Behaviour of the UK Stock Market - Coursework Example

I. Introduction The concept of efficient market, which was developed during 1960s and 1970s, has been having a great impact on the financial market up to now. In the sense of efficient market theory, the prediction of share price beheviour is said to be ‘correct’ and provide accurate signals for resources allocation. However, there are many critics on the efficient market hypothesis (EMH) in relation to behaviour finance, especially behaviour of share prices, in reality. In particular, the recent global financial crisis has led to renewed scrutiny and criticism of the hypothesis. According to Paul McCulley, ‘the hypothesis, had not failed, but was “seriously flawed” in its neglect of human nature. Is the efficient market theory still valid?. In this essay, we will study whether the UK stock market bahabiour in 2010 and my FTSE100 share (BLT.L) were consistent with the efficient market theory. II. Theoretical discussion 1. Principles of efficient market theory The efficient market hypothesis was developed by Professor Eugene Fama at the as an academic concept of study in early 1960s and widely accepted in 1990s. The efficient market theory holds that market prices fully and instantaneously reflect all available information. The efficient market theory was developed due to the evolution of capital markets and one of the best known forms of these markets is the stock market. The behaviour of stock market directly and indirectly influences the allocation of the scare capital resources. In order to maximize the efficient allocation of scare capital resources, stock market should ideally be perfect capital market. It means the capital market must at least response to something following basis conditions: Perfect competition in the market Frictionless market, i.e: all securities are perfectly divisible and marketable, no transaction costs, no restrictions or regulation on free market, etc Individual are rational expected utility maximisers Information is costless and received simultaneously by all participants 2. Different forms of efficient market There are three forms of efficient market: weak form, semi-strong form and strong form Weak form efficient market In the weak form efficiency, one of the most significant implications is no excess return can be earned by utilizing investment strategies based on historical share price or other financial data. If there is substantial dependence in price changes may be possible to earn excess return from using a simple trading rule. In UK, Brealey (1970), Cunningham (1973), Dryden (1970) and Girmes and Benjamin (1975) who used serial correlation tests and run tests found that there were no evidence of significant dependencies in price changes, thus providing evidence that UK stock market was weak form efficient. Semi-strong form efficient market The semi-strong form efficiency requires that share price fully and instantaneously reflect all public information, which include not only past share price but also a whole host of economic data are relevant in influencing share price movement. Despite having had number of contrary findings (Jensen 1978), the majority of studies have concluded that US stock market is semi-strong form efficient and UK stock market is found to be partially semi-strong form. Strong form efficient market Strong form market efficiency indicates that all information, whether publicly available or not, is instantaneously reflected in share prices and that no market participants can earn excess return except by chance. The major studies of strong-form efficient market have investigated the investment performance of managed funds and another approach is about insider trading. Basing on empirical research, it is suggested that stock markets are unlikely to be strong-form efficient in exact sense. However, insider dealing reduces the extent to which advance knowledge is utilized by insiders. Also, the concern about insider trading has made companies more aware of disseminating information quickly. 3. Random walk theory When referring to efficient market theory, it is impossible to ignore the random walk theory. The theory implies that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market can not be used to predict its future movement. The random walk model makes a statement about prices. However, it is frequently misinterpreted at saying or assuming something about the state of the market. “On one hand it assumes a highly competitive, efficient stock pricing mechanism. On the other hand, it denies the rewards to those capable, well-informed experts who make this market what it is, by operating in it” ( Rinfret, 1968). Moreover, stock do maintain price trends over time – in other words, that is possible to outperform the market by carefully selecting entry and exit points for equity investments. II. UK stock market behavour in 2010 in relation to efficient market theory As being aware, the financial crisis 2007-2010 has caused a lot of noise in the global as well as UK stock market behaviour. In this part, we will examine if UK stock market behaviour in 2010 was consistent with the efficient market theory mentioned above. 1. Prediction for UK stock market behaviour 2010 In the UK, 60% of expected stock market return is represented by consumer expenditure, which is largely driven by income growth and the “feel-good” factor from rising house prices. Hence, these two factors will crucially affect on the stock market behaviour. It was predicted that after a recession in 2009, the FTSE 100 would rise up to between 5,000 and 6,000 by the end of the year, which predicted by three-fifths of fund managers in an Association of Investment Companies survey. (http://www.independent.co.uk/news/business/sharewatch/will-the-stock-market-flop-or-climb-in-2010-1855191.html) At the same time, the Bank is seem to remain the low interest rates. This will continue to put pressure on investor looking for a real return on their cash, which during 2009 has played out to the advantage of the equity markets Evaluating FTSE as an Efficient Market in 2010 Did FTSE 100 rise to between 5,000 and 6,000 by the end of the year? Financial analysts in the midst of the worst economic crisis globally since 1929, nevertheless optimistically predicted a rise in prices on the FTSE by the end of 2010. As we now approach that point of assessment, we find that their optimistic assessment was accurate—the FTSE was, this week trading around 5,800 making the most optimistic assessment, (5,850, by Paul Kavanagh of Killik & Co) the most accurate. These predictions were based on slow, steady growth and particular consumer strength in the “Far East,” mainly in China’s emerging consumer market. This prediction was also somewhat accurate. http://www.timesonline.co.uk/tol/money/investment/article6906312.ece Does this accuracy suggest perfect, or near perfect, conditions of information in the market? If one ignores the crisis itself, in which misleading ratings of mortgage backed bond helped to sparked massive