Behaviors of Stock Markets - Essay Example

? Behaviors of Stock Markets Behaviors of Stock Markets Outline Introduction Market Behaviors Market Inefficiency Weak form efficiency Semi Strong form efficiency Strong form efficiency Practical researches on Capital markets Market Conclusions and practical situations Conclusion Bibliography Introduction The first part of this assignment is based on the efficiency of stock markets. It also includes the types of markets and the reasons of valuation of stock at fair prices, higher prices or at lower prices. The reason for including these details in the assignment is that it is necessary to understand the basic information about the behaviors of stock markets before to make any decision about the buying and selling decisions. Second part of the essay contains on a market conclusion about the practical behaviors of stock markets in relation with stock movements. This debate also include the information of the market behavior that in which circumstances an investor can make abnormal profits and in which conditions it is not possible to make abnormal gains and profits. It this part, debate is also made on the question that either market is efficient or not. The last part of this assignment is based on a general conclusion about this study. Topic: A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits by using this set of information to formulate buying and selling decisions. The efficiency of the stock market is based on the efficient market hypothesis. Many investors believe that they can select stock with the help of their forecasting and valuation techniques and can make abnormal profits easily. On the other side the efficiency market hypothesis states that all the stock prices are based on all the accurate information and reflect the full and fair information. This directly means that it is not possible to consistently outperform the market by using any information that the market already knows, except by luck. The idea is that now information is quickly and efficiently incorporated into share prices at any point of time, so that old information cannot be used to judge the future movements. The term "efficient market" was first introduced by in 1965 in a paper by E.F. Fama who suggest that “in an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected "instantaneously" in actual prices” For proper understanding of the efficient market hypothesis we must have to aware about the basic market categories. A short summary of these categories are described below Market inefficiency An inefficient form of efficient market is one in which the value of the securities is not always an accurate reflection of the available information. In an inefficient market, some stocks will be over priced and other will be underpriced, which means some investor can make excess while other can lose more than warranted by their level of exposure. The logic behind this process is that proper valuation of securities and stocks are depend upon the latest information and in an inefficient market no latest data about the stock and securities are available. So this can directly result into wrong decision about buying or selling any stock. (BORENSTEIN, S., BUSSE, M. R., & KELLOGG, R. (2007). Principal-agent incentives, excess caution, and market inefficiency evidence from utility regulation) Weak form efficiency In a weak form efficient market share prices reflects information about all the past prices movements. This situation directly relates that these past movements do not help in identifying positive trading strategies. (Returns and weak form efficiency: betting markets 1984) In these kinds of markets future prices movements cannot be predicted because all the information is available of the past price movements. And any technical analysis cannot help to make a consistent gain on the market. It is stated in a paper by Kendall in 1953 that the prices of shares followed a random walk. I.e. there are no patterns of trends. Any apparent pattern or trend purely occurs by chance. (F9 financial management 2010 page 590) In short, in the weak form efficient, study of the history share prices cannot be used to predict the future in any abnormally profitable. Semi Strong efficiency In a semi strong efficient market the share price incorporates all past information and all publicly available information. In these kinds of markets a fundamental analyst will not generally make an abnormal gain i.e. form analysis publicly information. The vast majority of investors cannot consistently beat the market because they have only public information available and this information is already reflected in the share price. Logically the term public information is only the information that is available to general public. And those decisions are not enough make any decision because all the companies own goals and internal information like future plans have a direct effect on the stock prices. Practically this kind of internal information is achieved by insider dealing. Insider dealing is explained in the later part of this assignment. More information about this phenomenon can be seen in this article “ALI, S. S., & MUSTAFA, K. (2001). Testing Semi-strong Form Efficiency of Stock Market. Pakistan Development Review. 40, 651-676” Strong form efficiency In strong form of efficient market the share price incorporate all information. The term “all information” includes all private and public information and the information which is yet unpublished. In these kinds of markets the investor could only make abnormal gains by luck. These gains can be made from “insider information”. Insider information is the based in the term “Insider dealing”. The term “insider dealing” is referred to the situation of the information that does not publish publicly. As it is well-known that share can be traded in the basis of information not in the public domain and thereby make abnormal profits. Stock markets are not strong form efficient. The engineer who discovers gold may buy shares before the discovery is made public. The merchant banker who hears a colleague is assisting in a surprise takeover bid has been known to purchase shares in the target firm. For more visit http://www.answers.com/topic/insider-trading or http://en.wikipedia.org/wiki/Insider_trading A breakdown in the fair game perception will damage the investor confidence and reduce investment. To avoid the loss of confidence most stock markets have codes of conduct and most countries have introduced legislation to curb insider dealing. “Insider dealing” become a criminal offence in the UK in 1980 and also banned by many other countries like Australia, united Stated, China. For more visit http://www.jstor.org/pss/1344507 Another weapon against the insider dealing is to make companies release price sensitive information quickly. For example the as in London