This action might not be possible to undo. Are you sure you want to continue?
: GHANA STOCK EXCHANGE A PROJECT REPORT UNDER THE GUIDANCE OF Mr Daniel Odei Tetteh SUBMITTET BY CAMARA MOHAMED BINTOU IN FULFILLEMENT OF THE REQUIREMENT FOR THE AWARD OF THE DEGREE OF MBA IN FINANCE SMU SIKKIM MANIPAL UNIVERSITY DIRECTORATE OF DISTANCE LEARNING FEBRUARY 2011
EFFICIENCY HYPOTHESIS OF THE STOCK MARKET
CASE STUDY: GHANA STOCK EXCHANGE
CAMARA MOHAMED BINTOU
MBA-FINANCE IN SIKKIM MANIPAL UNIVERSITY
First and foremost, I would like to express my deepest sense of gratitude to the Almighty ALLA H who has given me the opportunity, health and soundness of mind to write this project work. I am deeply indebted to my advisor Mr Daniel Odei Tetteh Whose expertise, understanding, patience, motivation, enthusiasm, immense knowledge and his constant support, added considerably to my experience. I appreciate his vast knowledge and skills in many areas and without which this project would not be possible. I could not have imagined a better advisor and mentor for this project. I am heartily thankful to Madam Claudia……………. at the Ghana stock exchange, whose encouragement, guidance and support from the initial to the final level enable me to develop an understanding of the subject. I owe my deepest gratitude to all my lecturers at Sikkim Manipal University and all my colleagues. Where would I be without my family and friends? To my father Elhadji KABA CAMARA who put the fundament of my learning character, showing me the joy of intellectual pursuit. To my mother BINTOU YATTASSAYE who raised me with so much care and love. To all my brothers, sisters and friends for being supportive financially and morally.
I dedicate this project to my family and my future wife Miss BINTILY KONATE
Certified that this project report titled ―EFFICIENCY HYPOTHESIS OF THE STOCK MARKET CASE STUDY GHANA STOCK EXCHANGE” is the bonafide work of ―CAMARA MOHAMED BINTOU‖ who carried out the project work under my supervision.
HEAD OF THE DEPARTMENT
FACULTY IN CHARGE
Sikkim Manipal University of Health, Medical and Technological Sciences Directorate of Distance Education Ring Road opposite Busy Internet www.smugh.edu.in
EXECUTIVE SUMMARY The efficient market hypothesis is one of the most controversial market theories in finance, which was developed in the 1960s by Eugene Fama. According to fama ―an efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take in the future. The purpose of this paper is to determine whether the GSE is weak form efficient and if it is possible to predict the future of the security prices, using all kind of information to increase returns on the portfolio and consequently to beat the market. As a result of this study, we found that the Ghana stock exchange is weak form inefficient .Which means that the prices can be predicted and some smart investors can earn abnormal profits. This inefficiency is due to factors like the volume of traded stock, the size of the market, lack of adequate knowledge of the market from the investors. To resolve this inefficiency, the market has to be large and liquid, the information must be available in term of accessibility, the cost of the transaction must be cheap and there should an efficient system of settlement. There should also be a campaign to sensitize people about the stock exchange. The system of trading should also be innovative.
Tableau of content TITLE PAGES
Acknowledgement………………………………………………………..III Dedication………………………………………………………………..IV Bonafide certificate……………………………………………………….V Executive summary………………………………………………………V Abstract ……………………………………………………………………1 Chapter 1…………………………………………………………………..2 Research questions…………………………………………………………2 Motivations………………………………………………………………….2 Justifications…………………………………………………………………3 Limitations of the study………………………………………………………4 Outline of the project…………………………………………………………4 Methodology…………………………………………………………………5 Background…………………………………………………………………..6 Previous studies……………………………………………………………..9 Performance of the GSE…………………………………………………….10 Importance of the stock exchange in the developing countries………………11
Political situations in Ghana …………………………………………….13 Chapter 2 History and development of the financial market in Ghana ………………14 Structure of the Ghana stock exchange……………………………………..16 Role of Ghana stock exchange in the Ghanaian economic ………………….17 Challenges facing the Ghana stock exchange…………………………………18 Chapter 3 Trading system…………………………………………………………………21 Clearing and settlement………………………………………………………..27 Legal and regulatory framework……………………………………………….28 Regulations affecting foreign and non-resident investors……………………….28 Listing on the Ghana stock exchange…………………………………………….29 Chapter 4 Literature review…………………………………………………………………33 History of efficient market hypothesis…………………………………………....33 Market conditions consistent to efficient market hypothesis……………………..41 Types of efficiency………………………………………………………………..42 Forms of efficiency………………………………………………………………42 Early Models……………………………………………………………………..49
Chapter 5 Technical analysis and efficient market hypothesis………………………………62 Fundamental analysis strategy for predicting the stock returns………………….67 Market anomalies……………………………………………………………….72 Behavioral finance and efficient market hypothesis……………………………82 Chapter 6 Data and research methodology……………………………………………….88 Reasons behind inefficiency……………………………………………………98 Solution for inefficiency………………………………………………………..99 Chapter 7 Conclusion and recommendation……………………………………………..101
LISTS OF TABLES Table 1 TABLE Table 2 REGRESSION TABLE Table 3 ANOVA Table 4 REGRESSION COEFFICIENT TABLE
LIST OF ABBREVIATION EMH GSE CSD ATS GATS CAT LDM GSE-CI GSE-FSI OCT FOL SOL EPS BM ROA GSM efficient market hypothesis Ghana stock exchange central securities depository Automated trading system General automated trading system Continuous auction trading system licensed dealing member Ghana stock exchange composite index Ghana stock exchange financial stock index over the counter market First official list Second official list Earning per share Book-to-Market value Return on Asset Ghana stock market
