Instead it may all come down to psychology. • Perhaps it is OK to pay too much for a stock if you can in turn sell it to a greater fool who will pay even more.

  14. Speculation • Historically, we have seen many famous exceptions to market efficiency that are often attributed to speculators: • The Tulip Bulb Craze • The South Sea Bubble • The “Tronics” Boom • Conglomerates • The Nifty Fifty • Internet Stocks ???

  15. Speculation • How do we reconcile speculative fads with market efficiency? • Possibly: • Markets are usually efficient and driven by fundamentals. • Markets experience occasional periods of speculative frency focused on certain stocks. • The trick is to know what is happening now.

  16. Technical Analysis • Technical analysis is the making and interpreting of stock charts. • Its practitioners are also called chartists. • They study a past for a clue about the future. • Technical analysts do not believe in market efficiency. • They believe markets follow trends and sustainable patterns.

  17. Technical Analysis • Technical analysts do not believe in market efficiency. • They believe markets follow trends and sustainable patterns.

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