Market Efficiency Essay

Open, View, and/or
Download this Document

Total Length: 2059 words ( 7 double-spaced pages)

Total Sources: 6

Page 1 of 7

Excess Stock Returns

The author of this report has been charged with doing a brief literature review and then answering two basic questions. The first question is whether the empirical evidence available leads to a predictability of stock returns using technical analysis. The second question asks the author to critically evaluate whether return predictability is a good indicator and test of market efficiency. While some people can get rich in the nastiest and most volatile economic climates, there is generally a correlation between how well the market tends to be and how well returns tend to be during the same time period, based on the totality of the evidence reviewed in this report.

Asness weighs in on the two questions to be answered in a fairly textbook way. Asness et al. (2013) asserts that there is a "value" effect whereby the long-term view of an investment is compared to its current value. Concurrently, there is a shorter-term effected all the "momentum" effect that would tend to indicate what will happen in the near-term. It is also noted that these ratios are typically looked at separately rather than concurrently. One interesting assertion in the Asness text is that they say that there are only modest links between some macroeconomic variables as compared to others. For example, the business cycle, consumption and default risk are not seen as having correlations but this is not true with negative liquidity and a few others. In other words, assessing potential returns is about keying in on the right variables and disregarding others. Regardless, the ostensibly common practice of looking at short-term and long-term returns in a vacuum, rather than together, is less than wise (Asness, Moskowitz & Pedersen, 2013).

The words of Johnson (2002) are quite similar in that he notes that there is sometimes an under-reaction by the market as compared to the details of a particular firm and the excess returns it has or could offer. The "nut" of Johnson's treatise is summarized when he says "the case for rational momentum efforts is not hopeless, however." He continues by saying "the key to the model is stochastic expected growth rates." He rounds out what he says by saying that growth rates and expected returns are positive correlated. This does not mean that mega-returns cannot be found when the common economic indicators are sour. However, the chances of this happening are decidedly less than they would be if the underpinning economic systems were in better shape (Johnson, 2002).

When it comes to efficient markets, Kim, Shamsuddin and Lim (2011) speak on the efficient market hypothesis (EMH). The hypothesis basically states that all of the needed and relevant information about a firm and its ability to make high profits and offer high returns is out there for the finding. Thus, this makes getting higher returns a lot more difficult to impossible as there is no "secret" information or missing information that can be fettered out or guessed. This was asserted two generations before Kim et al. And has found by other researchers to be widely non-credible. For example, analysts and traders jockey and pay good money for information all the time. Some get lucky, some do not and some just know things that others do not, for whatever reason. Grossman and Siglitz (1980) are cited by Kim as saying that a perfectly inefficient market is not possible. However, relative efficiency would be a better opinion as the market generally jives with the returns from that market. However, there will always be outliers in terms of information being completely present and overall performance. Some firms just do well even if the wider market or economy is in the doldrums and the same is true in reverse. The reasons for this vary but this is true nonetheless. When it comes to the market's performance and overall returns from that market generally correlating, Kim points to the work of Lo (2004), among others (Kim, Shamsuddin & Lim, 2011).

The work of Fama (1997) points to the idea of how stock and other markets react to information as it comes out in the news and such. Fama notes that short-term reactions to news, if they even happen, are usually short-lived and truncated in nature. Fama notes that markets tend to over-react to information. However, there will tend to be both under-reaction and over-reaction in the grand scheme of things. These under-reactions and over-reactions will tend to cancel each other out and the returns garnered for any given investment will tend to match the overall market conditions.

Stuck Writing Your "Market Efficiency" Essay?

View All Our Example Market Efficiency Essay

Have A Custom Example Essay Written

This is not to say that people cannot exploit a quick price spike or dip. However, it is exceedingly hard to do this unless one knows what is coming in advance and that is generally impossible, not to mention illegal. One problem with a lot of the tests of this subject, at least in the view of Fama, is that there are not a lot of tests that look to the opposite of market efficiency. Indeed, market inefficiency is often not what is looked at as it relates to an outcome. The reason for this is probably due to the fact that, as stated by Fama, such a perspective requires that once "specify biases in information processing that cause the same investors to under-react to some types of events and over-react to others." In other words, it would be hard to pin down why investors react differently and/or reap returns that are different from what the market typically suggests or dictates and why this ends up being the case. This is a much taller order than figuring out whether returns and the market conditions are in sync. Of course, the market and the associated returns do tend to be in sync more often (if not much more often) than they are not. Further, Fama points to the work of DeBondt and Thaler (1985) who found that prior winners are not necessarily future winners. Indeed, the opposite is the case when looking at windows as short as two to five years. There seems to be a protracted reaction to earnings and other metrics. However, the window of time over which those reactions occur seems to be constricting. The Fama treatise points to that window being about a year in 1980 but it has since shortened to three to six months. Even with the outlier reactions, Fama seems to generally support market efficiency as the general way that things can and should work (Fama, 1998).