There is an old joke among economists which goes like this: “two economists were walking along the street. One of them saw a note of GHc 10 cedis lying down at the middle of the road and leans down to retrieve it. The second one said” don’t be ridiculous because if that were a genuine GHc 10 someone would have picked it up ABSTRACT This paper is an attempt to investigate the validity of weak form efficiency market hypothesis on Ghana stock exchange. A study conducted by frimpong Joseph Magnus concluded that Ghana stock exchange is weak form inefficient and another study conducted by Kofi A. Osei also confirmed that GSM is inefficient with respect to annual earnings information releases by the companies listed in the GSE.This paper provides a brief description of the Ghana stock exchange and gives the meaning of efficient market. The regression coefficient is applied on the Ghana stock exchange all-share index to carry out the test. If a capital market is efficient the price of the stock should reflect the knowledge and expectation of the investors and consequently no investor should be able to receive an abnormal return since there is no way that he could know something that has not been already reflected in the price of the stock. The main findings of this project do not support the weak form efficient market hypothesis in the Ghana stock exchange. The GSE is weak form inefficient which means that some investors are able to predict the price of the security and get excess returns.
Chapter 1 INTRODUCTION
RESEARCH QUESTION This paper aims at investigating the weak form efficiency of the Ghana stock exchange and also to determine whether the theoretical ideas are pertaining to the real life. In this context the Ghana stock exchange will be tested and the results obtained would be used to answer the following questions: 1- Is Ghana stock exchange weak form efficient? 2- How far does the weak form efficiency hold true in the functioning of the Ghana stock market? 3- Can the security prices be predicted in the Ghana stock market? 4-can there be investors with information which is not reflected in the security prices? 5-Is Ghana stock market fully reflecting the information? 6-How is the Ghana stock exchange reacting to new information?
MOTIVATIONS OF THE RESEARCH As stated earlier, the objective of this study is to test the weak form of efficiency in Ghana stock exchange which has not been deeply investigated and studies about the weak form are very few. This study will help the investors to know how the
Ghana stock market works, how to invest in the Ghana stock exchange and the importance of an efficient market such as encouraging share buying, giving correct signals to managers and allocating the resources. In the objective of testing the weak form efficiency some theories will be tested and some aspects of the Ghana stock market will be looked at in order to achieve the stated objective. JUSTIFICATION OF THE RESEARCH This project will be added to the body of knowledge by making a special case on GSE on the subject of efficiency hypothesis of the stock market in its weak form. This study attempts to investigate the weak form efficiency and ways of improving the GSE to become a world class exchange. This study will inform the investors about how to invest in the stock market, the benefits that they can derived from the stock market and also roles of the government in improving the efficiency of the stock market. The Ghana stock market has been operating for some years now. The movement of the market is measured by the GSE-All share index. The GSE is an emerging capital market where many of the investors do not have adequate education about investing in the stock exchange. Investing is not a game of luck or chance but it requires knowledge about securities, the stock market and the economic indicators. So there is a need for them to understand how the stock exchange works and how its responds to the changes in the economic variables such inflation, GDP, interest rate and others. Also arouse investors‘ awareness about the opportunities available in the stock market and how to exploit them.
LIMITATIONS OF THE STUDY The aim of this study is to investigate the weak form efficiency of the Ghana stock exchange. Other forms of the market efficiency have not been taken into account. The time for this study is limited to the period of January 2007 to December 2008 excluding the holidays and non-working days.
THE OUTLINE OF THE PROJECT This project work consists of seven chapters. Chapter 1 is the introduction which deals with abstract, research question, motivation, justification, methodology, background of the study, previous studies, underlining assumption, performance of the GSE, importance of the stock market in the developing countries and the political situation in Ghana. Chapter2 deals with history and development of the financial market in Ghana, structure of the GSE, role of the GSE in the Ghanaian economy and challenges face by the GSE. Chapter 3 deals with the trading system, legal regulatory framework, the listing requirement and clearing and settlement. Chapter4 deals with literature review where we define the EMH, talk about the forms and types of efficient market, market conditions consistent with efficiency and the early models. Chapter 5 describes other techniques like fundamental and technical analysis, market anomalies and behavioral finance. Chapter 6 deals data and research methodology, reasons behind inefficiency and the solutions for efficiency and chapter 7 deals with conclusion and recommendation for further research.
