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SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT-BA9257
UNIT – IV-TECHNICAL ANALYSIS
Fundamental Analysis vs Technical Analysis –Charting methods –Market Indicators-trend and Trend
Reversals-patterns moving average –Exponential moving average-Oscillators –Market indicatorsEfficient market theory.
Table of Contents
Chart Types .................................................................................................................................................. 4
Toolbar ..........................................................................................................................................4
View Menu ..........................................................................................Error! Bookmark not defined.
Close ...................................................................................................................................................... 5
OHLC...................................................................................................................................................... 5
OHLC/Close ........................................................................................................................................... 5
Candle ................................................................................................................................................... 6
Candle/Close ......................................................................................................................................... 6
Equivolume ........................................................................................................................................... 6
Point and Figure .................................................................................................................................... 6
Trend Lines.................................................................................................................................................. 7
Trend Line Basics .........................................................................................................................7
Support and Resistance ...................................................................................................................... 8
Highs or Lows ...............................................................................................................................8
Closing Price ............................................................................................................................... 10
Log or Normal Scale?.................................................................................................................. 11
Normal Scale...................................................................................................................................... 12
Log Scale ............................................................................................................................................ 12
Short Term ........................................................................................................................................ 12
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Long Term ......................................................................................................................................... 12
What Chart Scale Should I Use? ..................................................................................................... 12
Strengths & Weaknesses ............................................................................................................. 12
Long Term: Up-Trends .................................................................................................................... 13
Long Term: Down-Trends ............................................................................................................... 13
Short/Medium Term ......................................................................................................................... 15
Drawing Trendlines .................................................................................................................... 17
Trendlines Must Be Respected At Least Three Times .................................................................. 17
Trendlines Should Not Intersect Price ............................................................................................ 19
Trading Signals ........................................................................................................................... 21
When should Trendline breaks be acted upon? ............................................................................. 21
Blow-offs ............................................................................................................................................ 21
Normal Long Term Breaks .............................................................................................................. 22
When to Use Trendlines .............................................................................................................. 23
Another Pitfall ................................................................................................................................... 23
Summary ............................................................................................Error! Bookmark not defined.
Candlestick Charts .......................................................................................... Error! Bookmark not defined.
Candlestick Charts ....................................................................................................................................... 24
Shadow and Tail .................................................................................................................................. 25
Candlestick Colors ........................................................................................................................ 26
Candlestick Patterns ..................................................................................................................... 26
Long Lines............................................................................................................................................ 26
Marubozu Candlesticks ....................................................................................................................... 26
Doji Candlesticks ................................................................................................................................. 27
Dragonfly ............................................................................................................................................. 28
Hammer and Gravestone .................................................................................................................... 28
Hanging Man ....................................................................................................................................... 29
Dark Cloud........................................................................................................................................... 30
Piercing Line ........................................................................................................................................ 30
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Engulfing Candlesticks......................................................................................................................... 31
Harami Candlestick ............................................................................................................................. 31
Star Formations............................................................................................................................ 32
Morning Star ....................................................................................................................................... 32
Evening Star ........................................................................................................................................ 32
Doji Star ............................................................................................................................................... 33
Shooting Star ....................................................................................................................................... 33
Rising Three Methods ................................................................................................................... 34
Falling Three Methods ........................................................................................................................ 35
Evaluation .................................................................................................................................... 35
Head and Shoulders Patterns ..................................................................................................................... 36
Head and Shoulders ..................................................................................................................... 36
Volume Confirmation.......................................................................................................................... 37
Trading Signals .................................................................................................................................... 37
Inverted Head and Shoulders ........................................................................................................ 38
Volume Confirmation.......................................................................................................................... 39
Support and Resistance .............................................................................................................................. 39
Support................................................................................................................................................ 39
Resistance ........................................................................................................................................... 40
Role Reversal ....................................................................................................................................... 41
Strength of Support/Resistance .......................................................................................................... 42
Efficient-market hypothesis ........................................................................................................................ 42
Historical background ................................................................................................................... 43
Theoretical background ................................................................................................................ 44
Weak-form efficiency .......................................................................................................................... 44
Semi-strong-form efficiency ............................................................................................................... 44
Strong-form efficiency ........................................................................................................................ 45
Criticism and behavioral finance ................................................................................................... 45
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Chart Types
Toolbar
Use the Chart View toolbar to select a Chart Type and Daily, Weekly or Monthly bars.
