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8
Stock Price Behavior and Market Efficiency

McGraw-Hill/Irwin

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

If you see a bandwagon, its too late. -Sir James Goldsmith

Dont try to buy at the bottom and sell at the top. It cant be done except by liars. -Bernard Baruch

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Controversy, Intrigue, and Confusion

Our goal in this chapter is first to discuss bull markets and bear markets, as well as market psychology. Then, we will consider if anyone (i.e., you) can consistently beat the market. Finally we will examine some baffling market phenomena.
The Day of the Week Effect The January Effect The puzzling performance of professional money managers

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Technical Analysis
Technical analysis differs significantly from fundamental analysis. Technical analysis is a controversial set of techniques for predicting market direction based on
Historical price and volume behavior Investor sentiment

Technical analysts essentially search for bullish (positive) and bearish (negative) signals about stock prices or market direction.

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Dow Theory, I.
The Dow theory is a method that attempts to interpret and signal changes in the stock market direction. Historically, quite popular. The Dow theory identifies three forces:
a primary direction or trend, a secondary reaction or trend, and daily fluctuations

Daily fluctuations are essentially noise and are of no real importance.

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Dow Theory, II.

Dow Jones Industrial Average, January 2, 2001 to October 3, 2003
12,000

The primary direction is either bullish or bearish, and reflects the long-run direction of the market.
11,000

10,000

Level
9,000

8,000

Secondary trends, temporary departures

Corrections, reversions to the primary direction

7,000

01/01

04/01

07/01

10/01

01/02

04/02

07/02 Date

10/02

01/03

04/03

07/03

10/03

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Dow Theory, III.

Purpose: to signal changes in the primary direction. Must monitor two indexes:
Dow Jones Industrial Average Dow Jones Transportation Average

If ONE index departs from the primary direction, this is not a signal. However, if a departure in one is followed by a departure in the other, this is viewed is confirmation that the trend has changed.
The trend is your friend
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Support and Resistance Levels

A support level is a price or level below which a stock or the market as a whole is unlikely to go, while a Resistance level is a price or level above which a stock or the market as a whole is unlikely to rise. Resistance and support areas are usually viewed as psychological barriers
Bargain hunters help support the lower level. Profit takers resist the upper level.

A breakout occurs when a stock (or the market) passes through either a support or a resistance level.
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Market Diaries, A Collection of Technical Indicators

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Technical Indicators, Notes

The advance/decline line shows, for some period, the cumulative difference between advancing and declining issues. Closing tick is the difference between the number of shares that closed on an uptick and those that closed on a downtick. Closing arms or trin (trading index) is the ratio of average trading volume in declining issues to average trading volume in advancing issues. Using data from the "Previous Close:"
Arms 754,540,57 0/1,734 435,144 1.6944 384,700,63 0/1,498 256,809

zBlock trades are trades in excess of 10,000 shares.

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Charting, Relative Strength

Relative strength charts measure the performance of one investment relative to another. Comparing stock A to stock B, through relative strength.
Stock A (4 Shares)
$100 96 88 88 80 76

Month 1 2 3 4 5 6

Stock B (2 Shares)
$100 96 90 80 78 76

Relative Strength
1.00 1.00 0.98 1.10 1.03 1.00

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Charting, Moving Averages

Moving average charts are average daily prices or index levels, calculated using a fixed number of previous days prices or levels, updated each day. Because daily price fluctuations are smoothed out, these charts are used to identify trends. Example: Suppose the technical trader calculates a 15day and a 50-day moving average of a stock price.
If the 15-day crosses the 50-day from above, it is a bearish signaltime to sell. If the 15-day crosses the 50-day from below, it is a bullish signaltime to buy.
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Example: 15-Day and 50-Day Moving Averages

Dow Jones Industrial Average, 15-Day and 50-Day Moving Average
11,000 10,500 10,000 15-Day 50-Day

Index Level

9,500 9,000 8,500 8,000 7,500 1/2/02 3/6/02 5/7/02 7/9/02 9/9/02 11/7/02 1/10/03 Date 3/14/03 5/15/03 7/17/03 9/17/03

Note the "whipsaw" actioni.e., plenty of buying and selling signals. This happens because 15 and 50 may be too "close" together in time.
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More Chart Types

A hi-lo-close chart is a bar chart showing, for each day, the high price, low price, and closing price. A candlestick chart is an extended version of the hi-loclose chart. It plots the high, low, open, and closing prices, and also shows whether the closing price was above or below the opening price.

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Candlestick Making, Basics

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Candlestick Formations

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Point and Figure Charts, I.

Point-and-figure charts attempt to show only major price moves and their direction.
The point and figure chart maker decides what price move is major. That is, it could be $2, $5, or any other level.

A major up-move is marked with an X A major down-move is marked with an O

Start a new column when there is a direction change.

