Efficient Market Hypothesis-EHM

What does efficient Market hypothesis-EHM mean?

Investment hypothesis states that it is impossible to beat the market. As an explanation, this is because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

And according to the EMH, this actually means that stock always trade at their fair value on stock converts. Thus making it hopeless for investors to either purchase depreciated stocks or sell stocks for inflated prices. It should be impossible as such, to outperform the overall market through expert stock selection or market timing. The only way investor can possibly obtain higher returns is by purchasing riskier investments.

Investopedia explains efficient market Hypothesis -EMH Considered to be the cornerstone of modern financial theory, the EMH is still highly controversial and often disputed. It is pointless, believers argue, to search for depreciated stocks or to try to predict trends in the market through either fundamental or technical analysis.

A large body of evidence in support of EMH, has been pointed out by academicians, an equal amount of disagreement also exists. Investors such as Warren Buffett have systematically beaten the market over long periods of time. This by definition is hopeless according to EHM. It also points to events such as the 1987 stock market collapse when the DOW Jones Industrial Average (DJIA) fell by over 20% in a single day. This can serve as evidence that stock prices can severely deviate from their fair value.

Q1

EVALUATE THE CONTRIBUTION CHARLES .H. DOW NICKOLAI KONDRATIEFF AND JOSEPH SCHUMPETER TO GLOBAL FINANCIAL THEORY?

CHARLES .H. DOW

Although Charles .H. Dow Theory from his analysis of market price action in the late 19th century. In Dow’s time, the two averages were the Industrials and the Rails. The logic behind the theory is simple. Industrial companies manufactured the goods and the rails shipped them. When one average recorded a new Secondary or Intermediate high, the other average was required to do the same in order for the signal to be considered valid. If the two averages acted in harmony- with either reaching new highs or lows around the same time period- then the price action of each was said to be confirming.

                        However, if one average went to a new high, while the other was left behind, then there was bearish divergence. If the opposite occurred, with one average reaching a new low while the other held above a previous bottom, then the divergence was bullish.

At present, of course the rails are now the transports. However, Dow Theorists argue that the principle remains valid. As such, they contend that the activity of the Industrials and Transports provides a filter to detect whether the stock market is in a healthy or unhealthy state.

                    Charles Dow had the vision to create the benchmark that would project general market conditions and therefore help investors bewildered by fractional dollar changes. It was a revolutionary idea at the time, but its implementation was simple. The averages were plain old averages. To calculate the first average, Dow added up the Stock prices and divided by 11 – the number of stocks included in the index.

Nicolai Kondratieff:

Although Nicolai Kondratieff believed that the discovered expose a theory that capitalist economies have long term cycles.

A business cycle is emphasis on Industrial’s and commercial organisms’ innovation rather then banking sector most business cycle theories put their emphasis the other way essentially monetary and monetary encomiast her explanation of business cycle

The end of summer primary recession is caused by the cycle peak in interest rates. This recession is one of the four indicators signalling the beginning of the huge autumn stock bull market.

Autumn: Four events occur at the end of summer and anticipate the beginning of autumn:

1. A peak in prices.

2. A peak in interest rates.

3. A bear market in stocks.

4. A primary recession.

JOSEPH SCHUMPETER

Capitalism, Socialism and Democracy is one of the greatest classics in 20th century social science. What makes Schumpeter’s book so brilliant are three things in particular: its novel view of democracy; its hectic analysis of the workings of the capitalist economy; and its provocative argument that capitalism is bound to disappear- not because of its failure but because of its success. (John Kenneth Galbraith).

He is best known for his theory of “creative destruction” – the view that the capitalist system progresses by constantly revolutionising its economic structure. New firms, new products, new technologies continually replace old ones. Since innovation comes in fits and starts, the capitalist economy is naturally, and healthily, subject to cycles of booms and dust. The agent of this revolutionary process is the heroic entrepreneur: the individual owner in the 19th century, big business in the 20th. Innovation needs its reward, hence a dynamic economy is one which allows the innovator huge profits. Temporary monopoly is nature’s way of allowing innovators to gain from their innovations. Short-run inequity is the price of long run progress.

Q2

ARE GLOBAL FINANCIAL MARKETS EFFECTIVE? EVALUATE THE EFFICIENT MARKETS HYPOTHESIS (E H M) SHOULD THE E.H.M BE SCRAPPED?

EFFICIENT MARKET HYPOTHESIS

A market is efficient if

• The prices of securities traded in that market reflect all the relevant information accurately and rapidly, and are available to both buyers and sellers.

• No individual dominates the market.

• Transaction cost of buying and selling are not so high as to discourage trading significantly.

DEGREE OR FORMS OF EFFICIENCY

1. Weak Form

Weak form hypothesis states that current share prices reflect all relevant information about the past price movements and their implication. If this is true, then it should be impossible to predict future share price movements from historic information or pattern.

Share prices only changes when new information about a company and its profits become available. Since new information arrives unexpected, changes in share prices should occur in a random fashion, hence weak form can be referred to as random walk hypothesis.

2. Semi- Strong Form

It state that current share prices reflects both

1. all relevant information about past price movement and their implications and

2. publicly available information about the company

Any new publicly accessible information whether comments in the financial press, annual reports or brokers investment advisory services, should be accurately and immediately reflected in current share prices, so investment strategies based on such public information should not enable the investor o earn abnormal profit because these will have already been discounted by the market.

