Theories of nonrandom price motion

EMH
Theories of Nonrandom
Price Motion

Price Motion

The Efficient Markets Hypothesis
1.Weak-form efficiency
• Prices of the securities instantly and fully reflect all information of the past
prices. This means future price movements cannot be predicted by using past
prices. (and price-related data, like volume)
2.Semi-strong efficiency
• Asset prices fully reflect all of the publicly available information. Therefore, only
investors with additional inside information could have advantage on the
market.
3.Strong-form efficiency
• Asset prices fully reflect all of the public and inside information available.
Therefore, no one can have advantage on the market in predicting prices since
there is no data that would provide any additional value to the investors.

What Is an Efficient Market?
• An efficient market is a market that cannot be beaten. In such a
market, no fundamental or technical analysis strategy, formula, or
system can earn a risk-adjusted rate of return that beats the market
defined by a benchmark index.
• Prices in an efficient market properly reflect all known and knowable
information.
• Therefore, the current price provides the best estimate of each
security's value.
• According to EMH investors are constantly updating their beliefs with
the latest information in a probabilistically correct manner , so as to
project each security's future cash flows.

What Is an Efficient Market?
• Prices change only when new information arrives. When it does,
prices change almost instantly to a new rational price that properly
reflects the news.
• Prices do not gradually trend from one rational price level to the
next, giving the trend analyst a chance to get on board.
• If the news is favorable, prices rise, and if it's unfavorable, prices fall.
• It is not predictable whether the news will be favorable or
unfavorable (it wouldn't be news if it was), price changes will be
unpredictable as well.
• Efficient market’s response to positive and negative news on time
versus price with plots for negative news event and rational price.

The Consequences of Market Efficiency: Good and Bad
• Market efficiency has good and bad implications. They are good for the economy as a
whole but bad— very bad—for TA.
• Efficient market are unpredictable rendering all forms of TA useless
• According to Paul Samuelson, financial market prices follow a random walk because
of the actions of many intelligent/rational investors.
• To maximize wealth, they buy undervalued assets pushing their prices higher and sell
overvalued assets pushing prices lower
• “EMH rules out the possibility of trading systems, based on available information,
that have expected profits or returns in excess of equilibrium expected profit or
return

The Consequences of Market Efficiency: Good and Bad
• The efficient markets hypothesis also declares that when there is no news
entering the market, prices tend to oscillate in a random and unbiased fashion
above and below the rational price level.
• Subject to uncertainty, no technical or fundamental indicator can reliably
indicate when prices are above or below it.
• Graph shows efficient market’s hypothesis for random and unbiased pricing
errors on time versus price with plots rational price.

Myths of EMH
• EMH claims that investors cannot outperform the market
• EMH claims that financial analysis is pointless and investors who
attempt to research security prices are wasting their time.
• EMH claims that new information is always fully reflected in market
prices.
• EMH presumes that all investors have to be informed, skilled, and
able to constantly analyze the flow of new information.

The Evidence in Favor of EMH
• The weak form of market efficiency
• The random walk hypothesis implies that successive price
movements should be independent.
• A number of studies have attempted to test this hypothesis by
examining the correlation between the current return on a security
and the return on the same security over a previous period.
• The Semi-strong Form
• The semi-strong form of the EMH is perhaps the most controversial,
and thus, has attracted the most attention.

• If a market is semi-strong form efficient, all publicly available information is
reflected in the stock price.
• It implies that investors should not be able to profit consistently by trading on
publicly available information.
• Strong Form of Market Efficiency
• The Strong Form Empirical tests of the strong-form version of the efficient
markets hypothesis have typically focused on the profitability of insider trading.
• If the strong-form efficiency hypothesis is correct, then insiders should not be
able to profit by trading on their private information.

Efficient Market Response to Bullish News
Overreaction to Bullish News (Implies
Nonrandom Price Movements).
Under reaction to News Can Explain Nonrandom Trends.

