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8
Chapter
Stock price behavior and market
efficiency
Fundamentals
of Investments
Valuation & Management
second edition
Charles J. Corrado Bradford D.Jordan
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
6-2
Technical analysis
 Fundamental analysis focuses mostly on the
company financial information.
 Technical analysis is a technique for predicting
the market direction based on :
1. Historical price and volume behavior
2. Investor sentiment
 Investors with a positive outlook on the
market are called bulls and a rising market is
called a bull market
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Technical analysis
 Pessimistic investors are called bears and a
falling market is called a bear market
 Technical analysts search for bearish or bullish
signals meaning positive and negative
indicators about the stock prices or the market
direction
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6-4
Dow Theory
 Is a method of analyzing and interpreting the
stock market movements that relies on the
Dow Jones industrial average and the Dow
Jones Transportation averages
 The essence of Dow theory is that there are at
all times three forces at work in the financial
markets
1. A primary direction or a trend
2. A secondary reaction or a trend
fluctuations
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Dow Theory
 According to the theory, the primary direction
is either bullish ( up) or bearish ( down)
 It reflects also the long direction of the market
 However, the market can depart for limited
periods of time from the primary direction
 These departures are called the secondary
trends , may last for several weeks or months
 These are eliminated by the corrections which
are the reversion back to the primary direction
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Dow Theory
 Daily fluctuations are noise and are of no real
importance
 The basic purpose of the Dow theory is to
signal changes in the primary direction
 Depends on the two stock averages
 If one of these departs from the primary trend,
the movement is viewed as a secondary
 If a departure in one , followed by a departure
in another this is viewed as confirmation
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6-7
Dow Theory
 A confirmation is a signal that the long-run
trend has changed direction.
 Support level : price or level below which a
stock or a market as a whole is unlikely to fall
 Resistance level: price or level above which a
stock or a market as a whole is unlikely to rise
 As a stock price falls , it reaches a point where
investors believe that it can fall no further
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6-8
Resistance and support levels
 Bottom feeders picks up at that point, there by
they are supporting the price
 The resistance level is the same thing in the
opposite direction, as a stock rises , it tops out
and investors selling the picks up this selling is
often referred to profit taking
 Break out : occurs when a stock passes
through either a support or a resistance level.
The breakout interpreted to mean that the price
will continue in that direction
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6-9
Technical indicators
 Technical analysts rely on a variety of so
called technical indicators
 Look at page 253
 The first item listed is the number of issues
traded . This number is fluctuated
 Advancing issues and declining ones and the
number of unchanged prices, then the number
of the stock prices reaching new highs and new
lows
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6 - 10
Technical indicators
 One popular technique is the advance/decline
line
 Which shows the cumulative difference
between advancing issues and declining issues
 A downward sloping advance/decline line
would be considered as a bearish signal
 The upward slope is a positive sign
 Advance/decline line is often used to measure
the market breadth
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Technical indicators
 If the market is going up, the technical analyst
view it as a good sign
 The next row is the trading volume for the
advancing, declining and unchanged issues
 Heavy advancing volume is viewed as a
bullish signal
 The last three numbers , are of the interest of
technicians , ( closing tick) is the difference
between the number of shares that closed on an
uptick and those that closed on downtick
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continue
 Closing arms (trin) is the ratio of average
trading volume in declining issues to the
average trading volume in advancing issues
 Values greater than 1 are considered bearish
because the indication is that the declining
shares are heavier volume
 The final piece of information is the block
trades refers to trades in excess of 10,000
shares
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Charting
 Technical analyst rely heavily on charts
showing the recent market activity in terms of
either prices or volume
 Technical analysis is called charting and
technical analysts are called chartists
 There are four charting techniques:
1. The relative strength charts
2. Moving average charts
3. Hi-lo-close and candlestick charts
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Relative strength chart
 A measure of the performance of one
investment relative to another
 A ratio bigger than 1.0 indicates that on
relative basis , the company is outperformed
 Example page 255 between ford and GM
