Superior Trading Returns Technical or Fundamental Analysis and Self-Defeating Techniques - Coursework Example

Superior trading returns technical or fundamental analysis and self-defeating techniques al affiliation This work examines the assumptions underlying efficient markets, Chartism and Fundamental Analysis. After providing a brief overview of each of them it tries to investigate the link their link with superior trading returns. OVERVIEW As long as financial markets have existed, people have tried to forecast them, in the hope that good forecasts would bring them great fortunes. In financial practice it is not the question whether it is possible to forecast, but how the future path of a financial time series can be forecasted. Investors were obliged to revise this approach in the past eighteen months, due market crashes and historically high volatility. In comparison to their peaks at the end of 2007, the Dow Jones Industrial Average Index and the DAX index have dropped almost 50% in value. Considering recent events many investors have reconsidered the concept of fair value of a stock and the efficiency of techniques used. In addition to this, the approach applied by many academics on Technical and Fundamental Analysis1 and of Efficient Market Hypothesis theory, rather than on how to forecast, has induced us to base the structure of this essay on a similar approach. Therefore in Section 1, 2 and 3 after providing a brief overview of FA and of TA the EMH theory, we have explored alternative views and discussed the validity of the statement in object. After illustrating the need for analysts to create efficiency in Section 4 we have explored the extent to which FA, TA or EMH may be essential to achieve market efficiency. Finally, after examining in Section 5 the Stiglitz-Grossman paradox, in Section 6, we have explored anomalies and invalidities of EMH and presented our conclusions. 1. FA: theory overview and statement assessment FA found its existence in the firm-foundation theory developed in the 1930s though it was later popularised by Graham. Its purpose is to find and explore all economic variables measuring different economic circumstances and influencing the future earnings of an economic asset. Clearly the philosophy behind FA is that in the end, when enough traders realize that the market is not correctly pricing the asset, the market mechanism of demand/supply, will force the price of the asset to converge to its fundamental value. Early writers on the subject of security analysis assumed that the essence of investing was to determine the "true," "intrinsic," or "fundamental" value of a security and that this value could differ from the current market price. Graham and Dodd (1934) first highlighted the concept of the intrinsic value of a security as a function of the future earnings of a company, rather than "book value". Implicit in their approach to the evaluation of securities was the assumption that some investors have better information than others and therefore can accumulate underpriced securities without a significant and self-defeating impact on the market price of the stock. This assumption turned out to be critical in understanding both the development of the EMH and the recent literature on market-making mechanisms. This approach tries to generate an abnormal return by analyzing fundamental factors of a company to be able to draw a comparison between the theoretically justified fair value and the actual stock market price2. These fundamental factors are derived by analysing public information, on the ground of which the FA can generate an abnormal return, because all public information is already correctly processed by the stock market and therefore correctly reflected by the actual stock market prices3. 2. TA: theory overview and statement assessment A second approach to choosing securities is termed TA or "charting", which plots the history of past prices and tries to discern some predictive pattern for future price movements as illustrated by Exhibit 1. This theory, developed at beginning of the 20th century into a standard tool, is currently used by every bank to write technical reports spreading around forecasts with all kinds of fancy techniques. The general consensus among chartists is that there is no need to look at the fundamentals, because everything that is happening in the world can be seen in the price charts and then deduce the probable future trend of the security price. Various reasons are given to explain why there might be predictive patterns in past prices. The main one is examined by Malkiel and can be traced in the fact that investors with superior information about the future level of earnings of a company begin to accumulate its shares. This buying generates increased volume and an increase in price. Some chartists may be able to detect this pattern before others and start accumulating the security, driving the price to higher levels and producing profits both for the chartists and the original investor with superior information. 3. EMH: theory overview and statement assessment Despite the existence of a behavioural approach4, in 1965 Salmuelson introduced the concept of EMH, based on the concept of unforecastable price changes in an efficient market. In fact since news is announced randomly5, prices must fluctuate randomly. This important observation, combined with the notion that positive earnings are the reward for bearing risk, and the earlier empirical findings that successive price changes are independent, led to the EMH theory. However the influential paper of Fama (1970) contributed to popularise Samuelson’s article by reviewing the theoretical and empirical literature on the efficient markets model until that date and by distinguishing three forms of market efficiency. He called a financial market weak efficient, if no trading rule can be developed forecasting future price movements on the basis of past prices, semi-strong efficient if it is impossible to forecast future price movements on the basis of publicly known information and finally strong efficient on the basis of all available information6, making impossible to forecast future price movements. If capital markets are efficient in the weak sense, there are no dependencies in past price changes that a chartist could use to predict future changes, whereas if a market is semi-strong efficient, the current price of a stock reflects all publicly available information. If this is so, such information has no value in forecasting future price changes, since it is already discounted in the price. Since such information is as likely to be favourable as unfavourable, the assets price movement is as likely to be upward as downward. However this process takes place so quickly that it would be impossible to exploit the prior run in prices. The price of the security adjusts to a new level instantaneously and thereby eliminates all statistical price dependencies. Despite the existence of various tests examining this topic, Fama and Blume (1966) only, provided a consistent contribution to the returns topic. Their conclusions became extremely important and induced various academics to reject the usefulness of TA which relied on these patterns to predict future prices. 