Challenging EMH
• A good theory is consistent in two ways.
1) Its logic is internally consistent.
2) It is consistent with observed evidence.
• The Smart versus Dumb Paradox :
• One implication of market efficiency is that knowledgeable investors should not
be able to earn higher returns than investors who are less knowledgeable.
• This follows from the premise that market efficiency means that whatever
information is known or knowable has already been reflected in security prices.
• In an efficient market, there is no competitive advantage to being smart or
disadvantage to being dumb.

Challenging EMH
• The Cost of Information Paradox
• It is reasonable to assume that it costs time, money, and intelligence to gather
information and process it into useful investing strategies.
• At the same time EMH contends that such information cannot earn incremental
returns for investors who incur these costs.
• Remember, EMH contends that information is instantly reflected in prices.
• This implies that no matter how wide or deep the research effort, whatever is
discovered will be of no value.

The Assumptions of EMH
(1) investors are rational,
(2) investors' pricing errors are random, and
(3) there are always rational arbitrage investors to catch
any pricing errors.

Flaws in EMH Assumptions
• Investors Are Rational
• Investors who follow the advice of financial gurus who base their advice on noise
signals are noise traders
• investors are guilty of numerous departures from rationality. For example, they fail to
diversify, they trade too actively, they increase their tax liabilities by selling
appreciated stocks but hold onto losing positions, and they trade mutual funds with
high fees.
• “Investors' deviations from the maxims of economic rationality turn out to be highly
pervasive and systematic.”
• Investors typically do not assess risks in conformity with the normative ideal put
forward by Neumann and Morgenstern, known as “expected utility theory.”
• Research has shown that investors make numerous systematic errors when assessing
risks and making choices.
• Prospect Theory, which was proposed by Kahneman and Tversky (1979).It explains
how people actually make decisions under conditions of uncertainty.

• Investors Are Rational
• investors depart from the rational ideal of EMH is in their judgments of
probability. EMH assumes that, as investors receive new information, they
update their probability assessments in accordance with Bayes' theorem, a
formula for combining probabilities in a theoretically correct way.
• One common error is the crime of small numbers—drawing grand conclusions
from small samples of data.
• investors' decisions can be strongly impacted by how choices are described
(framed).
• when the same choices are framed in terms of potential losses, investors will
assume the risk of a very significant loss just to avoid the certainty of a small
loss. This error, called the “disposition effect,”

• Investor Errors Are Uncorrelated
• psychological research which shows people do not deviate from rationality
randomly in situations characterized by uncertainty.
• people tend to make similar mistakes in such situations and hence their
deviations from rationality are correlated.
• Many investors will be tempted to buy the same stock because the stock
appeals to a common heuristic rule of judgment that makes it look like a
candidate for further appreciation.
• This problem is made worse by social interactions, or herding, between
investors. “They follow each other's mistakes listening to rumors and imitating
the actions of their fellow traders.”
• Professional money managers also engage in imitative behavior and move
herd-like into the same stocks, for fear of falling behind the pack

• Arbitrage Forces Prices to Rational Levels
• No one rings a bell when securities become mispriced. The rational price is the discounted value of a
stream of future cash flows, which is, by definition, uncertain. Investors try to estimate future
earnings, but their forecasts are prone to significant error.
• Arbitrageurs do not have unlimited tolerance for adverse price movement—for example, when an
underpriced stock that has been purchased continues to go lower, or an overpriced security that has
been sold short continues to soar. The actions of noise traders can easily push prices further away
from rational levels before they return to them
• Improper use of leverage is yet another factor that can impair the role arbitrage plays in driving
markets to efficiency.
• Constraint on an arbitrage's ability to enforce efficient pricing is the lack of perfect substitute
securities.
• Arbitrageurs do not have unlimited funds to correct pricing errors nor do they have total freedom to
pursue any and all opportunities.