stock exchange there has strict guidelines to encourage the companies to make announcements to the market as early as possible. It is clearly stated in the rule of London stock exchange that “The purchase or sale of securities by someone who possesses 'inside' information affecting securities which has not yet been made available to the market and which, if made available, would significantly affect the share price. In the UK such deals are a criminal offence” A third approach is to completely prohibit certain individuals form dealing in the company share at crucial time periods. The stock exchange model code for directors dealing precludes directors of quoted companies form trading shares for a period of two months before the announcement of the annual results. The code also precludes dealing before the announcement of matters of an exceptional nature unpublished information, which is potentially price sensitive. Practical example of insider dealing can be seen in Enron Scandal. For more information about this scandal please visit http://whatreallyhappened.com/WRHARTICLES/enron.html Practical researches on Capital markets Research has shown that well developed capital markets are weak from efficient, so that it is not possible to generate profits by studying and analyzing past information, such as historic share price movements. This research also has also shown that well-developed capital markets are semi-strong form efficient, so that it is not possible to generate abnormal profits by studying publicly available information such as company financial statements or press releases. “PRACTICAL LAW COMPANY. (2010). Capital markets handbook. London, Practical Law Company” Capital markets are not strong form efficient, since it is possible to use insider information to buy and sell shares for profit. For further information “Modern Portfolio Theory and Investment Analysis by Elton, Edwin, and Martin Gruber, page 399-448”. Conclusion for the market As it is mentioned above that well developed stock markets are weak and semi strong market efficiency most of the time, once new information is communicated to the market it is rapidly reflected in the share price. Thus managers can achieve the overall objective of the maximizing shareholder wealth by making good decision and communicating them to the market. At this stage the most common question is asked by every one that is it worth acquiring and analyzing public information? The answer of this question is that in semi strong efficiency it is true, because there are also some fundamentals factors attached with the share price like risk associated with the company, details of the company team, technological changes etc. This information is used in the valuation of shares and can affect easily the share price. Investors can use this technique to earn abnormal returns for example buying under-valued shares before the price rise and by selling over-valued shares before the price fall. In practical life there are many sophisticated investors who examine the smallest piece of information about each company and its environment. By the start of the twenty 1st century, many financial economists and statisticians began to believe that stock prices are at least partially predictable. “Burton Malkiel The Efficient Market Hypothesis and It's Critics (Journal of Economic Perspectives, 17 (1), pp.59 – 82, 2003.” Conclusion According to the mentioned study it is clear the vast majority of investor cannot beat the market and cannot make abnormal returns only by the information that is available to them. The main reason of this in current practical stock markets all the public information is reflected in the share price. Exception can be made through deep analysis of the stock position of any company but it may require more cost and can be a waste of money sometimes. A number of studies have mentioned this deep analysis as the way of forecasting. For example, Dyl and Maxfield (1987) selected 200 trading days in random in the period January 1974 to January 1984, each day the three NYSE or AMEX stocks with the greatest percentage price loss (on average- 12%) were noted. For more info please visit this journal “Clive Granger Forcasting Stockmarket Prices: Lessons for Forecasters. (International Journal of Forecasting, 8, pp. 3--13, 1992.) “ On the other side abnormal profits can be generated with the help of insider information. But using the insider information is another name of alarming situation because in current modern environment it is prohibited by law and in some countries insider dealing treat as the criminal offence and directly results in to heavy fine or imprisonment. Practically in current environment all the modern stock markets are the form of semi strong efficient market. It directly means that market responds quickly and accurately to the new information as it arrives on the market. The share price of the company quickly responds if the new information is related to company is released. The share prices quoted on the stock exchange are therefore always fair prices, reflecting all information about the company that is relevant to buying or selling. So we can say generally that it is impossible to make abnormal profits in current developed economic markets except by luck. Bibliography Andrew Lo, The Adaptive Markets Hypothesis: Market Efficieny from an Evolutionary Perspective, Journal of Porfolio Theory, 2004. Burton Malkiel The Efficient Market Hypothesis and It's Critics (Journal of Economic Perspectives, 17 (1), pp.59 – 82, 2003. Clive Granger Forcasting Stockmarket Prices: Lessons for Forecasters. (International Journal of Forecasting, 8, pp. 3--13, 1992.) Harrision Hong and Jerremy Stein, Simple Forecasts and Paradigm Shifts (NBER Report) HANNIGAN, B. M. (1994). Insider dealing. London, Longman. ASSOCIATION OF CHARTERED CERTIFIED ACCOUNTANTS (GREAT BRITAIN). (2009). Financial management. Wokingham, Berkshire, Kaplan Pub. KAPLAN PUBLISHING. (2007). ACCA: for exams 2007 and 2008. Wokingham, Kaplan Publishing. London Stock Exchange http://www.londonstockexchange.com/home/ir-apracticalguide.pdf Efficient Capital Markets http://www.econlib.org/library/Enc1/EfficientCapitalMarkets.html ARNOLD, G. (2007). Essentials of corporate financial management. Harlow, Financial Times Prentice Hall. BIRD, P. J. W. N. (1983). The weak form efficiency of the London gold market. [Stirling], University of Stirling. SATCHELL, S. (2007). Forecasting expected returns in the financial markets. Oxford, Elsevier/AP. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=205483. DYCKMAN, T. R., & MORSE, D. (1986). Efficient capital markets and accounting: a critical analysis. Englewood Cliffs, N.J., Prentice-Hall. MEDIA, B. L. (2010). ACCA Paper F9 - Financial Management Study Text. London, BPP Learning Media. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=647653. Read More