The final article reviewed for this report is the work of the aforementioned De Bondt and Thaler as defined and covered in their 1989 work about means (averages) and Wall Street. The duo points out that economics is its own bird when it comes to social sciences as it is grounded in reacting and behaving in a certain way given a totality of the facts. Further, it is asserted that the financial markets are so efficient that the values of firms as stated in the books and in the minds of investors happens to match perfectly to the "intrinsic" values of the companies. Indeed, a thorough review of Dow Jones stock prices in the late 1950's and early 1960's found that there was a strong correlation among thirty stocks when it came to daily fluctuations. However, the authors of that study also held that the amount of the fluctuations was exceedingly small and insignificant so those results perhaps did not mean much. Even so, short-term returns do vary from long-term patterns and they also differ, at least in some ways, from what the news about the firm would seem to suggest.

Analysis

The author will now answer the questions asked for this assignment based on the analysis of the sources used as compared to what the author of this report would otherwise surmise and gather based on what is known about the markets and how they operate. Regarding technical analysis leading to excess stock returns, it would seem that there is not really a reliable way to fetter out excess stock returns based on regular analysis alone. There are so many factors that are not really stated all that much in these works that could lead to a shift in performance over time. The author of this report personally remembers the travails of Netflix when they started to raise prices on DVD and Blu-Ray rentals. They caught holy Hell for doing that even though the price hike was a few dollars a month. Their stock price probably took a hit at the time. However, the people that were investing (or not investing) in Netflix surely at least wondered what their long-term strategy was and why they would do that. Those that just looked at the dollars and cents and perhaps only looked at how customers would revolt and leave Netflix might surmise that Netflix would start to fall and fail. However, the evidence since then suggests that Netflix was trying to wean people off of physical discs and nudge them….....

Show More ⇣

     Open the full completed essay and source list


OR

     Order a one-of-a-kind custom essay on this topic


Related Essays

United States Markets Essay

Essay Prompt Consider the following. The theory of market efficiency is based on the premise that a market is considered efficient when stock prices are an actual reflection of information known about a company. U.S. markets are generally viewed as semi-strong form market efficient. What would happen if U.S. markets became less efficient? What might lead to markets becoming less efficient? How do markets in other countries compare to the U.S. in terms of efficiency?   The efficient market hypothesis is based on the idea that a market is regarded efficient when stock prices are the true reflection… Continue Reading...

Globalisation and Business Cultures and Practices

notably North America and Europe, rely on these guidelines to ensure the stability of their financial system. The guidelines have remarkably driven financial market efficiency across the globe. The increased uniformity of business practices is not restricted to the financial industry. The modern global manufacturing industry is now heavily influenced by practices that originated in Japan. Management practices based on models such as total quality management (TQM) and lean principles are now popular across the globe. This uniformity of business practices may not have been achieved without globalisation. Global interconnectedness in terms of economic activities often implies that events occurring in one part of the globe can quickly spread other parts of the… Continue Reading...

sample essay writing service

Cite This Resource:

Latest APA Format (6th edition)

Copy Reference
"Market Efficiency" (2015, March 05) Retrieved May 18, 2024, from
https://www.aceyourpaper.com/essays/market-efficiency-2149818

Latest MLA Format (8th edition)

Copy Reference
"Market Efficiency" 05 March 2015. Web.18 May. 2024. <
https://www.aceyourpaper.com/essays/market-efficiency-2149818>

Latest Chicago Format (16th edition)

Copy Reference
"Market Efficiency", 05 March 2015, Accessed.18 May. 2024,
https://www.aceyourpaper.com/essays/market-efficiency-2149818
   

Open, View, and/or
Download this Document
order custom essay example