Empirical Challenges to EMH
•Excessive Price Volatility
• studies show prices are far more volatile than fundamentals
• EMH also predicts that large price changes should occur only when significant
new information enters the market. The evidence does not agree.
• Evidence of Price Predictability with Stale Information
• The evidence most damning to EMH are studies showing that price movements
can be predicted to a meaningful degree with publicly known (stale)
information
• Strategies based on stale information can generate risk-adjusted returns that
beat the market. If it were true that prices quickly incorporate all known
information, as EMH asserts, this should not be possible

How Cross-Sectional Predictability Studies Are Performed
• These studies measure the degree to which indicators based on public information
are able to forecast the relative performance of stocks.
• Indicators tested included a stock's price-to-earnings ratio, its price-to-book-value
ratio, its recent relative price performance
• Predictability studies employ a cross-sectional design
• the stocks are ranked on the basis of an indicator that is being examined for its
predictive power, such as a stock's rate of return over the past six months
• Portfolio 1 would contain the top 10 percent of all stocks ranked by their prior six-
month rate of return. That is to say, the portfolio is composed of those stocks whose
prior six-month rate of return was in greater than the ninetieth percentile.
• A second portfolio is formed containing stocks ranked from the eightieth percentile to
the eighty-ninth percentile, and so on until a final portfolio is formed from the 10
percent of stocks with the worst prior six-month performance.

How Cross-Sectional Predictability Studies Are Performed
•
Studies quantify the indicator's predictive power
as the return earned by a long portfolio versus a
short portfolio. In other words, a long position is
assumed to be taken in all portfolio 1 stocks and a
short position in all portfolio 10 stocks
Flow chart shows cross-sectional study
with universe N stocks leading to N
stocks ranked by PE, 10 ranked
portfolios formed, and future
performance differential.

Predictability Studies Contradicting Semistrong EMH
• The semistrong form of EMH is the boldest testable version of EMH , no
information in the public domain, fundamental or technical, can be used to
generate risk-adjusted returns in excess of the market index.
• Cross-sectional time series studies is this: Price movements are predictable to
some degree with stale public information, and excess risk adjusted returns are
possible.
- Small capitalization effect
- Price-to-earnings ratio effect
- Price-to-book-value effect
- Earnings surprise with technical confirmation

Predictability Studies Contradicting the Weak Form of EMH
• The weak form of EMH is the least bold version of the theory. It claims that only
a subset of public information, past prices, and price returns is unhelpful in
earning excess returns
• Momentum persistence : A strategy of holding long positions in stocks with the
highest returns over the prior 6 months (top decile) and holding short positions
in stocks with the worst performance
• Momentum reversal : Strong trends measured over the prior three to five
years display a tendency to reverse.
• Non reversing momentum : speculates that investors become mentally
anchored to prior 52-week price highs. Anchoring is known to prevent people
from making appropriate adjustments to new information.
• Momentum confirmed by trading volume : A synergism can be attained by
combining price and volume indicators. The return of the combination is 2 to 7
percent higher than the return can be earned using price momentum alone

Behavioral Finance-
Price Motion

Behavioral Finance
• Behavioral finance incorporates elements of cognitive psychology, economics,
and sociology to explain why investors depart from full rationality and therefore
why markets depart from full efficiency.
• the impact of emotions, cognitive errors, irrational preferences, and the
dynamics of group behavior, behavioral finance offers succinct explanations of
excess market volatility as well as the excess returns earned by stale
information strategies.
• Behavioral finance does not assume that all investors are irrational. Rather, it
views the market as a mixture of decision makers who vary in their degree of
rationality.

Foundation of Behavioral Finance
• Limits of Arbitrage : Arbitrage is not the perfect enforcer of efficient pricing that
EMH assumes. The lack of perfect security substitutes turns arbitrage from a risk-free,
no-investment-required transaction into one that requires capital and incurs risk.
• Limits of Human Rationality : Cognitive psychology has revealed that, under
conditions of uncertainty, human judgment tends to error in predictable (systematic)
ways.
• By taking into account the systematic errors of human judgment, behavioral finance
can predict the type of departure from market efficiencies that are most likely to
occur in a given set of circumstances.
• More is understood about the limits of arbitrage than about investor irrationality.
This is because arbitrageurs are expected to be rational, and economic theory has a
firmer grasp on the behavior of rational actors than irrational ones.