METHODOLOGY The primary data was collected through interview and questionnaires sent to the various brokerage houses and interview with the staff and management of the GSE. The secondary data was collected through the website of the GSE by using information sources like press releases, half year and annual reports and others. Other information was collected through the use of the library of the GSE and other reading materials. In addition to information collected through the internet. Some information like the Ghana stock exchange all-share index for the period of January 2007 to December 2008 was collected through the website of the security and exchange commission in Ghana. In addition to other relevant information
BACKGROUND OF THE STUDY The stock market is an organized public market for the trading of a company stock and derivatives at an agreed price. The stock market is different from the stock exchange which is an entity that brings together buyers and sellers of a stock. They buy and sell securities such as shares and bonds etc... Prices on the stock market are determined by the forces of the demand (what people are willing to buy) and supply (what sellers have available for sale). The market is supervised by officials of the stock exchange as well as the Securities and Exchange Commission. On this market, individuals and companies can buy shares and bonds and other securities of the companies through licensed dealing members or stockbrokers of the Ghana stock exchange. The buyers include people residing in Ghana as well as non-residents. It includes Ghanaians and foreigners. Adults (people above 18 years) can buy shares for themselves and also buy in trust for their children. The Ghana stock exchange is the cornerstone of the Ghanaian capital market. The idea of establishing a stock market in Ghana lay on the drawing board for almost two decades prior to its implementation. In February 1989, the issue of establishing a stock exchange moved a higher gear when a 10 – member National Committee, under the chairmanship of Dr. G.K Agama, then governor of the Bank of Ghana, was set up by the government. The work of the committee was to consolidate all previous work connected to the stock Exchange project and to fashion out modalities towards the actual establishment of the Exchange. As a result of the work of the committee, the stock exchange was established in July 1989 as a private company limited by guarantee
under the companies‘ code of 1963. It was given recognition as an authorized stock exchange under the stock exchange act of 1971 (act 384) in October 1990. The council of the exchange was inaugurated on November 12, 1990 and trading commenced on its floor the same day. The exchange changed its status to a public company limited by guarantee in April 1994. The exchange was set up with the following objectives: 1- To provide the facilities and framework to the public for the purchase and sales of bonds, shares and other securities, 2- To control the granting of quotations on the securities market in respect of bonds, shares and other securities of any company, corporation, government, municipality, local authority or other body corporate, 3- To regulate the dealings of members with their clients and other members, 4- To co-ordinate the stock dealing activities of members and facilitate the exchange of information including prices of securities listed for their mutual advantages and for the benefit of their clients, 5- To co-operate with associations of stockbrokers and stock exchanges in other countries, and to obtain and make available to members information and facilities likely to be useful to them or to their clients. Since its inception, the GSE's listings have been included in the main index, the GSE All-Share Index. In 1993, the GSE was the sixth best index performing emerging stock market, with a capital appreciation of 116%. In 1994 it was the best index performing stock market among all emerging markets, gaining 124.3% in its index level. 1995's index growth was a disappointing 6.3%, partly because of high inflation and interest rates. Growth of the index for 1997 was 42%, and at the end of 1998 it was 868.35 (see the 1998 Review for more information). As of
October 2006 the market capitalization of the Ghana Stock Exchange was about 111,500bil cedis($11.5 billion). As of December 31 2007, the GSE's market capitalization was 131,633.22bil cedis. In 2007, the index appreciated by 31.84% (see the ―Publications‖ section on the GSE‘s website for more information).The manufacturing and brewing sectors currently dominates the exchange. A distant third is the banking sector while other listed companies fall into the insurance, mining and petroleum sectors. Most of the listed companies on the GSE are Ghanaian but there are some multinationals. Although non-resident investors can deal in securities listed on the exchange without obtaining prior exchange control permission, there are some restrictions on portfolio investors not resident in Ghana. The current limits on all types of non-resident investor holdings (be they institutional or individual) are as follows: a single investor (i.e. one who is not a Ghanaian and who lives outside the country) is allowed to hold up to 10% of every equity. Secondly, for every equity, foreign investors may hold up to a cumulative total of 74% (in special circumstances, this limit may be waived). The limits also exclude trade in Ashanti Goldfields shares. These restrictions were abolished by the Foreign Exchange Act, 2006 (Act723).There is a 8% withholding tax on dividend income for all investors. Capital gains on securities listed on the exchange will remain exempt from tax until 2015. The exemption of capital gains applies to all investors on the exchange. There are no exchange control regulations on the remittance of original investment capital, capital gains, dividends, interest payments, returns and other related earnings. Potential changes at the exchange include the introduction of automated trading and the listing of some state banks. The Bank of Ghana plans the development of mutual funds, unit trusts and municipal bonds at a subsequent date. These changes are aimed at making the exchange more relevant, efficient and
effective. The exchange was also involved in preparing the draft law on collective investment vehicles.
