Efficient Market Hypothesis - Essay Example

SHARE TRADING ASSIGNMENT Table of Contents Introduction 4 Efficient Market Hypothesis 4 Technical Analysis 5 Fundamental Analysis 6 Economic Analysis7 Industry Analysis 8 Stock Market Analysis 10 Findings of Study & Review of EMH 10 Conclusion 12 References 13 Bibliography 16 Appendices 17 Table 1 – List of Companies in Portfolio I 17 Table 2 – List of Companies in Portfolio II 17 Table 3 – Risk-Return Analysis for Portfolio I 17 Table 4 – Risk-Return Analysis for Portfolio II 18 Table 5 – Trading Costs (Portfolio I-Technical) 18 Table 6 – Trading Costs (Portfolio II-Fundamental) 18 Table 7 – Performance Evaluation Using Technical Analysis 19 Table 8 – Performance Evaluation Using Fundamental Analysis 20 Introduction A portfolio is created by allocating certain amount of investible sum into different asset classes such as stocks, bonds, and derivatives. A market participant contributes the cash to reduce the danger of holding a specific security through diversification. Diversification spreads the risk of investment over multiple assets thereby avoiding concentration on a particular stock. Such strategies will reduce risk because when a particular stock will experience negative trends other stocks in portfolio that are simultaneously moving in positive direction will reduce the impact of volatility. The Efficient Market Hypothesis (also known as EMH) states that since the stock prices reflect all significant information available in market it will not be possible beat the market by acquiring stocks that are currently undervalued or short selling stocks that are overvalued. Alternatively, an investor will not be able to beat the market by factoring all publicly available information such as declaration of financial results. In contrast, the technical analysis believes that if an investor is able to predict the future movement of stock prices by observing historical trends, it will be possible to beat the market and achieve superior returns by identifying trend reversal at early stage. Efficient Market Hypothesis The EMH assumes that market participants behave rationally and that current prices reflect all information available in market. Alternatively, the true value of stock is reflected from historical price movements (Jegadeesh, and Titman, 1993, pp.65-91). This argument suggests that given the availability of information to public in the market, all securities will be correctly priced. This means that an investor who is expecting to earn more than market return will not be able to do so since efficiency in stock market causes securities to be correctly priced and hence reflect all relevant information. With the objective to verify the above arguments and check whether it is possible to construct a portfolio of assets that will be able to ‘beat the market’ or not, two different sets of portfolios were constructed. One portfolio is based on fundamental analysis while the other on technical analysis. Both portfolios constitute stocks of companies that are traded in UK FTSE All Share Index and each of them invests a corpus of £50,000. The trading strategies of both portfolios will be different but the overall objective will be the same which is to earn superior returns above the market. The details of companies for two portfolios are depicted in Appendix - A (See Table 1 – List of Companies in Portfolio I and Table 2 – List of Companies in Portfolio II). Technical Analysis Technical analysis involves identification patterns or trends in the movements of stock prices at an earlier stage and then device an appropriate strategy with the objective to benefit from such market movements. The basic concept of technical analysis is identifying trend reversal at a prior stage and then makes profits from these market movements. Thus, if the investor is to identify particular stocks which are currently trending and then include such stocks in portfolio of assets, technical analysis is almost 60 percent complete. For instance, if there is any clear signal that stock prices are showing ‘up trend’, then the investor will just have to buy the scrips at early stage and then book profits when stock prices reach historic highs or target price. The converse theory is also applicable when the stock prices show down trends. Momentum Strategy The ‘Momentum Investing’ strategy will help the investor to analyse the existence of continuous trends in market as well as selected companies. The momentum strategy will take the advantage of identifying up or down trends in stock prices and then employ ‘buy-hold’ strategy to achieve the objective of earning superiors returns over the market. The portfolio investor will capitalise investment decision by noting the point of trend reversal. At this point the investor will have to book profit in order to avoid losses. The secret of momentum strategy is that overvaluation of security prices is generally followed by additional gains over the market returns and converse when stock prices are undervalued. This is in contrast to the EMH theory discussed earlier that states in efficient markets the investors will not be able to achieve superior returns over market. Fundamental Analysis Fundamental analysis is mainly done by based upon the historical and present data with an aim to make financial forecasts. Analyzing the health of the company by fundamental analysis also includes dividend received by the investors or shareholders, cash flow statement of the company and earning of the company. Top down approach is described as stepwise designing of the process. It is the process through which we get to know the stepwise breakdown of a system. This approach helps the investor to assess the market with a big picture of