Coverage of Behavioral Finance
Psychological Factors
Conservatism Bias,
Confirmation Bias,
and Belief Inertia
Too Much Anchoring
and Too Little
Adjustment
Anchoring to Stories
Optimism and
Overconfidence
The Crime of Small
Numbers (Sample
Size Neglect)
Social Factors:
Imitative Behavior,
Herding, and
Information Cascades
Information Cascades
and Herd Behavior
The Diffusion of
Information Among
Investors

• Psychological Factors : Cognitive errors impact subjective technicians and result
in erroneous beliefs.
• Conservatism Bias : The conservatism bias is the tendency to give too little
weight to new information. Investors tend to underreact to new information
that is relevant to security values and so security prices fail to respond
adequately
• Confirmation bias : occurs from the direct influence of desire on beliefs. When
people would like a certain idea/concept to be true, they end up believing it to
be true. They are motivated by wishful thinking. This error leads the individual
to stop gathering information when the evidence gathered so far confirms the
views (prejudices) one would like to be true.

• Psychological Factors : Cognitive errors impact subjective technicians and result
in erroneous beliefs.
• Conservatism Bias : The conservatism bias is the tendency to give too little
weight to new information. Investors tend to underreact to new information
that is relevant to security values and so security prices fail to respond
adequately
• Confirmation bias : Occurs from the direct influence of desire on beliefs. When
people would like a certain idea/concept to be true, they end up believing it to
be true. They are motivated by wishful thinking. This error leads the individual
to stop gathering information when the evidence gathered so far confirms the
views (prejudices) one would like to be true.

Belief Inertia
- Revising beliefs on time versus
confirmatory news and
contradictory news with plots
for strong, belief strength, and
weak, confirmatory bias and
conversation bias and crime of
small numbers.
- Prior beliefs can be subject to a
radical and irrational weakening
if several bits of contradictory
information arrive in a streak.

Too Much Anchoring and Too Little Adjustment
- People rely on heuristics to simplify and speed complex cognitive tasks like
estimating probabilities. One heuristic, not discussed thus far, is called
anchoring.
- The rule is applied as follows: An initial estimate of the quantity is made,
based on preliminary information called the anchor.
- Then upward or downward adjustments are made to the initial estimate
based on additional information.
- People commonly make two mistakes when applying this heuristic.
- First, initial estimates can be strongly influenced by a completely irrelevant
anchor. This occurs even when the anchor's irrelevance is completely
obvious.
- Second, even in cases where the initial estimate is based on relevant
anchoring information, there is a tendency for subsequent adjustments up
or down to be too small (the conservatism bias).

Too Much Anchoring and Too Little Adjustment
- The anchoring heuristic is thought to be related to investor under
reaction.
- Under reactions to bullish news cause asset prices to remain too
cheap,
- whereas under reactions to bearish news leave prices too dear.
- Over time, the market's temporary state of inefficiency is resolved
as prices drift (trend) to the rational level.
- Thus, anchoring can help explain the occurrence of price trends.

Anchoring to Stories
- Investors not only become anchored to numbers, they can get
stuck on intuitively compelling stories, too.
- The effect is the same; prices do not respond efficiently to new
information and thus depart from rational valuations.
- Stories are compelling because “much of human thinking that
results in action is not quantitative, but instead takes the form of
storytelling and justification”
- Investors rely more on causal narratives than on weighing and
combining evidence to estimate probabilities and make decisions

Optimism and Overconfidence
- To recap, people are generally too confident about the quality
and precision of their knowledge.
- Investors tend to be overconfident about their private
interpretations of public information and overly optimistic about
the profits they will achieve.
- The combined effect of overconfidence and over-optimism leads
investors to overreact to their private information, and in turn
pushes security prices too far.
- Overextended price movements lead to price reversals and
systematic movements back toward rational levels.