PREVIOUS STUDIES Some studies have been done in order to test the efficiency of the GSE. First Osei in 2002 conducted a study on the GSE. The objective was to test the response to annual earnings announcement on the GSE. The study concluded that the GSE was inconsistent with efficient market hypothesis with regard to earning announcement. Frimpong in 2008 test the weak form efficiency on the GSE and rejected the null hypothesis in concluding that the GSE is weak form inefficient. As a result of this study, we can say is not a waste of time for an investor to look for an under-valued or over-valued stock. Some hardworking investors can reap abnormal profits and also some smarts investors can outperform the market or consistently beat the market. This inefficiency has a positive effect on the investors because it can allow them to increase their returns, to know in which company invests and save their investment. The negative effect of this inefficiency is that investors will know about the under-valued stocks and give low price for them which will discourage the managers and the shareholders. Sometimes it will lead to the nonperformance of the company which will even discourage other companies to list in the GSE.
UNDERLINING ASSUMPTIONS This study investigates the weak form efficiency with focus on the Ghana stock exchange. It explains how the trade, listing, clearance and settlement take place in the Ghana stock exchange and also how an investor foreign or national can invest and reap profits from the Ghana stock exchange. The implicit assumption is that the Ghana stock exchange should be efficient for investors to make inform decision and not allowing some investors to get excess returns without accepting extra cost. Hence the topic ―efficiency hypothesis of the stock market‖
PERFORMANCE OF THE GHANA STOCK EXCHANGE The benchmark measure of performance of the Ghana stock exchange was the Ghana stock exchange all-share which is now the GSE-composite index (GSE-CI). From 1990 to 2009 this index has increased from 77.25 points to 5,572.34 points. Despite the global financial crisis, the GSE in 2008 has performed well by recording 10,431.64 points. In 1993, the GSE emerged has the 6th best performing emerging stock market with an impressive return of 114%. In 1994, in a study conducted by Birinyi Associates, a research group in the USA, the GSE came out as the best performing market among all the emerging markets with a gain of 124%. In 2008, the GSE was the world‘s best performing stock exchange despite of the world global financial crisis with a gain of 58% but in the subsequent year the performance was poor with a loss of 47%.
In February 18, 2011, the stock inched down to 0.86 points for the fourth straight session to close at 1,048.78 points. The year to now stands at 4.88 percent. The GSE financial stock (GSE-FSI) which tracks the performance of listed stocks was also down 0.54 points to 1,036.56 points from 1,037.10 points at the previous session, with a year-to-date change of 3.66 per cent. There were three price changes, a gainer and two losers. Standard Chartered Bank, the sole gainer for the session, was up GH¢0.04 to GH¢46.79. Decliners for the session were Fan Milk Limited, which dipped GH¢0.02 to GH¢2.50 and Ghana Commercial Bank fell GH¢0.01 at GH¢2.49. Market Capitalization closed the session marginally lower at GH¢20,124.29 million from GH¢20,128.54 million. Total shares traded are 210,775 shares, valued at GHC96, 469.(the Ghanaian journal February 18, 2011).
IMPORTANCE OF THE STOCK EXCHANGE IN THE DEVELOPING COUNTRIES One way of achieving economic growth in the developing countries is through an efficient financial market that will channel resources for productive investments, mobilize foreign capital and also provide funds to increase the productivity of the national industries and reduce poverty by creating more jobs. The financial stock market serves as a veritable tool in the mobilization and allocation of savings among competing uses which are critical to the growth and efficiency of the economy (Alile, 1984). Other researchers have showed that the stock market development positively influences the economic growth (Korajczyk, 1996, Levine and Zervos, 1998).
Levine (1991) showed a positive relation between financial stock market and economic growth by issuing new financial resources to the firms. The financial stock market facilitates higher investments and the allocation of capital, and indirectly the economic growth. An efficient stock market contributes to attract more investment by financing productive projects that lead to economic growth, mobilize domestic savings, allocate capital proficiency, reduce risk by diversifying, and facilitate exchange of goods and services (Mishkin 2001; and Caporale et al, 2004). Further, Levine and Zervos (1998) found strong statistically significant relationship between stock market development and economic growth. The result of Filer et al. (1999)‘ studies show that there is positive causal correlation between stock market development and economic activity. Many other researchers argue that there is a positive correlation between financial development and economic growth (Goldsmith, 1969; Shaw, 1973; McKinnon, 1973 and King & Levine, 1993). They found that financial development is an important determinant of future economic growth of a country. Atje and Jovanovic (1989) found also a significant impact of the level of stock market development and bank development. Joseph Schumpeter (1912)‘s book was the most important and thorough one of the earlier contribution on financial development and economic development. For him, financial development causes economic development – that financial markets promote economic growth by funding entrepreneurs and in particular by channeling capital to the entrepreneurs with high return projects. Therefore the GSE also needs to be efficient so that it can contribute the growth of the Ghanaian economy.
POLITICAL SITUATIONS IN GHANA One of the major differences between efficient and inefficient market is the political situation in the country. Political instability sometimes results in stock market being manipulated by the government which will cause the inefficiency of the stock market. When the government is controlling the stock market all the information will not be provided to the public therefore the decision making process will be difficult and the decision base on this information will not be accurate. The prices will reflect neither the true value of the securities nor other information in the market. This will result in the stock market being inefficient. Also as a result of this political instability, investors will not be motivated to invest neither in the Ghana stock exchange nor in the capital market by fear of losing their investments. Therefore, we need a stable political situation as one of the conditions of the market being efficient.
