Technical Analysis of the Financial Markets_6

62 The Stock Market To explain this, we need to ask what investors expected the change in the unemployment rate to be in both instances. Suppose that prior to the first announcement market participants expected no change in the unemployment rate. Then the news to financial market participants was that the economy was doing better than expected. This may translate into greater expected future earnings and stock prices rise. Suppose, however, that prior to the second announcement, investors expected the un-employment rate to fall. If the announced decline is more than expected, the news to financial market participants is that the economy may be weaker than anticipated. This may generate revised expectations of future earnings, and stock prices fall. What the government told everyone about the economy was the same in both instances but the announced change in the unemployment rate was dif-ferent from what the market expected. Viewed in this light, it is only natural to expect the stock market to behave differently even though the same in-formation was provided. THE ROLE OF EXPECTATIONS The efficient markets view highlights the importance of expectations in explaining stock price changes over time. The basic principle is that what is expected by market participants is largely embedded in current stock prices. For example, if everyone expects that a company will announce very strong earnings for the next year, market participants act upon what is expected and price this into the current stock price. If the company then announces strong earnings, as expected, the efficient market hypothesis predicts that the stock price will not change when the earnings are announced. If the actual an-nouncement is that earnings actually are expected to drop, this bit of contrary news will cause the stock’s price to fall. Since the announcement went against themarket’sexpectation, thenewinformation caused theprice toreact.What happened was not as expected and the stock price adjusted to the new ex-pectation. To fully understand stock markets, we should always be asking ourselves what is expected, because the market’s expectation is driving observed market prices. This is why the financial press is full of survey information, such as analysts’ forecasts of future company earnings or economists’ forecasts of the unemployment rate and inflation. Stock prices are constantly adjusting as ex-pectations are changing. Besides, not everyone takes the same piece of in-formation and comes up with the same expectation. This difference is what creates buyers and sellers. To keep up with the stock market, we should always be asking ourselves ‘‘what is priced into the market?’’ Knowing what is Today’s Stock Market in Action 63 expected is never easy, but at least our attention is focused in the right direction. China offers a good case study. The Chinese economy has been growing quite rapidly as the Chinese government has slowly allowed more and more of the economy to become market-oriented. The growth rate of the Chinese economy in the early 2000s is as much as three times that of other developed countries in the world. The naıve investor might say that China obviously is a great place to invest because this rapid economic growth will translate into healthy earnings growth. A student of market efficiency would be more cautious, wondering what market participants expect. If market participants expect a continuation of the strong economic growth experienced in recent years, current stock prices already reflect this. In this case, if China grows as expected, investors buying into the market today should not anticipate ex-cessive total returns. Remembering the idea of stock market efficiency might save a little time and agony the next time a broker calls with a great stock tip. Ask the broker why this information, if they already know it, is not priced into the firm’s current stock price. If the broker does not have a good answer, they are prob-ably just trying to sell something and not looking out for your best financial interests. Unless you are convinced that the broker really knows something that is not priced into the market, there is little reason to expect high returns based on such a tip. EVIDENCE OF EFFICIENT MARKETS The notion of efficient markets is simply a theory that predicts how markets should work. Researchers at universities and advisors to brokerage houses spend a great deal of time studying this theory. Some find evidence supporting the theory that is overwhelming and accept it as given. For in-stance, there is a large body of evidence that considers the impact of various surprises on the market. One strand of this analysis examines the impact of monetary policyactions on stock prices.Theefficient market view isthatonly unexpected changes in monetary policy affect stock prices since expected policy actions already are priced into the market. For instance, the evidence indicates that when monetary policy is tightened (interest rates raised) un-expectedly, stock prices often decline. On the other hand, if the change in policy was expected by market participants, stock prices show little response. Such evidence is consistent with the idea of market efficiency. Another piece of evidence supporting efficient markets comes from mu-tual funds. If the efficient markets theory is correct, it is very difficult for someone to consistently ‘‘beat the market’’ as a whole. To do so requires that 64 The Stock Market they consistently know things that others do not. If information flows freely to all, no one investor should have a greater ability to consistently predict the correct movement in stock prices. A testable implication of this view is that mutualfunds thatemploy activemanagers—those who decideon whatstocks the fund should buy (or sell)—should not do better (have higher returns) than funds that merely mimic the market as a whole. Numerous studies have investigated the proposition that mutual fund managers should not consistently do better than the stock market as a whole. Almost without exception such analyses find that active mutual fund man-agers do not consistently beat the market over time. This has led many fi-nancial advisors to suggest that the best way to invest is to simply buy into a stock index mutual fund where the manager simply buys the stocks for the index in proportion to their importance in the market index. Such investing, for example the buying of index funds (see Chapter Three), is recommended due to the fact that the managers are unlikely to consistently beat the market. EVIDENCE AGAINST MARKET EFFICIENCY: BEHAVIORAL FINANCE The vast majority of financial economists subscribe, in one form or an-other, to the efficient markets theory of the stock market. In recent years, however, there is a growing number of financial economists, especially in academia,whoquestionitsvalidity.Perhaps,thebest-knownproponentofthis view