The Crime of Small Numbers (Sample Size Neglect)
- The crime of small numbers is the failure to consider the number of
observations comprising a sample being used to form a conclusion.
- For example, if a sequence of 10 coin flips produces 7 heads, it would be invalid
to conclude the coin has a 0.7 probability of producing heads. The true head
rate for a coin can be reliably inferred from only a large number of flips.
- The crime of small numbers can cause two different judgment errors:
- the gambler's fallacy : the occurrence of a positive streak does not alter the
probability of the next outcome in any way. The false expectation of a reversal is
called the “gambler's fallacy”
- the clustering illusion: The clustering illusion is the misperception of order (non
randomness) in data that is actually a random walk. It occurs when an observer
has no prior belief about whether the process generating the data is random or
nonrandom

Social Factors: Imitative Behavior, Herding, and Information Cascades
- When faced with uncertain choices, people often to look to the behavior of
others for cues and imitate their actions.
- I should clarify that herd behavior is not defined by similarity of action.
- Similar actions by many individuals can also occur when individuals have made
similar choices but those choices have been arrived at independently.
- Herd behavior refers specifically to similarity of action arising from imitation.
- Herd behavior stops the diffusion of information throughout a group, but
independent decision making does not.
- When information diffusion is impeded, it becomes more likely that investors
will make the same mistakes and prices will systematically diverge from rational
levels.

Why Do We Imitate?
- Imitative behavior was a consequence of social pressure to conform
- social heuristic: When one's own judgment is contradicted by the majority,
follow the majority.
- people operate with an implicit rule: The majority is unlikely to be wrong.
- “This behavior is a matter of rational calculation: in everyday living we have
learned that when a large group of people is unanimous in its judgment on a
question of simple fact, the members of the group are almost certainly right.”
- Information Cascades and Herd Behavior
- An information cascade is a chain of imitative behavior that was initiated by the
action of one or just a few individuals. In some instances that initiating action
may have been a random choice.
- Information cascade, investors make the rational choice of copying the actions
of others, rather than expending the considerable effort required to arrive at an
independent choice.

Shifts in Investor Attention
- Where investors are focusing their attention at any given moment can shift
dramatically due to minor changes in the news.
- “The human brain is structured to have essentially a single focus of attention at
a time and to move rapidly from one focus to another.”
- automatic unconscious rules used by the brain to filter relevant from irrelevant
information is the rule to look to other people for cues.
- we presume that what grabs the attention of others must be worthy of our
attention as well.
- communal attention has great social value, because it promotes collaborative
action, it has a downside.
- It can lead an entire group to hold an incorrect view and take similar mistaken
actions.

The Role of Feedback in Systematic Price Movements
- Social interaction among investors
creates feedback.
- Feedback refers to the channeling
of a system's output back into the
system as input.
- Feedback output becomes input
with external input leading to
system with no feedback leading to
output and interrupt with feedback
loop.

- Two types of feedback, positive and
negative.
- In the case of negative feedback,
the system output is multiplied by a
negative number and the result is
feedback in.
- In the case of positive feedback the
multiplier is a positive number.
- Flowchart shows positive and
negative feedback loops with
external input leading to system
leading to output and interrupted
with negative feedback loop.

- Negative feedback has the effect of dampening
system behavior, driving the output back toward a
level of equilibrium.
- Positive feedback has the opposite effect, amplifying
a system's behavior, thus driving its output further
from equilibrium.
- Negative feedback system is a household heating & air
conditioning system.
- When the temperature falls below a desired or
equilibrium level, the thermostat turns on the
furnace, returning the system's output, the household
temperature, back to the desired level.
- Positive feedback is illustrated by the growing screech
in a public-address system when the speakers are
placed too close to the microphone.
- With each cycle, the sound comes out louder,
developing into a loud screech. Positive feedback is
also known as the snowball effect or vicious cycle.

Biased Interpretation of Public Information: The Barberis, Shleifer, and Vishny
(BSV) Hypothesis
- Why do investors sometimes overreact
while at other times they underreact?
- First, BSV asserts that two distinct
cognitive errors are involved:
conservatism bias and sample-size
neglect.
- Second, they assert that the particular
error that is operative at a given point
in time depends on circumstances.
- The conservatism bias is at work when
investors underreact to news, leaving
prices too low after good news or too
high after bad news.
- The crime of small numbers explains
investor overreaction.