CHAPTER 2 A-HISTORY AND DEVELOPMENT OF THE FINANCIAL MARKET IN GHANA The economy of Ghana underwent economic reforms in 1983 at the time when the country was collapsing with high inflation around 123%, large exchange rate swings and negative real interest rate. These reforms were aiming at liberalizing the Ghanaian economy. So the government of Ghana with the help of the World Bank had launched the structural adjustment programme to address the deterioration problems in the financial sector. As part of the reforms, monetary policy was instituted and market for securities was created. In 1986 a weekly auction in treasury bills was introduced. Again the bank of Ghana bills was also introduced in 1988 to take care of excess liquidity in the system especially in the rural areas and also to provide an avenue of investment for banks (bank of Ghana consultation paper October 2007). The Ghana stock exchange was established as part of these reforms. The GSE though incorporated in July 1989, the normal operations started on November, 1990. One main objective of establishing the GSE was to enable corporate institutions and government to raise quick capital to accelerate development in order to reduce undue reliance on donors. After establishing the GSE in November 1990 with only 12 listed companies and one government bond, the market capitalization within two years of operation increased from GH ¢3 billion in 1991 GH¢4.3 billion in 1992 while the listed companies increased to 15. With a drop of 46.58% in the GSE All-share index, the
GSE ended the year 2009 as the least performing market in Africa. In the previous year 2008, the gain in the GSE All-share index was 58% and this moved Ghana ahead of all the African markets. The market capitalization of the exchange declined by 11% to end the year at GH¢15.94billion down from GH¢17.90billion in 2008. The decline in the value of Ghana‘s market was mainly due to price depreciation. According to Bank of Ghana report, for the fifth consecutive month, headline inflation went up from 12.8% in January to 13.2% in February and this was due to prices increased in the first two months of the year. This increased, the report said was driven by surges in food prices and rising crudes oil prices. (Bank of Ghana Monetary Policy report: vol 3 no 2: 2008 1). In this market condition one would confirm the theory put forward by Samuelson and Mandelbrot followed by Eugene Fama, which is ―Efficient Market Hypothesis‖: they said that when markets are working properly, then all public information regarding an asset will be incorporated immediately into the price. The GSE was adjudged ―the most innovative African stock exchange for 2010‖ at the African investors prestigious annual index series awards held at the new York stock exchange on Friday, 17th September 2010. The African investor index series awards are the only international pan-African that recognize and reward Africa‘s institutional investors, stock exchanges, bestperforming listed companies, stockbrokers and capital market regulators. The awards assessed performance between April 2009 and April 2010 out the group of seven stock exchanges nominated (www.gse.com)
In their objective of being efficient and to position the GSE to compete favorably on the international market as well as attracting more investors in the domestic and international market, the GSE has adopted the automated trading system(GATS) which is a computer base trading that automatically submits trades onto the trading system. The system is designed to match orders placed by the stockbrokers to buy and sell shares in an electronic order book and these orders are automatically matched i.e the system determines who buys what at which price and from which seller B-THE STRUCTURE OF THE GHANA STOCK EXCHANGE The exchange is governed by a council with representation from licensed dealing members, listed companies, the banks, insurance companies, money market and the general public. The Managing Director of the exchange is an ex-officio member. The council sets the policies of the exchange and its functions include preventing fraud and malpractices, trading and settlement and maintaining good order among members, regulating stock market business and granting approval for listing, maintaining public confidence in the market and promoting the exchange. It has the power to suspend or expel any licensed dealer member that contravenes the rules of the exchange. The council‘s membership includes some of the most distinguished and competent people in the Ghanaian commerce, industry, finance and public service.