individual stocks (Thomsett, 1998, pp.2-6). Economic Analysis It is a systematic approach to maximize the optimum usage of resources. It also considers the opportunity costs of the resources that are employed and measure it in monetary terms. It also measures the benefits and social costs of projects to the economy. Interest rates – It is rate at which the Central banks and other commercial banks purchase currency. It has direct impact on the consumer borrowing and lending. So, the lower rates encourages more borrowing and consequently creating more jobs and leading to economic growth. Continued quantitative easing will boost business optimism across US and needless to say that a part of bond purchase stimulus programme will flow into emerging Asia mostly to tap potential markets. This will encourage higher consumption of goods and services ultimately leading appreciation of consumer goods oriented stocks especially FMCG sector. Consumer spending – It depends on the fiscal budget prepared by the government every year. The budget allocated to each sector of economy determines the retail prices, which is higher than wholesale prices. Thus, consumers will be encouraged to spend more when retail prices for the goods and services are lower. Higher spending will create more demand and more jobs that will expand the growth of economy and increase the GDP. Gross Domestic Product – GDP is defined as the sum of total cost of all goods and services produced in a country for a period of time. The higher the value, the better it is for the economy to expand in future. According to the economic theory, GDP per capita is equal to the gross domestic income or GDI (Wessels, 2006, p.68). Higher values are better for economic growth and prosperity. Also, according to Bloomberg, the GDP of UK has grown fastest in 2013 compared to period from 2009 to 2012. The higher the value, the better it is for the economy to expand in future (Bloomberg, 2013). Inflation – It is condition when the overall prices goods and services increases due to various reasons including demand-supply mismatch, increased government spending, etc. High inflation rates reduce the real value of money and hence low inflation rates are favourable for economic prosperity. High inflation rates reduce the real value of money and hence low inflation rates are favourable for economic prosperity. Negative effects include the rising in opportunity cost for holding money in different schemes. Similarly uncertainty decreases the investment and savings behaviour of an investor (Arnold, 2008, p.294). Business Cycle – Business cycle refers to the fluctuations in trade, production, economic activities that can be observed over years or months in an economy. It indicates the upward and downward movement in the level of GDP. Forbes estimated that US economy grew at 3.6% during third quarter of current year. The GDP growth in developing Asia is expected to grow at average rate of 6.5% during 2014. Continued quantitative easing programme will create positive sentiments in the market and the bench mark indices across globe such as FTSE All Share Index, NASDAQ, FTSE 100, etc. are expected to perform better in future (Financial Times, 2014). Industry Analysis It is a market assessment tool which helps the investors to get an idea of the complexity of industry of operation of selected companies in portfolio. Porter’s five factor framework analysis has been designed for managers taking into account the systems and resources that identify the key activities in order to provide competitive advantage to a company to maximize its value by minimizing the costs (Bischoff, 2011, pp.3-5). It reflects the contribution of each part in the overall value addition of business (Sekhar, 2009, p.115). Bargaining power of customer – It determined from factors such as number of customers willing to buy product, buying volumes, price elasticity, incentives, brand identity, switching cost, etc. The retailers may ask for incentives and lower price which otherwise might lead to reduced spending on computers during economic downturns. Bargaining power of suppliers – It is determined by the number of suppliers available in market, switching cost, size and reputation of supplier, etc. Threat of substitutes – It is determined from the performance of substitute in the market, willingness to buy substitutes by the customers, and switching cost form one brand to another. Threat of new entrants – It is determined by the economies of scale, technological advancement, cost advantage, knowledge, time and cost of entry in market. Competitive rivalry within an industry – It is determined by the number of competitors in global as well as niche market, exit barriers, differentiation, switching cost, industry concentration and saturation, and brand recognition. The oil and Gas sector is an important sector but extremely volatile. For instance, some of the risks associated in the oil and gas sector are political risk (especially for MNC), geological risk (including oil exploration, extraction, and supply chain management factors), demand and supply shocks, huge initial investments often compels the companies to highly leverage their financial statements, and so on. According to US Energy Information Administration, the domestic production of natural gas increased over 65 billion per day and natural gas production also swelled. But the developing economies in Asia do not have high reserves of oil and gas due to which they mostly rely on imports from OPEC countries (Deloitte, 2013). Stock Market Analysis Stock market or equity market refers a virtual market where buyers and sellers meet for buying and selling of shares. Stock market participants can be individual investor, large institution