is Robert Shiller, author of Irrational Exuberance.1 The main argument by this group is that investors and market participants do not always behave as rationally as predicted by the efficient markets theory. Those that do not believe in efficient markets have some evidence to support their view. Consider the so-called January effect. The January effect refers to the observation that U.S. stock prices, on average, rise in January more than any other month of the year. This means that stock returns also are highest in January relative to any other month of the year. Proponents of the efficient market view argue that stock prices should notbehave anydifferently in January than any other month of the year. After all, even if there are tax effects that make January different from other months, everyone knows when January is going to occur, so it should not be a surprise year in and year out. Those who believe in behavioral finance, however, point to this phenomenon as evidence that markets are not efficient. Another example of something apparently inconsistent with efficient marketsistheperformanceofstockpricesforsmallcompaniesrelativetolarge companies. The theory of efficient markets suggests that an investor should not expect, all else the same, to receive a different return from buying stock in a small company than a large one. If everyone thought small company stock Today’s Stock Market in Action 65 prices would do better than large companies, investors will drive up the stock prices of small companies. Their actions, based on their expectations, would forcetheinvestmentreturnsonsmallandlargecompany’sstockintoequality. The record in the United States indicates just the opposite: The average stock return is higher for small company stocks compared with stocks of larger companies. Someone who believes in behavioral finance might point to this evidence and say ‘‘See, I told you markets are not efficient.’’ Proponents of market efficiency offer a rational explanation. The comparison is not really fair be-causesmallcompanystocksarenotasliquid;thatis,theydonottradeasoften, on average, as the stock of a large corporation. Consequently, small company stocks are usually more difficult to buy and sell. It also is true that small companystockpricesaremorevolatilethanthoseoflargercompanies,sothere is more risk in owning such stocks. And investors must be compensated for this risk. So, the comparison may not be an accurate one. There are other examples of observed stock price activity that are difficult to reconcile with the efficient markets view. A popular one is that the stock market generally has a higher return in years when one of the original NFC teams wins the Super Bowl. This should not happen according to the efficient marketsview:ThisinformationisknownattheconclusionoftheSuperBowl, so it should already be reflected in stock prices at that time. Observations like this are difficult to reconcile with the efficient markets view and may be anomalies. After all, not every theory is correct 100 percent of the time. As you might imagine, the two camps remain divided on how to interpret such anomalies. Behavioral finance offers it as evidence against market efficiency while others offer rational explanations of the anomalies. FUNDAMENTAL VERSUS TECHNICAL ANALYSIS It is important to distinguish between the type of analysis that stock an-alysts relyonwhenselecting stocksthattheythinkwilldo particularlywell(or poorly for that matter). One type of selection process is referred to as fun-damentalanalysis.Fundamentalanalysisfindsitsorigininanareacloselyakin to the efficient markets theory. A fundamental analyst aims at trying to guess thecompany’sforthcomingfinancialstatementsbetterthanotherparticipants in the market. In other words, these analysts are looking to derive a better (more accurate) set of expectations (forecasts) than anyone else in the market. They select stocksthat they thinkwill performbetter than othersexpect based on their forecast of key financial information, such as earnings growth. Mar-ket efficiency says that such analysts should not expect to make it a habit of beating the market, even though they may experience short-term success. 66 The Stock Market The other type of stock analysis is called technical analysis. An advisor who uses such analysis is often referred to as a technician. A technician usually startswithpaststockpricebehaviorandtradingvolume(thenumberofshares being bought and sold on a given day). Technicians believe that they can predict a stock’s future performance from its past behavior and its trading volume. Like those in the behavioral finance camp, technicians do not believe that investors are completely rational. They argue, for example, that investors have a tendency to sell stocks that are ‘‘winners’’ (having risen in price) too early (before they have peaked). Similarly, investors tend to hold stocks that are ‘‘losers’’ (having fallen in price) too long. Technicians believe that past price and volume patterns can identify winners and losers. Of course, since techniciansare only using known availabledata in distinguishing winners and losers, market efficiency proponents argue that investment strategies based on this approach also should not, over time, generate higher investment returns relative to the market. SUMMARY It is useful to put the stock market into a context of today’s investment environment. Some stocks are listed on public exchanges while others, most notably the privately traded stocks, are not. These latter stocks are an im-portant, though often overlooked, aspect of today’s financial system. Private stocks represent an important source of funds for smaller businesses, espe-cially start-up companies. Because these stocks are not bought and sold on exchanges, they are neither as liquid nor are they as widely recognized or discussed, as publicly traded stocks. Stock exchanges, where public stocks are traded, play a vital role in the economic and financial well-being of a country. In the United States, there are three major exchanges, the NYSE, the NASDAQ, and the AMEX. On these exchanges there are thousands of companies listed. To make help un-derstand the general movements of the individual stock prices, broad stock price indexes are used. These include the popular DJIA and the S&P 500. More specialized indexes also exist, including the NASDAQ composite and the various Russell indexes of small firms. Understanding how stock prices are determined—the information used to make buy and sell decision—is important to a successful investor. An over-viewofstockmarketefficiencyprovidesaframeworktounderstandwhystock prices change over time. Basically, this idea is based on the notion that investors gather information about the company and what may affect its business.Thisinformationisusedtoformsomeexpectationofthecompany’s future success, and, from that, a ‘‘correct’’ stock price. Only when there is new ... - tailieumienphi.vn