Principles of Finance

Principles of Finance (2017 – 2018) [SV1- SEM1]

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1200 words

9/NOV/2017

Do you believe that it is possible to develop trading rules to “beat the market”? Why? Provide your explanation based on the efficient market hypothesis (EMH).

Introduction. Since the beginning of financial markets, investors have always been seeking abnormal returns. Fama (1970) introduced the Efficient Market Hypothesis which states that it is impossible to “beat the market” as securities prices always incorporate all relevant information. However, the EMH was not successful in explaining why anomalies appear in the markets. For this purpose, the Adaptive Market Hypothesis was introduced. It has managed to unite the EMH and behavioural finance together with evolutional human models. Therefore, anomalies such as “January Effect” now could be put and studied in to some framework that greatly coexists with the EMH. Furthermore, the infamous, among academics, technical analysis received some recognition and now is considered by some academics as another interpretation of behavioural finance.  

This essay will look into some technical analysis rules (TAR) as well as the “January Effect” based on the EMH that could potentially aid investors in "beating the market."

The efficient market hypothesis. EMH is a financial theory that states it is impossible to have an abnormal return because securities market efficiency makes current securities prices to always include and reflect all relevant information. According to the EMH, securities always exchange at their reasonable prices on the market which makes it impossible for traders to either buy securities that are under-priced or sell securities for inflated prices.

[pic 1]

Pic. 1. Informational system of financial markets

There are three forms of efficiency in the EMH, according to Fama (1970):

1. The Weak Form of the EMH indicates that prices of traded security in that market include only historical price information and that the rest of public information and private information is not available to the market participants. (see pic.1) Therefore, by analysing historical prices, no investor would identify under-priced securities and technical analysis is of no value to investors.
2. The Semi-Strong Form of the EMH indicates that prices of the traded security in that market include available public information and that it is incorporated into the current price of the stock, in addition to the historical price data. Therefore, fundamental analysis is of no value to investors.
3. The Strong Form of the EMH indicates that non-public insider’s information is already included and reflected in the current price of the security, in addition to all included information in the weak and semi-strong forms. Therefore, no investor would be able profit, even if private information was available.

Markets, where all available information is accessible to all participants at the same time, and where prices respond immediately to all available information, are called “efficient.” In these kind of markets, there are two groups of investors - rational and irrational. (Fama 1970)

Adaptive Market Hypothesis. Despite success of the EMH in general, questions about inefficiencies and anomalies had still remained unanswered. For this purpose, the AMH was introduced. It is a new framework that unites the EMH and behavioural finance principles. It states that investor behaviour such as loss aversion, overconfidence and overreaction can be explained through evolutionary models - competition, adaptation and natural selection. In other words, all possible inefficiencies or anomalies in markets are caused by investors and can be analysed through psychology based theories (Lo 2004). Furthermore, this not only explains anomalies such as “January Effect” and such, but also recognises technical analysis as a form of human behaviour recognition, which is another use of behavioural finance (Lo 2010).

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Pic. 2. Reversal and breakout rules

Technical Analysis. Although the weak form of the EMH rejects the idea of using technical analysis in investing, some technical analysis rules (TAR) can be profitable. This is possible due to the study of the action of the market with a further deduction from it in order to forecast the possible future trends (Edwards 2007). That is, according to Murphy (1986), securities prices move in trends and these trends repeat themselves over time which allows investors to analyse them and withdraw profits. Zarrabia (2017) reveals positive results in profitability of TAR such as simple/linearly/exponentially moving averages, channel breakout (see Rectangle and Double Bottom/Top rules in pic. 2) and moving average oscillator in the foreign exchange markets over the period of 1995-2014. Similarly, in a study on price momentum model in the Canadian Equity Markets, Foerster (1994) finds that investors could have earned a staggering excess of 30% from the period of 1978 to 1992. Moreover, by using TAR such as “1-day candlestick patterns” or 2pa, 2pb, 2pd and 3pc (see pic. 2), investors can expect more returns on their investments in market reversal trends (Shiu 2016). In Another study that used a data set of more than 90,000 observations which shows positive results in applying the breakout and consolidation flag pattern rule (Royo 2015). However, Lucke (2003) claims that TAR such as “head and shoulder” is not significantly positive and cannot be considered profitable. Similarly, Daniotti (2012) states that not one rule of technical analysis can beat market inefficiency, at any time.