Predictability of Surplus Stock Returns - Essay Example

Evaluate the Predictability of Excess Stock Returns Inserts His/Her Inserts Grade Inserts 4-3 Evaluate the Predictability of Excess Stock Returns First and foremost, predictability of excess returns in the stock markets is an issue which is affected by not just a factor but many factors in the environment. The issues which daily affects the markets such as politics and economical environments will definitely affect the predictability of stock returns. The companies which are in the stock markets also find it a hard nut to crack regarding the predictability of excess returns. Specifically for this factor pertaining to predictability of excess stock returns, it basically means that the company in question incurred abnormal profits in the course of their business. This is a phenomenon which is supposedly not possible to happen since it is coined in that the stock prices are transparent and they show exactly the performance of a company in the industry in its entirety without leaving anything to chance. This makes it even harder to evaluate the predictability of stock returns in a company. However, through the use of some statistical techniques, it is fairly possible to predict stock returns in the stock markets. There are various measurement options which are used to assess the degree to which the predictability of returns from stocks can be ascertained. Investors in the modern world are largely after investing in securities that will give them abnormal or excess returns. These phenomena have been refuted by scholars and have led many investors in making the wrong investment choices. Since by some predicted securities the investors make wrong choices, it is important to evaluate the issue of predictable returns in the stock market. The predictable returns have virtually not presented a good investment opportunity for the investors to realize documented profits; it is also a fact that though these returns may be publicized after the discovery there is a high profitability that they will not provide an opportunity to the investors to realize excess profits as they wish. (Burton G., 2003). Based on the arguments documented here, the predictability of stock returns is something that can basically not be done. The argument is that all there are about the future of the stock markets is basically news. News is always unpredictable since if something could be predicted then it ceases being news. This being the case, predicting the excess returns from securities is by all means an impossible undertaking. The reason as to why there is a deep conviction among some people that it could be possible for them to predict excess returns for a stock unit in the future are based majorly on the past information and extrapolation of economic trends. This is basically an activity which, though much important for planning by the investors, it should not be assumed that there will be always a similar market behavior. This is because the response of the people to the stock market is not always the same the response is sometimes affected by the psychological disposition of the people who are affected. The issue of the excess returns and the investors is a matter of irrationality. This is because there seems to be some flagrant slurs to the proposition of rational markets. This is in contrast to the idea of existence of excess returns in a large magnitude to simple strategies in the momentum of the stock markets. The excess stock returns somehow do suggest an under reaction by the market in a systematic way. Thus, theorists of the asset pricing models see the task of investing in the stock markets based on the two factors as a decision between the types of investor irrationality is in play (Johnson, 2002). The return predictability of a stock unit is proportional to the growth rate risks, the possibility of predicting the performance of a stock in the future will depend on the unit’s growth rate. If a stock growth rate is high, the risk of growth rate also increases along. This means that the possibility of predicting excess returns of a stock which is growing constantly is a hard issue. The reason for this is that, for a growing product, the predictability can only be made in the short term. Predicting on a long term basis leads to uncertainty since simple fluctuations in the market conditions would definitely affect the returns of a stock. The issue of abnormal returns has several inferences which are nevertheless not affected in a large magnitude by the model of expected returns. (Fama, 1998). Most of the studies that have been done on the stock markets have focused on the performance of those stocks on a short term window. Through this, the returns almost zero, based on this, there is need to evaluate, the long term possibility of realizing excess returns by the investors. For this reason, there have been developing views that challenges the short term approach to stock returns and proposes the examination of the long term performance of returns in order to get the full view of the efficiency of the markets. The empirical reviews of the excess returns where long term return anomalies are experienced in a stock market focus on the methodology. The long term return anomalies which lead to excess returns can therefore not just be attributed to chance. In the empirical approach to the issue of excess stock returns in the market, there is the use of a model of stock prices which was proposed by BSV to help capture the two biases involved in judgment by the investors. The truth about stock returns is that it is more of a random walk, however, investors think that there are two regimes where in the first regime, they think that it is more likely, the earnings set out to be mean reverting where when the investors think that the regime holds, there would be a price under reaction. The investors would think that the change is temporary and if the expectation is unmet, the stock prices exhibit a delay in response to the earlier earnings. In case of the second regime, there is an overreaction due to extrapolation of the trend which makes reversal of the long term results (Jae H. Kim, 2011). As earlier pointed out, the predictability of excess stock returns depends on various factors. Factors such as market crashes, political crises, economic crises, economic bubbles as well as major regulatory changes by the government affects the predictability of stock returns. During crashes in the stock markets, there is a high degree of uncertainty in the returns; this is associated with different measures of return predictability. However, in times of economic and political crises, there is a high degree of return predictability where the obvious prediction is a reduction in the stock market prices. These are not the only factors that affect the excess stock return predictability, other factors which are in the macroeconomic environment also affects the predictability. These are factors such as inflation as well as interest rates and market volatility. All in all, the predictability of excess stock market returns is evidenced by various factors as evaluated in detail above. The use of return predictability as a test for the efficiency in the market is a good approach. First and foremost, there should be a predictable performance in a market. If this factor is not observed in the stock markets, it indicates that the market is not efficient. Efficient markets are those which are not adversely affected by issues such as political interferences. This is a fact because, according to Fema, the degree of market efficiency is governed by the market conditions. Since market conditions directly affect the predictability of stock returns, the measure of return predictability would be used to determine the market efficiency. The issue of market efficiency can be approached from the point of momentum. This explains the good performance of some markets and poor performance of others. For example in japan, the momentum of the market was low in 2011. This indicated lower market efficiency. Other countries such as United Kingdom experience better momentum which in other words indicates better market efficiency (Clifford S. Assness, 2013). The adaptive market hypothesis is also a factor which contributes to the efficiency of the stock market returns. Through the hypothesis, there is the possibility of realizing market efficiency through the use of some basic techniques (Werner, 1989). There are also other factors that affect the returns predictability which can be used as effective measures of market efficiency. All in all, the use of stock returns can be used as an effective measure for market efficiency and unpredictable markets indicates that the efficiency of the market in question is not effective. References Burton G., M., 2003. The Efficient Market Hypotheses and its Critics. Journal of Economic Perspectives, 17(1), p. 61. Clifford S. Assness, T. J. M. L. H. P., 2013. Value and Momentum Everywhere. The Journal of Finance, LXVIII(3), pp. 930-981. Fama, E. F., 1998. Market Efficiency, Long Term Returns, and Behavioural Finance. Journal Of Financial Economics, 49(12), pp. 285-286. Jae H. Kim, A. S. K.-P. L., 2011. Stock Return Predictability and the Adaptive Market Hypothesis: Evidence from Century Long U.S Data. Journal of Emphirical Evidence, IV(18), pp. 868-879. Johnson, T. c., 2002. Rational Momentum Effects. The Journal of Finance, LVII(2), p. 2. Werner F. M De Bont, R. H. T., 1989. Anomalies: A Mean-Reverting Walk Down Wall Street. Journal of Ecconomic Perspectives, III(1), pp. 189-202. Read More