ROLES OF GHANA STOCK EXCHANGE IN THE GHANAIAN ECONOMY The GSE plays the following roles in the Ghanaian economy: -Raising capital for businesses -Major link between companies and governments with capital need and the public with savings to invest. -The growth of the economy by mobilizing savings for investment -Creation of jobs -Promote savings and investment habit -Provide liquidity to investors -Establish a pricing mechanism for financial asset -Enhance corporate transparency or corporate governance -Improved share appreciation -Enhance volumes of securities traded -Facilitating company growth -Profit sharing -Barometer of the economy -It provides a market place for trading -Provide a powerful tool for the government and policy makers to manage economies -Improve share price appreciation and enhance volumes of securities traded
THE CHALLENGES FACE BY THE GHANA STOCK EXCHANGE The Ghana stock exchange is facing the following problems: First is the political instability that has been discussed in the earlier section. The second is the macroeconomic instability or volatility. The Ghana‘s economy has been characterized by high inflation, high interest rate and large exchange rate swings as stated by the Bank of Ghana Monetary Policy report: (vol 3 no 2: 2008 1). These variables when they are high, they discourage the investors to invest in a specific country because they can‘t diversify the risk and also are not sure of getting their investment back. Another problem facing the GSE is due to the stock exchange itself. According to Benimadhu (2003), among the exchange specific issues affecting stock markets in Africa are low level of liquidity, few listed companies and the small size of the exchange as well as efficiency. We assume that the stock exchanges in Africa face the same challenges. Other factors which has stifled the development of the GSE relates to the absence of a strong and active domestic investor base, led by institutional investors such as pension funds and insurance companies. Clearing, Settlement and Trade systems as well as trading infrastructure should be ameliorated. The following points need to be noted carefully: 1-Investors confidence Fluctuation in interest rates, high rate of inflation and instability of the cedi made it difficult to predict the future of the capital market and because of this, the investors
find it difficult to invest or borrow money from the market. According to the bank of Ghana in his report, inflation went up to 12.8% in January 2008 to 13.2% in February 2008. The report attributed the price increased to the increased in food prices and the rising crude oil. (Bank of Ghana monetary policy report: Vol 3 No 2 2008 1) 2-Unpredictability of the market In terms of instruments traded and the number of participants in the market, the capital market in Ghana is relatively small as compared to that of the stock exchange in America or Paris or UK. Fluctuation of the economic indicators and instability of the cedi have made very difficult for the investors to predict the Ghanaian capital market. An evaluation of the real return on the Ghana stock exchange by the Bank of Ghana revealed that ― the total annual real return on the stock listed on the Ghana stock exchange have followed an undulating pattern since 1991 falling every two years and rising every two years‖.(Bank of Ghana report) 3-Price forecast The capital market in Ghana has been characterized by unstable price. Prices of goods and services are volatile and the same for inflation, interest rates and exchange rates. This condition will make it difficult for predicting the share prices which will confirm the theory of efficient market hypothesis. Some positive changes Re-denomination According to Ghana news agency report in 2008, the re-denomination of the Ghanaian cedi in july 2007 was predicted as something which will strengthen the
financial market in Ghana. This is because it will reduce high transaction costs and also reduce the inconvenience and high risk in carrying loads of currency for transaction purposes. It would further ensure compatibility with data processing software and the strain on payments system, particularly Automated Teller Machine (ATMs) and above all it would reduce the difficulties in maintaining financial and statistical records. Foreign investors Non-resident foreign investors can now hold more than 10% of any security listed in the stock market which was not the case few years back. They can trade in money market instruments and also maintain a foreign currency account with the local banks which can be credited with transfer in foreign currency from abroad or other foreign currency account. (www.ghanaweb).
Chapter 3 A-TRADING SYSTEM 1-Principles of trading The purpose of the Ghana stock exchange is the determination of the price of the securities in a functional and efficient market, where all parties to the market have simultaneously at their disposal sufficient information as a basis for price formation. Procedure that is contrary to good conduct shall not be employed in securities trading. A licensed Dealing Member shall maintain confidence in the market through it activities. A licensed Dealing Member must not take measures that are designed to distort the price level or the number of securities, or any measures that do not correspond to the form or intent of a legal act. A licensed Dealing Member shall carefully follow the principles and rules pertaining to trading. Trading is carried out on the floor of the exchange under the continuous Auction Trading system (CAT). Over the counter trading is however allowed in Ashanti Goldfield Company‘s shares. Trading is done in lots of 100 shares. The automated trading on the Ghana stock exchange is done through three alternative levels of access, namely 1-on the trading floor of the Ghana stock exchange 2-At the office of the stockbroker through the wide Area Network
3-Through the internet When an investor instructs his stockbroker to buy or sell a particular security, the broker will enter the order on his terminal using any of the three means and the order will instantly be routed electronically to the stock exchange‘s ATS (automated trading system). The system automatically matches the orders resulting in trades. The GATS records the sale, quantity, buyer and seller and time of trade. All these are done under the supervision of the Ghana stock exchange. The Ghana Stock Exchange (GSE) has begun a new arrangement for a "continuous auction trading" on trial basis for eight equities listed on its counters.
The new arrangement, which started two weeks ago, allows the Exchange to trade for longer hours and forms part of measures to address difficulties faced in the use of the current trading system known as the 'Call Over System'.
Equities involved in the new arrangement were chosen at random to give all listed companies a chance to benefit from the trial run, which will last for three weeks.
If successful, the new arrangement will cover the rest of the equities after an assessment.
Equities picked for the trial are British-American-Tobacco Company (BAT), Enterprise Insurance Company (EIC), Fan Milk Limited (FML), Ghana Commercial Bank (GCB), Guinness Ghana Limited (GGL), Mobil Ghana Limited, Produce Buying Company (PBC) and Unilever Ghana Limited (UNIL).
The General Manager of GSE, Francis Tweneboa, told the Ghana News Agency
(GNA) that the exchange had experienced some difficulties in the current Call over System.
This system allows offers and bids for only one stock at a time and does not make room for clients to bid to their advantage.
With the Call over System, names of the stocks are shouted for offers and bids. If a client wishes to make a transaction after his chance elapses, he or she has to wait until the next round to make a match.
In the new system, boards will be provided for the quotation or display offers and brokers can match orders as and when it favours their clients.
Tweneboa said whereas the Call over System lasts for about two hours, the new arrangement would continue for about six hours from 1,000 hours to 1,600 hours.
The closing time would also give brokers enough room to make settlements.