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Moving average charts
 An average daily price calculating using a
fixed number of previous day’s prices or levels
updated each day
 Such charts are used in an attempt to identify
short and long term funds
 The way we construct a 30 day moving
average stock price is to take the prices from
the previous 30 trading days and average them
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Hi-lo-close and Candlestick charts
 Is a bar chart showing for each day, the high
price, the low price and the closing one
 Candlestick chart is an extended version of hilo-close that provides a compact way of
plotting the high, low , open and closing price
through time while also showing whether the
opening price was above or below the closing
price
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6 - 17
Hi-lo-close and Candlestick charts
 The name stems from the fact that the resulting
figure look like a candlestick with a wick at
the both ends
 Candlestick are abbreviated As HLCO
 The body of the candlestick is defined by the
opening and closing prices
 If the closing price is higher than the opening,
the body is clear or white, otherwise its black
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Hi-lo-close and Candlestick charts
 Extending above and below the body are the
upper and the lower shadows, which are
defined by the high and low prices for the day
 Dark cloud cover: a white candle with a long
body is followed by a long bodied black
candle, when this occurs during a general
uptrend , the possibility of a slowing or
reversal in the uptrend is suggested
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Hi-lo-close and Candlestick charts
 Bearish engulfing pattern: the market opened
higher than the previous day’s close, but
closed lower than the previous day’s open
(Bearish Indicator)
 Harami: the body of the second candle lies
inside that of the first day’s , the harami
signals market uncertainty and the possibility
of a change in a trend
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6 - 20
Point and Figure charts
 Technical analysis chart showing only the
major price moves and their direction
 Chartists believe that point and figure charts
provide a better indication of important trends
 The whole example in book page 259
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6 - 21
Chart formation
 Head and shoulders , in the eyes of the
technical analysts , a bearish indicator , when
the stock price “pierces the neckline” , after
the right shoulder is finished , its time to sell
 Technical analysts believe that the chart
interpretation is a subjective art rather than an
objective matter
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6 - 22
Other technical indicators
 Odd lot indicator: looks whether the odd lot
purchases are up or down
 Odd lot purchases: purchases of fewer than
100 shares
 One argument is that the old lot purchases
represent the activities of smaller,
unsophisticated investors , so when they start
buying its time to sell
 Increasing the short sales are a negative signal
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6 - 23
Other technical indicators
 Some indicators are a little silly , there is the
Hemline indicator
 The idea that stock prices move in the same
general direction as the hemlines of women's
dresses. Short skirts in the 1920s and 1960s
were considered bullish signs that stock prices
would rise, whereas longer dresses in the
1930s and 1940s were considered bearish
(falling) indicators.
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6 - 24
Other technical indicators
 Super bowl indicator: which forecasts the
direction of the market based on whether the
national football conference or the american
football conference wins
 A win by the national football conference is
bullish
 You might be surprised to learn that for the
period 1967-1988, this indicator forecast the
direction of the stock market with more than
90% accuracy !
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6 - 25
Market Efficiency
 Relation between the stock prices and the
information available to investors , indicating
whether its possible to beat the market
 If the market is efficient , it is n’t possible
except by luck
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What does beat the market mean ?
 Riskier investments have larger returns than
less risky investment, so the fact that an
investment appears to have a high or low
return doesn’t tell us much
 To determine if an investment is superior , we
need to compare excess return which is the
difference between what the investment earned
and what other investments with the same risk
earned
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6 - 27
What does beat the market mean ?
 A positive excess return means that an
investment has outperformed other investment
of the same risk
 So earning a positive excess return is what we
mean by beating the market
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6 - 28
Forms of market efficiency
 Weak form efficient market : a market in
which past prices and volume figures are of no
use in beating the market
 SemiStrong form efficient market: a market in
which publicly available information is of no
use in beating the market
 Strong form efficient market : a market in
which information of any kind , public or
private is of no use in beating the market
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6 - 29
Why would a market be efficient?