like mutual funds, banks, insurance companies and large corporate. Stock market is an important source for business firms to raise money for expansion of their business. Stock market includes initial public offer and follow on public offer. Initial public offer indicates the time when a company issues its shares for the first time in capital market. IPOs are mainly done in primary market of capital market whereas FPOs are conducted in the secondary market of capital market. As discussed earlier, in efficient markets the investor will not be able to make super profits and beat the market. However, in a bull market it may be possible for the investors to maximise their return on investment if investors are able to invest before trend reversal begins. This is where technical analysis comes into play because it helps the investor to get an idea regarding direction of stock price movement in future by analysing past trends. Findings of Study & Review of EMH The two portfolios constructed earlier were created by dividing £100,000 in two equal parts and allocate respective sums into different stocks constituting the portfolios. All companies were listed in UK and traded in FTSE All Share index. One portfolio was created and monitored using fundamental analysis while the other was created and analysed using technical analysis. In order to evaluate the performance of portfolio and conduct a Risk-Return analysis, the share price analysis time frame of all companies constituting the two portfolios starts at October 10, 2013 to January 20, 2014. In order to compute the total trading cost it was assumed that investor has to pay Stamp Duty of 0.5% whenever shares are purchased (as there is no stamp duty when shares are sold). It is also assumed that shares are bought online through internet broker that charges a flat fee of £7.50 when shares are sold. The five year average market return was found to be 19.96 percent. In contrast, the weighted return of the portfolio created using technical analysis and fundamental analysis were found to be 57.7 percent and 4.75 percent respectively. This proves that EMH is not applicable to Portfolio I in current market scenario and that it is possible for the investor to ‘beat the market’ using both fundamental and technical analysis. For portfolio II, EMH has been found to be applicable as the Portfolio return (4.75 percent) is less than market return (20 percent). Conclusion The EMH states that there is no need to predict market trends through fundamental or technical analysis because in efficient market every individual has access to all relevant market related information which will not permit the market participants to earn superior returns over the market (Fama, 1991, pp.1575-1617). The finding of this study contradicts with the concepts of EMH but does not explicitly rule out the possible application of theory. This is because while portfolio II agrees with EMH theory, portfolio I do not agree with EMH. References Thomsett, M., 1998. Mastering Fundamental Analysis. USA: Kaplan Publishing. Wessels, W., 2006. Economics. USA: Barrons Educational Series. Bloomberg, 2013. U.S. Retail Sales Growth Will Slow to 3.4% This Year. [Online]. Available at: http://www.bloomberg.com/news/2012-01-16/u-s-retail-sales-growth-will-slow-to-3-4-this-year-nrf-says.html. [Accessed on January 22, 2014]. BBC, 2013. UK GDP: Fastest growth for three years. [Online]. Available at: http://www.bbc.co.uk/news/business-24668687. [Accessed on January 22, 2014]. Financial Post, 2013. Outlook for U.S. banking sector no longer negative: Moody’s. [Online]. Available at: http://business.financialpost.com/2013/05/28/moodys-says-outlook-for-u-s-banking-sector-no-longer-negative/. [Accessed on January 22, 2014]. Bank of England, 2013. The UK recession in context — what do three centuries of data tell us?. [Pdf]. Available at: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100403.pdf. [Accessed on January 22, 2014]. BBC, 2013. Ratings agency Moodys upgrades UK banking sector outlook. [Online]. Available at: http://www.bbc.co.uk/news/business-23252103. [Accessed on January 22, 2014]. BBC, 2013. UK GDP: Fastest growth for three years. [Online]. Available at: http://www.bbc.co.uk/news/business-24668687. [Accessed on January 22, 2014]. Fama, E. F., 1991. Efficient Capital Markets: II. [Pdf]. 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UK inflation rate expected to fall in new CPI report. [Online]. Available at: http://www.theguardian.com/business/2013/nov/11/uk-inflation-rate-fall-cpi-ons-petrol-prices. [Accessed on January 22, 2014]. Sekhar, S., 2009. Business Policy and Strategic Management. New Delhi: I. K. International Pvt Ltd. Bischoff, A., 2011. Porter’s Value Chain and REA Analysis as an Accounting Information System. Germany: GRIN Verlag. Bibliography Dimson, E. and Marsh, P., 1998. MurphYs law and market anomalies. working paper. Lakonishok, J., Shleifer, A., and Vishny, R. W., 1994. Contrarian investment, Extrapolation, and Risk. The journal of finance. Volume 49. De Bondt, W. and Thaler, R., 1985. Does the stock market overreact?. The journal of finance. Volume 40. Appendices Table 1 – List of Companies in Portfolio I Table 2 – List of Companies in Portfolio II Table 3 – Risk-Return Analysis for Portfolio I Table 4 – Risk-Return Analysis for Portfolio II Table 5 – Trading Costs (Portfolio I-Technical) Table 6 – Trading Costs (Portfolio II-Fundamental) [Note – Stocks which might experience fall in share price in future is sold. Alternatively, shares which are overvalued and are currently selling at premium will be shorted to avoid losses]. Table 7 – Performance Evaluation Using Technical Analysis Table 8 – Performance Evaluation Using Fundamental Analysis Read More