Biased Interpretation of Private Information: The Daniel, Hirshleifer, and
Subrahmanyam (DHS) Hypothesis
- the DHS hypothesis is founded upon investors' biased interpretations of private
research. In addition, DHS emphasizes somewhat different cognitive errors: the
endowment bias, the confirmation bias, and the self-attribution bias.
- Private research refers to an investor's independently derived interpretations of
public information (i.e., proprietary research).
- price reversals are an effect of overconfidence in privately derived signals
- DHS also explains price momentum (nonrandom price trends) as the result of
two other cognitive biases: confirmation bias and self-attribution bias.
- Conversely, if public information or price behavior contradicts the investor's
private research, it will be given too little weight (confirmation bias) and
investors will attribute it to bad luck rather than to poor private research (self-
attribution bias).

News Traders and Momentum Traders: The HS Hypothesis
- The hypothesis proposed by Hong and Stein91(HS) explains three market
phenomena: momentum, under reaction, and overreaction.
- The HS hypothesis asserts that an interaction between these two classes of investors
creates positive feedback and, therefore, price momentum
- News watchers confine their attention to fundamental developments. On the basis of
this information, they derive private estimates of future returns.
- In contrast, momentum traders confine their attention to past price changes and
derive their private forecast of future trends.
- The HS hypothesis claims that momentum traders only pay attention to signals from
price behavior.
- The overshooting occurs because momentum traders are unable to judge the extent
to which the news has been diffused and understood by all investors.
- HS assert that the overshooting of rational price levels, resulting from the positive
feedback of momentum traders, sets up the conditions for a trend reversal back
toward rational levels based on fundamentals.

How Systematic Price Motion and Market Efficiency Can Coexist
- In financial market terms, compensation for accepting increased risk is called a
risk premium or economic rent.
- Financial markets offer several kinds of risk premiums
- The equity market risk premium
- Commodity and currency hedge risk transfer premium
- Liquidity premium
- Information or price discovery premium for promoting market efficiency
- The good news about returns that come in the form of a risk premium is that
they are more likely to endure into the future
- it is every analyst's dream to discover true market inefficiencies because the
returns earned from them do not entail additional risk

How Systematic Price Motion and Market Efficiency Can Coexist
How do risk premiums explain the existence of systematic price movements?
- Such price movements can provide a mechanism for risk-accepting investors to
be compensated. The investor who is willing to provide liquidity to a
stockholder with a strong desire to sell winds up buying stocks that have a
systematic tendency to rise over the near term. These stocks can be identified
with countertrend strategies
- In the context of efficient markets, the profits-earned by TA strategies may be
understood as risk premiums; compensation for the beneficial effect the
strategy confers on other investors or the market as a whole.

Hedge Risk Premium and the Gains to Trend-Following Commodity Futures
The commodities futures markets perform an economic function that is
fundamentally different from the stock and bond markets.
The stock and bond markets provide companies with a mechanism to obtain
equity and debt financingand provide investors with a way to invest their capital.
The economic function of the futures markets has nothing to do with raising
capital and everything to do with price risk.
The futures markets provide a means by which these businesses, called
commercial hedgers, can transfer price risk to investors (speculators).

The Mt. Lucas Management Index of Trend Following Returns
The risk premium earned by commodity trend
followers has been quantified with the creation
of a benchmark index called the Mt. Lucas
Management Index (MLM)
The risk-adjusted returns earned by the MLM
index suggest that commodity futures markets
contain systematic price movements that can
be exploited with relatively simple TA methods.
The annualized return and risk, as measured by
the standard deviation in annual returns, of the
MLM index is compared with returns and risks
of several other asset-class benchmarks
The MLM index provides some evidence that
the futures markets offer compensation in the
form of systematic price movements.

Liquidity Premium and the Gains to Counter Trend Trading in Stocks
• Michael Cooper shows that buyers of oversold stocks can earn above-average short-
term returns.
• Study shows that stocks that have displayed negative price momentum on declining
trading volume earn excess returns.
• The pattern identifies stocks with distressed sellers in search of buyers. The excess
returns appear to be a liquidity premium.
• Stocks that have declined sharply over the prior two weeks on declining volume
display a systematic tendency to rise over the following week.
• “risk adopter for hire by hedgers,” or “desperately seeking liquidity provider—will
pay.” TA traders profiting from these signals are not getting a free lunch. They are
simply reading the market's Help Wanted advertisements.

Theories of nonrandom price motion

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