The drop-down arrow next to the Point & Figure icon displays all loaded P&F options
the View men offers further chart view options:
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Close
The chart will plot closing price only, as a line.
OHLC
Chart bars display Open, High, Low and Close. See Trading Guide: Chart Basics for further
details.
OHLC/Close
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The same as OHLC except that daily charts longer than 6 months will revert to closing price
only.
Candle
The chart bars will display as candlesticks. See Trading Guide: Candlesticks for further details.
Candle/Close
The same as Candle except that daily charts longer than 6 months will revert to closing price
only.
Equivolume
Equivolume charts can also be viewed with daily, weekly or monthly bars. The bars display the
same information as candlesticks, except that, in addition, bar width indicates volume. You can
amend Equivolume bars back to the original Incredible Charts format:



Select View >> Advanced Options >> Display Equivoque HLC
This will display only High, Low and Close, and not the Open.
Chart colors are also determined differently: in the same fashion as an OHLC chart.
See Trading Guide: Equivolume for further details.
Point and Figure
Point and Figure Charts do not use a time scale. See Trading Guide: Point and Figure Charts for
further details.
Use the Indicator Panel to set up new point and figure options.
Perfect
Your
Market
Timing
The weekly Trading Diary offers fundamental analysis of the
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economy and technical
gold, crude oil and forex.
analysis
of
major
market
indices,
The monthly What's New newsletter covers new articles
on Trading and the Economy, as well as new software updates.
Trend Lines
A trend line (shortened to "trend line" elsewhere on this website) is simply a momentum
indicator. It measures the rate of increase in the share price over time and alerts you to any
acceleration or deceleration of the trend. The difference between trend lines and other
momentum indicators is that you use a super-computer (the human brain) to visually identify the
trend, rather than a simplistic formula calculated on your PC.
Trend Line Basics
1. Draw trend lines through the lows of an up-trend — and through the highs of a downtrend;
2. On long-term charts, draw trend lines through closing prices;
3. Use either normal or log scale charts but be aware of their respective weaknesses;
4. Trend lines must be respected by at least three lows (or highs in a down-trend) — if
respected twice, the trend line is not yet confirmed;
5. Trend lines should not intersect (cut across) price at any point on the chart if extended.
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Support and Resistance
Trend lines do not predict levels of support and resistance. Support and resistance run
horizontally; not at an angle. For an explanation of the basics, see Support and Resistance. Many
traders confuse the two concepts: the lower line in a trend channel is often referred to as the
supporting trend line.
Highs or Lows
On a short-term chart (6 months or less), draw trend lines through the lows during an up-trend.
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And through highs during a down-trend.
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Closing Price
On a long-term chart, trend lines drawn with closing price are more effective.
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The lower trendline was drawn according to daily lows, to illustrate this point.
Log or Normal Scale?
There has been much debate on the Chart Forum over the years as to whether trendlines should
be drawn on log scale or normal scale charts.
The case for log scale has been summarized by Alsoran as:

Brokers and analysts chart in log mode. They advise institutional clients whose order
flow has a marked impact on price action and trend. Their advice is heavily influenced by
breaks and refusals of price at key trendlines and channels. These are based on
logarithmic charts. Logarithmic trendlines are, therefore, more important.
The case for normal scale (linear) trendlines:

Most trading authors use linear charts: Stan Weinstein, Alexander Elder, Chris Tate and
Daryl Guppy.
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
It is questionable whether most analysts and brokers use log scale charts. Many trading
authors (including Stan Weinstein and Chris Tate) are former analysts or brokers and use
linear charts.
In my opinion the two sides are talking about different time frames!
Normal Scale
Normal scale charts compare price against time. You would graph the speed of a car in a similar
manner: distance (y) over time (x). If a car travels at a constant velocity, the graph will be a
straight line. If stopped, the line will be horizontal. If accelerating, the graph will show a curve.