4. Analysts: the need to create efficiency, FA, TA and EMH contribution As mentioned in Section 3, Fama (1970) defined market in which prices always fully reflect available information as “efficient”. Although this definition reflects the main idea of the EMH, it may be extended by considering Malkiel’s (1992) perspective, who defines a capital market as efficient if it fully reflects all relevant information in determining security prices. Therefore, the market is efficient with respect to some information set, if security prices would be unaffected by revealing that information to all participants. It is evident that it is throughout the investors` actions, that markets are driven to efficiency as stressed by Roberts (1967) and that actions are based to the different information sets investors have access. These conclusions induce us to explore if EMH can lead to the view in object and investigate if FA & TA analysis may be essential to achieve market efficiency. On the ground of the controversial results of the empirical studies, it can be summarised that the EMH can neither be fully rejected nor fully confirmed7. Thus stock analysis concept like FA and TA cannot generally be considered worthless8 .The joint-hypothesis problem and particularly the theory of information paradox9 support the idea that these analysis concepts are necessary to achieve at least a certain level of information efficiency of the stock market10. As previously pointed out, most investors use FA to select what to invest in and TA to help them decide when to invest in it. When considering TA, it is evident semi-strong market efficiency would rule out the use of TA to earn abnormal returns since past stock price history is a readily available public information. If financial markets are characterised by semi-strong market efficiency, economists would argue that the only way to earn abnormal profits would be to act on information that is not publicly available. Implicit in the FA approach is the search for the discrepancy between the price of a future and its intrinsic value. Finally in terms of EMH, no trader will be presented with an opportunity for making a return on share that is greater than a fair return for the risk associated with that share except by chance. The absence of abnormal profit possibilities arises because current and past information is immediately reflected in current market prices. Stock market efficiency does not mean that investors have perfect powers of prediction but only that the current share price level is an unbiased of its true economic value based on the information revealed. The debate about EMH becomes a question of how active portfolio management works or if it is possible to beat the market. But the answer to this question depends on whether investors accept EMH and if so in which form. 5. The Stiglitz-Grossman paradox The contradicting conclusions of various texts induced Grossman and Stiglitz (1980) to explore the model and revise its connotations. In their famous “Paradox”, these Nobel Prize winners argued that perfect informational efficient market is impossible or that there would be no incentive for professionals to uncover the information that gets so quickly reflected in the market prices. Periods such as 1999 where “bubbles” seem to have existed at least in certain sectors of the market, are fortunately the exception rather than the rule. Moreover, whatever patterns or irrationalities in the pricing of individual stocks that have been discovered in a search of historical experience are unlikely to persist and will not provide investors with a method to obtain extraordinary return. This position is confirmed by Malkiel (2003) who adds that when the EMH is true and information is costly, competitive markets break down. Because information is costly, prices cannot perfect reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation, producing a fundamental conflict between the efficiency with which markets spread information and the incentives to acquire it. Although they theoretically pointed out that it is impossible for perfect efficient markets to exist, their conclusions have provided EMH proponents with a good excuse to resort to in case of need but did not prove its inefficiency. 6. Conclusions As mentioned in Section 5, Grossman’s and Stiglitz’s famous paradox induced many studies published in the later decade to analyse the contradictions between theory and practice as well as EMH’ inefficiencies. In terms of contradictions, it is evident that only a privileged investors may have prior knowledge of laws about to be enacted, as the public must treat these as random variables, though actors on such inside information can correct the market usually in discrete manner to avoid detection. Secondly towards the end of a crash, markets go into free fall as participants extricate themselves from positions regardless of the unusually good value that their positions represent. This is indicated by the large differences in the valuation of stocks compared to fundamentals11 in bull markets compared to bear markets. Indeed recent market failures12 contributed to increase the debit the responsibility of the current recession to EMH’s anomalies and inefficiencies. The most controversial issue in finance is whether the financial market is efficient in allocating or using economic resources and information or not. The limitation of the existing empirical tests of the efficiency issue in the financial market EMH has generated conflicting and inconclusive outcomes. Secondly a handful of anomalies such as the ‘weekend effect’13 have also been observed. However, the effects are usually too small to permit traders to gain significant profits after trading costs are taken into account and most disappeared not long after they were discovered. The disappearance of these anomalies can be motivated either with the possibility for traders to exploit the anomaly once publicised14or with the possibility of being the product of human pattern-finding. These elements suggest that although the model is robust, the continuous testing of the afore-mentioned assumptions and the recent market collapse either prevents us from fully supporting it. Word Count : 2,095 Words allowed: 1,850-2,100 REFERENCES Barber B., Lyon J., 1997. 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