Yofi Grant, an Executive Director of Databank Brokerage Limited, lauded the new arrangement, saying it is an attempt to modernise activities of the GSE.
"The Call over System has become obsolete and is a far cry from what exists on international markets," he said, commending its potential to allow brokers to talk to clients during trading on the floor.
Grant said brokerage firms agree to the new arrangement, which will serve as a pre-cursor to electronic trading to enable the Ghana bourse to be part of
He said, however, that modernisation of activities on the GSE must be gradual to allow the smaller of the 12 brokerage firms who trade on the floor to catch up with the pace in terms of expansion of offices, clients and expansion of the trading floor
OFFICIAL TRADING HOURS Trading in approved securities, as defined by the listing rules, shall be limited to the hours when the floor is open for the transaction of business. There will be no trading in approved securities on the floor or anywhere else before or after the official dealing hours, as defined by the council from time to time, unless the council has expressly granted an exemption in which case trading shall be done strictly within the conditions prescribed by the council. Dealing hours was as follows: -Pre-opening period -Open AUCTION -Regular trading 09.30 GMT 10.00 hrs GMT 10.00 hrs GMT and 10.00 hrs GMT -12.00 hrs GMT
According to the Business news of Tuesday, 4 January, 2011, the Ghana Stock Exchange (GSE) has
extended its daily trading hours from three hours to five hours
effective January 4, 2011. The new trading hours shall be between 10.00 hrs and
GMT instead of from 10.00 hours to 13.00 hours. A statement by the Exchange on Tuesday said the change in trading hours was to afford dealers increased contact hours with their clients during the trading day. It is also meant to afford nonresident investors in time zones different from Ghana, greater opportunity to reach out to their local brokers, it added. "It is our expectation also that the extended trading hours will help improve liquidity in the market place," the statement said. TYPES OF SECURITIES TRADED Ordinary shares Preference shares Debt securities corporate Government 2 years 3 years 5 years 56 36 3 35 1 2
INDEX An index is a numerical value used to measure changes in a variable or group of variables. The index is set of hypothetical or numerical level on the base period or starting point against which a percentage change can be compared to at any particular point of time.
The stock market index is a specialized tool used essentially to capture the overall performance of the stock market. It can also be employed to measure how a given equity or bond portfolio is performing. If an investor owns more than one stock, it is cumbersome to follow each stock individually to determine the composite performance of the portfolio. The stock index will reveal the overall trend in the performing of the market. It also shows the stock price movements. The Ghana stock exchange has introduced a new method of calculating closing prices of equities on the market with effect from January 4, 2011. Closing prices of listed equities will be calculated using the volume weighted average price of each equity for every given trading day. GSE has also published two new indices, namely the GSE composite index (GSECI) and the GSE financial stock index (GSE-FSI) *GSE composite index (GSE-CI) The calculation of the GSE composite index will be based on the volume weighted average closing of all listed stocks. All ordinary shares listed on the GSE are included in the GSE-CI at total market capitalization. The base date for the GSECI December 31, 2010 and the base index value is 1000. *GSE financial stock index (GSE-FSI) This index will have its constituents as listed stocks from the financial sector including banking and insurance sector stocks. All ordinary shares of the financial stocks listed on the GSE are included in the GSE-FSI at total market capitalization except for those stocks which are listed on other markets. The base date of the GSE-FSI is also December 31, 2010 and the base index value is 1000.
The new indices will be published on each trading day beginning January 4, 2010.
B-CLEARING AND SETTLEMENT Clearing is defined as ―the process of transmitting, reconciling and, in some cases confirming payment orders or security transfer instructions prior to settlement‖ (BIS, 2003, p.13). Whereas settlement is described as ―the completion of a transaction, wherein the seller transfers securities or financial instruments to the buyer and the buyer transfers money to the seller‖ (BIS, 2003, p.45). The objective for clearing and settlement process is that the system is prompt and reliable as well as cost-effective and convenient to use. (Guadamillas & Keppler, 2001, p.19) Clearing and settlement of securities transactions in listed securities shall be conducted at the premises of the exchange or as may be determined by the central securities depository (CSD) act or the exchange. The exchange in conducting the clearing and settlement business shall incur no other liability or responsibility for the conduct of such business other than seeing to an orderly conduct of the business until the central securities depository commences clearing and settlement for listed securities. The clearing and settlement for a trading session(T) shall take place three business days after the related trading session which is (T+ 3) at 11.am or within a given time frame that the exchange shall specify by notice of amendment of this rule. Settlement is manual but centralized. Currently, the settlement period is T+3 (business days). It is also delivery versus payment. The seller (stockbroker) of a security is responsible for the validity of all documents delivered. The exchange has set up a clearing house. All LDM (licensed dealer member) are members of the
clearing house. They together with the exchange have accounts with the settlement bank. On settlement day, the clearing house collects (debits) the bank account of the LDMs who have bought securities and pays the amount collected into an account of the clearing house. LDMs who sold securities are next paid or credited with the amounts due to them move to the buying LDM in the Ghana stock exchange depository.