bank failures in the US and UK and a crash in the United States, the predictable nature of the ongoing recovery might suggest that he FTSE is in fact working under conditions of relative transparency and thus meets the requirements of an efficient market. However, as David Shwartz recently argued in the Financial Times (http://www.ft.com/cms/s/0/4983f7f2-047b-11e0-a99c-00144feabdc0,s01=1.html#axzz17mthzA1u) part of the information being assessed by investors (and consumers) are the ways in which the crisis exposed particular companies to a “loss of credibility.” He argues that companies such as Promethean World and others have emerged struggling to convince other market actors of the validity of the data they provide. His article suggests that a key part of operating successfully in the current market over the last year is, rather than perfect in formation, awareness that the information you are receiving is imperfect, and an accurate estimation of the degree to which this is the case. This adjustment for imperfect information, then, can counteract the situation asymmetric knowledge in the market, allowing the market to function more or less efficiently. Recognizing this is crucial for developing theories of efficient markets. Is the current market operating as a frictionless market? While the 1990’s saw an increase in the ease of global trading and sales with real-time and 24 hour trading, the market is nevertheless not operating as frictionless as this condition of efficient markets is much more an ideal than a reality. This is increasingly the case post-crisis as many governments have increased market regulation and the decreased number of brokerage houses and options have increased transaction costs. In the current market, is it fair to evaluation individual players as rational expected utility maximisers ? While incentive deformations, both pre and post crisis create incentives that are non-intuitive or even injurious to the ideal of an efficient market, it is non-the-less useful to model the behavior of individual investors, traders, customers and others on the premise that they are rational profit maximizers. A key exception to this, highly visible in the last period has been government itself. As governments have tried to stave off the worst consequences of the crisis through regulation, “bail outs” or through attempts to buy unprofitable assets, government intervention in the market is largely directly counter to the model of rational individual profit maximizer. Information is costless and received simultaneously by all participants? The existence of a profession of financial analysts such as those cited above suggests this is never the case. Accurate market data is not costless and is a service that many market players pay for in various forms, such as real-time access to market fluctuations over the internet to subscriptions to reputable financial news. Those with better connections, and those who pay more have quicker access, often to better quality information. FTSE as weak, strong or semi strong? If data from the period of the financial crisis is included, it is very difficult to imagine any of the above-mentioned markets as strong or semi-strong. Likewise, it is also difficult to exclude this data; by leaving out companies that suddenly failed during the crisis, we would be making our case on a sample designed to produce the hypothesis. The compromise made by expert analysts, then to assess not only the company itself, but the quality of the information that company provides; through this mechanism, perhaps the FTSE and other financial markets may go on to operate as efficient markets would, despite the difficulties in using past data to predict current performance, and the obvious asymmetries in the knowledge market. BHP Billton Case Study BHP Billton is a “global resources” company dealing in energy resources and mining. British-based, it operates transnationally including in South Africa and Australia. The company’s performance in 2010 in some ways mirrors that of the FTSE overall, but is in other respects both a weaker and a stronger example than the top 100 as a group. Perfect competition in the market? BHP Billton is a highly credible company that has not been tarred with the accuasations of “creative accounting” and misleading information that has plagued many businesses since the financial crisis. Nevertheless, its position in the energy and mining sector means that it is exposed to certain market conditions that can impact both “friction” and other costs. Workers in this globally highly unionized sector are not individual profit maximers, and strikes (such as the one which recently impacted the company in South Africa) are common. Meanwhile the energy sectors is among the most heavily regulated in the world, with many market competitors operating as para-statals and other governments providing subsidies to energy production. http://af.reuters.com/article/southAfricaNews/idAFLDE6B81T020101209 At the same time, BHP Bilton is a great example of some of the more particular analyst predictions for 2010. The company’s growth in 2010 has, just as experts predicted, been led in large part by growing demand in East Asia, though the demand is largely industrial, rather than consumer. http://www.bhpbilliton.com/bb/home.jsp http://www.theaustralian.com.au/business/mining-energy/m-share-incentive-for-bhp-chief-marius-kloppers/story-e6frg9df-1225967893272 Finally, BHP Billeton is a good example of a company for which the current performance and growth is predictable through a look at its past performance, with profits increasing steadily during the five years preceding 2008, and continuing this with a low share price in the high fourties and a high near eighty for 2010. The company boasts of an “attributable profit” that is up “12.4 per cent to US$15.4 billion and Earnings Per Share (EPS) up 17.5 per cent, benefiting from buy-backs ,” along with “record” strength in market conditions for core company sectors such as “petroleum, base metals, iron ore, manganese” and coal. BHP Billeton has seen a “return on capital employed of 37.5 per cent, despite unprecedented level of capital investments” during the period and a high “net operating cash flow of US$18.2 billion, up 13.8 per cent.” They have exceeded previous “annual production records for petroleum, copper, iron ore, manganese ore and alloy, alumina and molybdenum.” Conclusion: BHP Billeton, when reviewed as a case, suggests that while efficient markets—and even strong or semi-strong market efficiency—are rarely present in real world conditions where information is at a premium and subject to asymmetries and markets themselves are subject to massive regulation. Nevertheless, efficient markets can be an effective model, particularly under normal (non-crisis) market conditions. Key to effective use of this model, however, is an accurate perception and recognition of the quality and availability of information in the market provided by companies themselves, and by industry and market analysts. Read More