Buy and sell signals are generated when new highs or new lows are reached. Congestion area, the area between buy and sell signalsa time of market indecision concerning its trend.
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Point and Figure Charts, II.

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Point and Figure Charts, III.

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Chart Formations
Once a chart is drawn, technical analysts examine it for various formations or pattern types in an attempt to predict stock price or market direction. One example is the head-and-shoulders formation.
When the stock price pierces the neckline after the right shoulder is finished, it is time to sell.

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Chart Formations, The Head and Shoulders

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Other Technical Indicators

The odd-lot indicator looks at whether odd-lot purchases are up or down. Followers of the hemline indicator claim that hemlines tend to rise in good times.

The Super Bowl indicator forecasts the direction of the market based on who wins the game.
Two Conference representatives play in the Super Bowl: one from the National Football Conference and one from the American Football Conference. A win by the National Football Conference (or one of the original members of the National Football League) is bullish.

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Market Efficiency
The Efficient Market Hypothesis (EMH) is a theory that asserts: As a practical matter, the major financial markets reflect all relevant information at a given time. Market efficiency research examines the relationship between stock prices and available information.
The important research question: Is it possible for investors to beat the market? Prediction of the EMH theory: If a market is efficient, it is not possible to beat the market (except by luck).

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What Does Beat the Market Mean?

The excess return on an investment is the return in excess of that earned by other investments that have the same risk. Beating the market means consistently earning a positive excess return.

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Forms of Market Efficiency, (i.e., What Information is Used?)

A Weak-form Efficient Market is one in which past prices and volume figures are of no use in beating the market.
If so, then technical analysis is of little use.

A Semistrong-form Efficient Market is one in which publicly available information is of no use in beating the market.
If so, then fundamental analysis is of little use.

A Strong-form Efficient Market is one in which information of any kind, public or private, is of no use in beating the market.
If so, then inside information is of little use.

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Why Would a Market be Efficient?

The driving force toward market efficiency is simply competition and the profit motive. Even a relatively small performance enhancement can be worth a tremendous amount of money (when multiplied by the dollar amount involved). This creates incentives to unearth relevant information and use it.

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Are Financial Markets Efficient?

Market efficiency is difficult to test.

There are four basic reasons for this:

The risk-adjustment problem The relevant information problem The dumb luck problem The data snooping problem.

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Are Financial Markets Efficient?

Nevertheless, three generalities about market efficiency can be made:
Short-term stock price and market movements appear to be difficult to predict with any accuracy. The market reacts quickly and sharply to new information, and various studies find little or no evidence that such reactions can be profitably exploited. If the stock market can be beaten, the way to do so is not obvious.

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Some Implications if Markets are Efficient

Security selection becomes less important, because securities will be fairly priced. There will be a small role for professional money managers. It makes little sense to time the market.

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Stock Price Behavior and Market Efficiency

The day-of-the-week effect refers to the tendency for Monday to have a negative average return.

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The Amazing January Effect, I.

The January effect refers to the tendency for small stocks to have large returns in January. Does it exist for the S&P 500?

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The Amazing January Effect, II.

The January effect refers to the tendency for small stocks to have large returns in January. What do we see when we look at returns on small stocks?

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The Market Crash in October 1987

On October 19, 1987 (Black Monday), the Dow plummeted 500 points to 1,700.
Investors lost about $500 billion in share value. The market lost over 20% of its value. The volume was a record at the time: 600 million shares.

Today the NYSE has circuit breakers.

Rules that kick in to slow or stop trading when the DJIA decreases (or increases) by more than a pre-set amount in a trading session.

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The Performance of Professional Money Managers

From 1963 to 1998, the S&P 500 index outperformed general equity mutual funds 22 times (out of 36). Why cant the pros beat the averages? (You can hold a market average very easilySPDRs)

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Useful Internet Sites

Technical Analysis Websites:
Dow Theory: Glossary of terms: Drawing charts: www.thedowtheory.com www.e-analytics.com www.stockcharts.com www.bigcharts.com http://finance.yahoo.com www.prophet.net www.stockta.com www.chartpatterns.com

Charts and other indicators:

Chart patterns:

Market Efficiency: Is astrology useful? (ed. No.) www.afund.com

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Chapter Review, I.
Technical Analysis
Dow Theory Support and Resistance Levels Technical Indicators Charting
Relative Strength Moving Average Hi-Lo-Close and Candlestick Point-and-Figure

Chart Formations Other Technical Indicators

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Chapter Review, II.

Market Efficiency
What Does Beat the Market Mean? Forms of Market Efficiency Why would a Market be Efficient? Are Financial Markets Efficient? Some Implications of Market Efficiency

Stock Price Behavior and Market Efficiency

The Day-of-the-Week Effect The Amazing January Effect The October 1987 Crash Performance of Professional Money Managers

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