 The driving force toward market efficiency is
simply competition and the profit motive
 Investors try to identify superior performing
investment, using the most advanced
information processing tools available,
investors appraise the stock values , buying
those that look undervalued and selling those
that look even overvalued.
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6 - 30
Why would a market be efficient?
 The fundamental characteristics of an efficient
market is that prices are correct in the sense
that they fully reflect relevant information
 When new information comes to light , price
may change and they may change by a lot
depends on the new information.
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6 - 31
Are financial markets efficient?
 They are four basic reasons why market
efficiency is so difficult to test:
1. The risk adjustment problem
2. The relevant information problem
3. The dumb luck problem
4. The data snooping problem
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The risk adjustment problem
 The risk adjustment problem is the most
straightforward to understand
 Beating the market means earning a positive
excess return . To determine whether an
investment has a positive excess return , we
have to look at the risk associated with it
 But we aren’t certain exactly what we mean by
risk , much less how to measure it and adjust
for it.
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The risk adjustment problem
 So , what appears to be a positive excess return
may just the result of a faulty risk adjustment
problem
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6 - 34
The relevant information problem
 Market efficiency is just meaningful only to
some particular information
 But we can’t know all the information that
have been underlying the behavior
 Suppose that we see the 10 years ago , the
price of a stock shot up by 100 percent over a
short period of time and then collapsed , we
dig through the historical data , but we don’t
find any reason for this behavior
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6 - 35
The dumb luck problem
 By tracking the performance of thousand of
money managers over some period of time ,
some managers accumulate remarkable track
records and a lot of publicity
 Are they good or are they luck?
If we could track them for many decades , we
might be able to tell , but for the most part ,
money managers aren’t around long enough
for us to accumulate enough data.
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The data snooping problem
 Ghosts in data
 If we look enough and hard enough at any
data, we are bound to find some patterns by
sheer chance
 But are they real???
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6 - 37
Some implications of market efficiency
 Investment process can be divided into two
ways:
1. Asset allocation
2. Security selection
 if all the markets are efficient , asset
allocation is still important because the way
that you divide your money between the
various types of investment will influence
the overall risk relation
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6 - 38
Some implications of market efficiency
 If the market is efficient , the security selection
is less important and y don’t need to worry too
much about overpaying and underpaying for
any particular security
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6 - 39
The day off the week
 The weekend effect (also known as the Monday
effect, the day-of-the-week effect or the
Monday seasonal) refers to the tendency of
stocks to exhibit relatively large returns on
Fridays compared to those on Mondays. This
is a particularly puzzling anomaly because, as
Monday returns span three days, if anything,
one would expect returns on a Monday to be
higher than returns for other days of the week
due to the longer period and the greater risk.
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6 - 40
The amazing January effect
 January effect is the tendency of stock markets
to rise in the month of January. The tendency
is more evident in first week of January.
January effect is more evident in small-cap and
mid-cap stocks and different stocks and
markets are differently affected by the effect.
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6 - 41
The amazing January effect
 The main reason for January effect is related to Tax
paying. Investors and traders sell-off their holdings to
claim a capital loss or to get lower taxes before the
end of the tax calendar (in December) causing the
prices to fall. In first week of January these
investors/traders reinvest their money and buys-back
stocks, and the prices rise. For S&P January effect
took place 32 times out of total 39 years from 1979.
As the effect is widely expected it is difficult to profit
from this effect.
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6 - 42
Black Monday (1987)
 Black Monday refers to Monday, October 19,
1987, when stock markets around the world
crashed, shedding a huge value in a very short
time. The crash began in Hong Kong, spread
west through international time zones to
Europe, hitting the United States after other
markets had already declined by a significant
margin. The Dow Jones Industrial Average
(DJIA) dropped by 508 points to 1738.74
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6 - 43
Performance of professional money
managers
 Despite the different resources , experiences ,
opportunities and incentives and despite the
patterns that existed in the stock market.
Money managers aren’t able to beat the
market.
 This is true for professionals as a group and as
individuals
McGraw Hill / Irwin
 2002 by The McGraw-Hill Companies, Inc. All rights reserved.