Log Scale
Log charts are not designed to measure velocity, they measure acceleration: the rate of growth
in stock prices. A constant velocity will be depicted as a flattening curve; a constant rate of
growth (acceleration) will be depicted as a straight line.
Short Term
In the short/medium term we focus on velocity: "Is this week's price increase as good as last
week?" The time period is too short to be concerned with compound growth rates.
Long Term
Most institutions hold stocks for the long-term and do not concern themselves with short-term
fluctuations. They want to know the annual compound growth rate; a very different concept from
short-term velocity.
What Chart Scale Should I Use?


On short-term and medium-term charts (3 years or less) we recommend that you use
normal scale.
For long-term charts (more than 3 years), use either normal scale (linear) or log charts,
but be aware of their respective strengths and weaknesses. Personally, I prefer to draw
trend lines on linear charts unless we are looking at a 10 or 20 year time period.
Strengths & Weaknesses
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Long Term: Up-Trends
Linear trend lines appear to accelerate over time if a stock grows at a constant compound rate.
Logarithmic trend lines more accurately present the rate of growth (or decline) over very long
time periods.
Long Term: Down-Trends
Linear trend lines appear to decelerate over time if a stock declines at a constant (negative)
growth rate.
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Logarithmic trend lines more accurately present the rate of decline.
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Short/Medium Term
Logarithmic trend lines tend to disguise accelerating trends in the short/medium term. We are
talking about accelerating trends rather than a steady growth rate. Accelerating trends normally
end up in blow-offs (or cathartic sell-offs in a down-trend) followed by a sharp reversal.
On a 3-year chart, normal scale highlights the accelerating trend.
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While log scale tends to camouflage (flatten) the acceleration.
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Drawing Trendlines
Let's take a look at some of the basics in more detail.
Trendlines Must Be Respected At Least Three Times
What do we mean by respect? Price should reverse in close proximity to the trend line but not
cross it. Take the Allegheny Energy chart, from earlier, as an example:
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What does close proximity mean? Price does not have to touch the trend line. Any reversal
within a reasonable distance is good enough. On the 3-year chart below you can see that a
number of troughs are short of the trend line, but within close enough proximity that they can be
said to have respected the trend line.
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Trendlines Should Not Intersect Price
Short-term charts often display candles with long tails or shadows when stops are shaken out, or
traders get caught in a false break, initiated by market professionals. If the daily high or low gets
in the way of an obvious trend line -- ignore it, but do not intersect closing prices.
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Trading was suspended, on the above chart, for two days in February. Longer suspension periods
may distort trend lines and the results should be treated with caution.
Avoid intersecting closing price except on a long-term chart if there is a spike that does not fit
the overall pattern. And only do so in exceptional circumstances: the trend must really be
obvious.
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Trading Signals
Trend line breaks signal a change in momentum; not necessarily a change in trend. Trend line
breaks often look obvious with hindsight, but you will normally find that the trend line depicted
was not the first one drawn: several trend lines may be broken before there is a trend reversal.
When should Trendline breaks be acted upon?


If trading short-term or swing trading, act upon trend line breaks when you receive price
confirmation (or confirmation from another indicator), as you would for any other
momentum indicator.
In the longer-term, trend lines are an effective tool for exiting trends that have spiked into
a blow-off (or down-trends that have spiked into a cathartic sell-off).
Blow-offs
A fast accelerating trend, or blow-off, is normally identified by at least 3 accelerating trendlines,
each at a markedly steeper gradient than the previous one. Yahoo displays a classic example in
1999/2000.
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Normal Long Term Breaks
Normal trend line breaks on long-term charts should be treated as an alert rather than as a trend
reversal signal The default indicator window is set at 20 days. To alter the default settings - Edit
Indicator Settings.
Indicator Panel for directions on how to set up an indicator.
.