Strong Form

The strong form hypothesis states that current share prices reflect all relevant information available from

1. past price changes

2. public knowledge and

3. insider knowledge available to specialists or experts such as investment managers.

IMLICATION OF E.M.H FOR FINANCIAL MANAGERS

If capital market are efficient, the main implication for financial managers are:

1. The timing of issues of debt or equity is not critical as the prices quoted in the market are fair. That is price will always reflect the true worth of the company, no over or under valuation at any point.

2. Any entity can not mislead the markets by adopting creative accounting techniques.

3. The entity’s share price will reflects the net present value of its future cash flows, so managers must only ensure that all investments are expected to exceed the company’s cost of capital.

4. Large quantities of new shares can be sold without depressing the share price

5. The market will decide what level of return it requires for the risk involved in making an investment in the company. It is pointless for the company to try to change the market’s view by issuing different types of capital instruments.

6. Merges and takeovers. If share are correctly priced this means that the rationale behind mergers and takeovers may be questioned. If companies are acquired at their current market valuation then the purchases will only gain if they can generate synergies. (operating economies of rationalization).In an efficient market these synergies would be known , and therefore already incorporated into the price demanded by the target company shareholders.

The more efficient the market is the less the opportunity to make a speculative profit because it become impossible to consistently out perform the market.

Evidence so far collected suggests that stock markets show efficiency that is at least weak form, but tending more towards a semi strong- form. In other words, current share prices reflects al or most publicly available information about companies and their securities.

An efficient markets hypothesis (EHM) maintains that market prices fully speculate all open information. This was developed independently by Paul. A Samuelson and Eugene F. Fama in the 1960s this idea has been applied extensively to theoretical models and empirical studies of financial securities prices, generating considerable controversy as well as fundamental insights into the price-discovery process. But the most enduring critique comes from psychologists and behavioural economists who argue that the EMH is based on counterfactual assumptions human behaviour that is rationality. However, recent advices in evolutionary psychology and the cognitive neurosciences may be able to harmonize the EMH with behavioural anomalies.

Our British CFA recently asked its members for the first time whether they trusted in market efficiency and discovered more than two, thirds of respondents no longer believed market prices reflect all available information. More startling is the fact that 77 per cent of the group strongly or very strongly disagreed that investors behaved rationally in apparent defiance of the wisdom of crowds idea that has driven investment hypothesis.

The shift is significant as the assumption of effective market as a cornerstone of calculating the value of everything from stocks to pension fund liabilities to executive compensation.

The chief executive of the CFA society, William Good hart of UK, yesterday admitted the result showed a new mood of questioning following the financial crisis.

However, the tread appears to reflect a winder intellectual swing in the past three decades the global assets management industry has been dominated by the so- called efficient market hypothesis which has given birth to ideas such as the capital asset pricing model that portrays investing as a trade off between risk and return.

Global Financial Markets:

Suppose the government announces a new bond. We can say the government is issuing a new bond we could just as easily say that the government is selling a new bond we might see it as a sign of the government‘s need to borrow more money. If you hear of the new bond you may tell a friend that you have decided you probably won’t think if it that way but you are the lender of money to a doubt ungrateful government .it may seem as obvious point but all those terms might be used sometimes newcomers need to be reminded that whoever buys a security is directly or indirectly lending money unless it is equity.

Q3

COULD THE RECENT CRISIS IN GLOBAL FINANCIAL MARKETS HAVE BEEN PREDICTED OR PREVENTED?

The recent global financial crisis:

After the Asian crisis the world is again confronted with a veritable financial crisis. Only this time the harbingers arose on the other side- the USA rather than East Asia. On the other hand, ten years ago a real estate bubble in Thailand burst triggering the flight of international speculative capital, today it is the side effect of the real estate crisis in the USA which threatens the financial markets.

Each and every financial crisis has its peculiarities and its similarities with predecessor. The ongoing crisis differs from the Asian crisis also because the research for its origins is not leading to some form of crony capitalism in emerging economies but to the centres of the world financial system with all its modern financial innovations. As some analysts say that is the first crisis in the modern financial markets where new products created by debt and asset securitization are traded globally. The 1994/95 Mexican crisis was however, labelled the first major crisis in our new world of globalised financial markets by former managing director of the IMF Michel Camdessus.

The ongoing credit crunch shares certain qualities with prior financial crises, such as the pattern of rising asset prices, expanding lending activity, increasing speculation to excess and them declining prices in which the investors try to save their gains as rapidly as possible . And in such situations the analysts ask whether this is due to a mere accommodation correcting the overheating of certain markets under fundamentally healthy conditions or the beginning of a longer period of turbulence with potentially systemic consequences. Nevertheless, the favorite chimes of health fundamentals seem rather queer in this context since development in the financial markets has long been relatively immune from the real economy.

In the US, prime mortgage crisis, seems to have already taken a serious toll on global financial markets the total sup prime mortgage market losses suffered by the world largest banks once estimate $300 and $ 600 billion in a subject of several months are now estimated by several institutions to surpass $1 trillion. Even the major stock market indices have declined by more than 10 % while stock in some emerging market economies slid by close to 30 % since mid October while all stock market want through episodes of volatility outbursts.

The near collapse of bear Stearns, one of the five largest US investment banks and its immediate fire- sale purchase by J P Morgan Chose on march 16 has nothing but proved that the extent of the financial crisis could be larger than was previously thought while the bear Stearns operation was successfully carried out by the federal reserve it has shown the possible repercussions of the ongoing financial crisis