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1. The first trend line drawn after an inverted head and shoulders is broken at signaling that
momentum is slowing;
2. Price tests support at $8.00 several times before resuming the up-trend, establishing a
second trend line
3. If the up-trend continues, we may draw a third trend line: through the low at $8.00 and
the low at $14.0
When to Use Trendlines
Drawing trend lines is time-consuming and in most cases unnecessary. Use stock screens to
identify the most likely candidates and concentrate on these. Following more than 20 stocks with
trend lines is, in my opinion, a waste of time.
Another Pitfall
You have to look at the wood not the trees!
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With thanks to AndrewK.
Draw trend lines through the lows in an up-trend and through the highs in a down-trend. Use
closing price for longer-term charts (more than 6 months). Use normal scale for short and
medium-term charts. Use either normal or log scale for long-term charts but beware of their
weaknesses.
Valid trend lines must be respected by at least 3 troughs in an up-trend (or 3 peaks in a downtrend) and should not intersect the closing price line if extended in either direction. Use
trendlines as a momentum indicator for short-term trades but only as an alert on long-term trades.
They are also an effective exit tool for blow-offs.
Don't waste time drawing trendlines on every chart. They are time-consuming and should only
be drawn on a
Candlestick Charts
The Japanese have been using candlestick charts since the 17th century to analyze rice prices.
Candlesticks were introduced into modern technical analysis by Steve Nison in his book
Japanese Candlestick Charting Techniques.
Candlesticks contain the same data as a normal bar chart but highlight the relationship between
opening and closing prices. The narrow stick represents the range of prices traded during the
period (high to low) while the broad mid-section represents the opening and closing prices for
the period.


If the close is higher than the open - the candlestick mid-section is hollow or shaded blue/green.
If the open is higher than the close - the candlestick mid-section is filled in or shaded red.
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The advantage of candlestick charts is the ability to highlight trend weakness and reversal signals
that may not be apparent on a normal bar chart.
Shadow and Tail
The shadow is the portion of the trading range outside of the body. We often refer to a
candlestick as having a tall shadow or a long tail.


A tall shadow indicates resistance;
A long tail signals support.
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Candlestick Colors
For improved presentation, Incredible Charts uses colors such as red and blue/green to indicate
filled or hollow candlesticks:



Blue (or green) candlestick if the close is higher than the open;
Red candlestick if the open is higher than the close (i.e. the candlestick is filled);
The same color as the previous day, if the open is equal to the close.
Candlestick Patterns
Long Lines
The long white line is a sign that buyers are firmly in control - a bullish candlestick.
A long black line shows that sellers are in control - definitely bearish.
Marubozu Candlesticks
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Marubozu are even stronger bull or bear signals than long lines as they show that buyers/sellers
have remained in control from the open to the close -- there are no intra-day retracements.
Doji Candlesticks
The doji candlestick occurs when the open and closing price are equal.
An open and close in the middle of the candlestick signal indecision. Long-legged dojis, when
they occur after small candlesticks, indicate a surge in volatility and warn of a potential trend
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change. 4 Price dojis, where the high and low are equal, are normally only seen on thinly traded
stocks.
Dragonfly
The dragonfly occurs when the open and close are near the top of the candlestick and signals
reversal after a down-trend: control has shifted from sellers to buyers.
Hammer and Gravestone
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The hammer is not as strong as the dragonfly candlestick, but also signals reversal after a downtrend: control has shifted from sellers to buyers. The shadow of the candlestick should be at least
twice the height of the body.
A gravestone is identified by open and close near the bottom of the trading range. The
candlestick is the converse of a hammer and signals reversal when it occurs after an up-trend.
Hanging Man
A hammer that occurs after an up trend is called a 'hanging man' and is a bearish signal.
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Dark Cloud
A Dark Cloud pattern encountered after an up-trend is a reversal signal, warning of "rainy days"
ahead.
Piercing Line
The Piercing Line is the opposite of the Dark Cloud pattern and is a reversal signal if it appears
after a down-trend.
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Engulfing Candlesticks
Engulfing patterns are where the body of the second candlestick 'engulfs' the first. They often
follow or complete doji, hammer or gravestone patterns and signal reversal in the short-term
trend.
Harami Candlestick
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A Harami formation indicates loss of momentum and often warns of reversal after a strong trend.
Harami means 'pregnant' which is quite descriptive. The second candlestick must be contained
within the body of the first, though the shadows may protrude slightly.
Star Formations
Stars are similar to gaps. A long body followed by a much shorter candlestick with a short body,
where the bodies must not overlap -- though their shadows may.
Morning Star
The Morning Star pattern signals a bullish reversal after a down-trend. The first candlestick has a
long black body. The second candlestick gaps down from the first (the bodies display a gap, but
the shadows may still overlap) and is more bullish if hollow. The next candlestick has a long
white body which closes in the top half of the body of the first candlestick.
Evening Star
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The Evening Star pattern is opposite to Morning Star and is a reversal signal at the end of an uptrend. The pattern is more bearish if the second candlestick is filled rather than hollow.
Doji Star
A Doji Star is weaker than the Morning or Evening Star: the doji represents indecision. The doji
star requires confirmation from the next candlestick closing in the bottom half of the body of the
first candlestick.
Shooting Star
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With a Shooting Star, the body on the second candlestick must be near the low -- at the bottom
end of the trading range -- and the upper shadow must be taller. This is also a weaker reversal
signal than the Morning or Evening Star.
The pattern requires confirmation from the next candlestick closing below half-way on the body
of the first.
Rising Three Methods
The Rising Method consists of two strong white lines bracketing 3 or 4 small declining black
candlesticks. The final white line forms a new closing high. The pattern is definitely bullish.
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Falling Three Methods
The bearish Falling Method consists of two long black lines bracketing 3 or 4 small ascending
white candlesticks, the second black line forming a new closing low.
Evaluation
While candlesticks may offer useful pointers as to short-term direction, trading on the strength of
candlestick signals alone is not advisable. Jack Schwager in Technical Analysis conducted fairly
extensive tests with candlesticks over a number of markets with disappointing results.
CUP and Handle triangle
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1.
2.
3.
4.
Start of the cup pattern.
The intervening peak completes the "cup" and starts the "handle".
Go long at the breakout [3] above the high of [2].
Place a stop-loss below the most recent low in the handle pattern.
Head and Shoulders Patterns
Head and Shoulders
A head and shoulders pattern consists of a peak followed by a higher peak and then a lower peak
with a break below the neckline. The neckline is drawn through the lowest points of the two
intervening troughs and may slope upward or downward. A downward sloping neckline is more
reliable as a signal.
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The extent of the breakout move can be estimated by measuring from the top of the middle peak
down to the neckline. This target is then projected downwards from the point of breakout.
Volume Confirmation




High volume on the first peak,
Moderate volume on the middle peak,
Low volume on the third peak, and
A sharp increase in volume on the break below the neckline.
Trading Signals
Go short at breakout below the neckline.
Place a stop-loss just above the last peak.
After the breakout, price often rallies back to the neckline which then acts as a resistance level.
Go short on a reversal signal and place a stop-loss one tick above the resistance level.
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Never trust a head and shoulders pattern where the neckline is clearly ascending (the second
trough being higher than the first). Also, the more level the neckline, the more reliable the
pattern.
Inverted Head and Shoulders
With inverted head and shoulders the neckline is drawn through the highest points of the two
intervening peaks. A downward sloping neckline signals continuing weakness and is less reliable
as a reversal signal.
The extent of the breakout move can be estimated by measuring from the top of the middle
trough up to the neckline. This target is then projected upwards from the point of breakout.
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Volume Confirmation





High volume on the first trough,
Moderate volume on the second trough,
High volume on the second peak,
Low volume on the third trough, and
A sharp increase in volume at the breakout.
Support and Resistance
Support and resistance form the foundation of most chart patterns.
Support
A support level is the price at which buyers are expected to enter the market in sufficient
numbers to take control from sellers.
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The market has a memory. When price falls to a new Low and then rallies, buyers who missed
out on the first trough will be inclined to buy if price returns to that level. Afraid of missing out
for a second time, they may enter the market in sufficient numbers to take control from sellers.
The result is a rally, reinforcing perceptions that price is unlikely to fall further and creating a
support level.
Resistance
A resistance level is the price level at which sellers are expected to enter the market in sufficient
numbers to take control from buyers.
When price makes a new High and then retreats, sellers who missed the previous peak will be
inclined to sell when price returns to that level. Afraid of missing out a second time, they may
enter the market in numbers sufficient to overwhelm buyers. The resulting correction will
reinforce market perceptions that price is unlikely to move higher and establish a resistance
level.
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Point and figure charts are useful for identifying support and resistance levels.
Role Reversal
Support levels, once penetrated, frequently become resistance levels and vice versa.
The market logic is fairly simple: buyers who purchase near a support level, only to see price
fall, are likely to sell in order to recover their losses, when price rallies to near their break-even
point. The support level then becomes a resistance level.
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Likewise, stockholders who sell when price approaches a resistance level will be disappointed if
price penetrates the level and continues to rise. They will be inclined to buy if price returns to
near the support level, fearing that they may miss out a second time. The resistance level thus
becomes entrenched as a support level.
Strength of Support/Resistance
Some support and resistance levels are more important than others. The significance of the
support level is identifiable by:





the number of times that the level has been respected;
the amount of volume that has been traded near the level;
whether the level is old or new - recent levels have greater significance;
whether the level is a new High or new Low - more extreme levels have greater impact; or
a level formed at a round number (e.g. $20.00 or $100.00) leaves a lasting imprint.
Efficient-market hypothesis
In finance, the efficient-market hypothesis (EMH), or the joint hypothesis problem, asserts
that financial markets are "informationally efficient". In consequence of this, one cannot
consistently achieve returns in excess of average market returns on a risk-adjusted basis, given
the information available at the time the investment is made.
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There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". The
weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already
reflect all past publicly available information. The semi-strong-form EMH claims both that
prices reflect all publicly available information and that prices instantly change to reflect new
public information. The strong-form EMH additionally claims that prices instantly reflect even
hidden or "insider" information. Critics have blamed the belief in rational markets for much of
the late-2000s financial crisis.[1][2][3] In response, proponents of the hypothesis have stated that
market efficiency does not mean having no uncertainty about the future, that market efficiency is
a simplification of the world which may not always hold true, and that the market is practically
efficient for investment purposes for most individuals.
Historical background
Historically, there was a very close link between EMH and the Random walk hypothesis and
then the Martingale model. The random character of stock market prices was first modelled by
Jules Regnault, a French broker, in 1863 and then by Louis Bachelier, a French mathematician,
in his 1900 PhD thesis, "The Theory of Speculation".[5] His work was largely ignored until the
1950s; however, beginning in the 1930s scattered, independent work corroborated his thesis. A
small number of studies indicated that US stock prices and related financial series followed a
random walk model.[6] Research by Alfred Cowles in the ’30s and ’40s suggested that
professional investors were in general unable to outperform the market.
The efficient-market hypothesis was developed by Professor Eugene Fama at the University of
Chicago Booth School of Business as an academic concept of study through his published Ph.D.
thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when
behavioral finance economists, who had been a fringe element, became mainstream.[7] Empirical
analyses have consistently found problems with the efficient-market hypothesis, the most
consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or
book value) outperform other stocks.[8][9] Alternative theories have proposed that cognitive biases
cause these inefficiencies, leading investors to purchase overpriced growth stocks rather than
value stocks.[7] Although the efficient-market hypothesis has become controversial because
substantial and lasting inefficiencies are observed, Beechey et al. (2000) consider that it remains
a worthwhile starting point.[10]
The efficient-market hypothesis emerged as a prominent theory in the mid-1960s. Paul
Samuelson had begun to circulate Bachelier's work among economists. In 1964 Bachelier's
dissertation along with the empirical studies mentioned above were published in an anthology
edited by Paul Cootner.[11] In 1965, Eugene Fama published his dissertation arguing for the
random walk hypothesis,[12] and Samuelson published a proof for a version of the efficientmarket hypothesis.[13] In 1970, Fama published a review of both the theory and the evidence for
the hypothesis. The paper extended and refined the theory, included the definitions for three
forms of financial market efficiency: weak, semi-strong and strong (see below).[14]
A. Kumar Assistant professor
KV Institute of Management and Information Studies
Coimbatore
44
Theoretical background
Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that
agents have rational expectations; that on average the population is correct (even if no one
person is) and whenever new relevant information appears, the agents update their expectations
appropriately. Note that it is not required that the agents be rational. EMH allows that when
faced with new information, some investors may overreact and some may underreact. All that is
required by the EMH is that investors' reactions be random and follow a normal distribution
pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal
profit, especially when considering transaction costs (including commissions and spreads). Thus,
any one person can be wrong about the market—indeed, everyone can be—but the market as a
whole is always right. There are three common forms in which the efficient-market hypothesis is
commonly stated—weak-form efficiency, semi-strong-form efficiency and strong-form
efficiency, each of which has different implications for how markets work.
Weak-form efficiency
In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past.
Excess returns cannot be earned in the long run by using investment strategies based on
historical share prices or other historical data. Technical analysis techniques will not be able to
consistently produce excess returns, though some forms of fundamental analysis may still
provide excess returns. Share prices exhibit no serial dependencies, meaning that there are no
"patterns" to asset prices. This implies that future price movements are determined entirely by
information not contained in the price series. Hence, prices must follow a random walk. This
'soft' EMH does not require that prices remain at or near equilibrium, but only that market
participants not be able to systematically profit from market 'inefficiencies'. However, while
EMH predicts that all price movement (in the absence of change in fundamental information) is
random (i.e., non-trending), many studies have shown a marked tendency for the stock markets
to trend over time periods of weeks or longer[16] and that, moreover, there is a positive
correlation between degree of trending and length of time period studied (but note that over long
time periods, the trending is sinusoidal in appearance).[17] Various explanations for such large
and apparently non-random price movements have been promulgated.
The problem of algorithmically constructing prices which reflect all available information has
been studied extensively in the field of computer science.[18][19] For example, the complexity of
finding the arbitrage opportunities in pair betting markets has been shown to be NP-hard.[20]
Semi-strong-form efficiency
In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new
information very rapidly and in an unbiased fashion, such that no excess returns can be earned by
trading on that information. Semi-strong-form efficiency implies that neither fundamental
A. Kumar Assistant professor
KV Institute of Management and Information Studies
Coimbatore
45
analysis nor technical analysis techniques will be able to reliably produce excess returns. To test
for semi-strong-form efficiency, the adjustments to previously unknown news must be of a
reasonable size and must be instantaneous. To test for this, consistent upward or downward
adjustments after the initial change must be looked for. If there are any such adjustments it
would suggest that investors had interpreted the information in a biased fashion and hence in an
inefficient manner.
Strong-form efficiency
In strong-form efficiency, share prices reflect all information, public and private, and no one can
earn excess returns. If there are legal barriers to private information becoming public, as with
insider trading laws, strong-form efficiency is impossible, except in the case where the laws are
universally ignored. To test for strong-form efficiency, a market needs to exist where investors
cannot consistently earn excess returns over a long period of time. Even if some money
managers are consistently observed to beat the market, no refutation even of strong-form
efficiency follows: with hundreds of thousands of fund managers worldwide, even a normal
distribution of returns (as efficiency predicts) should be expected to produce a few dozen "star"
performers.
Criticism and behavioral finance
A. Kumar Assistant professor
KV Institute of Management and Information Studies
Coimbatore
46
as computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year
mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual
return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling
twenty years later. Data from different twenty-year periods is color-coded as shown in the key.
See also ten-year returns. Shiller states that this plot "confirms that long-term investors—
investors who commit their money to an investment for ten full years—did do well when prices
were low relative to earnings at the beginning of the ten years. Long-term investors would be
well advised, individually, to lower their exposure to the stock market when it is high, as it has
been recently, and get into the market when it is low."[21] Burton Malkiel, a well-known
proponent of the general validity of EMH, stated that this correlation may be consistent with an
efficient market due to differences in interest rates.
A. Kumar Assistant professor
KV Institute of Management and Information Studies
Coimbatore