C-LEGAL OR REGULATORY FRAMEWORK Legislation - The company code, 1963, (act 179) - The security industry law, 1993 PNDCL 333 - Securities and exchange commission regulations 2003 1728 - Act 1695 GSE regulations/rules - Stock exchange (Ghana stock exchange) - Listing regulations 1990 LI 1509 - Stock exchange (Ghana stock exchange) - Membership regulations 1990 LI1509 - Trading and settlement rules D-REGULATIONS AFFECTING FOREIGN AND NON-RESIDENT INVESTORS Exchange control permission has been given to non-resident Ghanaians and foreigners to invest through the exchange without any prior approval. However, one external resident portfolio investor (whether individual or institution) can hold only up to 10% of any security approved for listing on the exchange. Furthermore,
the total holdings of all external residents in one listed security shall not exceed 74% Ghanaians externally resident and foreigners resident in Ghana though may invest any limit. The limits also apply in the case of AGC and PBC shares. There is free and full foreign exchange remittability for the original capital plus all gains and related earnings. There is a 10% withholding tax (which is also the final tax on the dividend income) for all investors both resident and resident. Capital gains on the listed security are exempt from tax until November 2005.
LISTING ON THE GHANA STOCK EXCHANGE A company is said to be listed on Ghana stock exchange when its securities are approved to be bought and sold on the stock exchange. Newly issued shares cannot be traded on the OCT (over the counter) market before getting listed on the GSE. In order to get your newly shares listed on the GSE, you need to communicate this intention early to the GSE and work with the exchange so that your prospectus will satisfy the exchange‘s listing requirements before the public floatation.
A-Requirements for listing There are certain requirements that the company must meet in order to qualify for listing on the Exchange. These requirements are stipulated in GSE rules Book. Many companies will meet these qualifications.
To make it possible for many companies to list on the exchange, there are two lists with fairly easy requirements: a- The first official list (FOL) b- The second official list (SOL) The approval of an application for the listing securities on the stock exchange is solely within the discretion of the council of the Ghana stock exchange.
The requirements are as follows: 1-listing requirements for shares Minimum stated capital The company must have a stated capital after the public floatation of at least GHc 1million in the case of an application relating to the first official list and GHc 0.5million for the second official list. Minimum public float Shares issued to the public must not be less than twenty-five percent (25%) of the number of shares issued by the company unless reasonable justification is provided for a smaller percentage. Payment of shares Shares must be fully paid for. Except in very exceptional circumstances, the exchange will refuse listing in respect of partly paid shares Spread of shares
The spread of shareholders existing at the close of an offer should be in the GSE‘s opinion adequate with at least 100 shareholders after the public offer. 2-listing requirements for debt securities A company seeking the admission of debt securities to the GSE may be considered for such admission if the security concerned has a total issue amount of not than GHc 1million face value or there are at least 50 holders of such security. In the case of government securities, there is no prescribe minimum in respect of either amount issue or number of holders to permit admission to the GSE‘s list Debt securities for which listing are sought shall be created and issued pursuant to a Trust Deed duly approved by Securities and Exchange Commission. ADDITIONAL REQUIREMENTS FOR LISTING The following additional requirements apply to both applications for listing of equities and debts securities. Period of existence For a company‘s securities(whether equity or debt) to be eligible for admission to the GSE, the company must have published or filed audited accounts in accordance with the companies code, 1963, (act 179) for at least three years immediately preceding the date of its application for listing. For the SOL, in respect of shares, the period is one year. Profitability Profitability must have been reasonable through the periods stated above or the company must have strong potential to be profitable.
Conditions relating to Directors and Management of Applicant There must have been continuity in the management of a company seeking admission to the GSE. The character and integrity of the directors and management of the company will be among the criteria taken into account by the council of the exchange. At least 50% of the board must be non-executive directors and this number at least two (2) or 25% shall be independent
Chapter 4 Literature review HISTORY OF EMH IN GEORGE Gibson‘s book the stock markets of London, Paris and New York, published in 1899; we see one the first reference to market efficiency. He says, ―In an open market, when the shares become publically know, the value they obtain may be considered to reflect the most intelligent appreciation possible”. Louis jean Baptist Alphonse Bachelier also made reference to market efficiency in his PhD mathematics dissertation paper to the University of Sorbonne. In his opening paragraph Bachelier recognizes that “past, present and even discounted future events are reflected in market price, but often show no apparent relation to price changes”. And he continue to say that ―if the market, in effect, does not predict its fluctuations, it does access them as being more or less likely and his likelihood can be evaluated mathematically‖. So according to this theory the mathematical performance expectations are useless. Therefore neither buyers nor sellers can make systematic profit and also the price in such market follows uncertain fluctuation. Bachelor‘s work was made known to Paul samuelson through Leonard j. savage who describes efficiency in terms of winning formula. From 1932-1953 the trio of cowls, working and kendall stir things up by challenging the ability of professionals to anticipate stock market prices, since they essentially would have uncertain progress. We must say that on Wall Street, there is quite an industry of advice to investors based on the forecasts of specialists.
In 1933 Alfred cowls publishes in econometrica ―can stock market forecasters forecast?‖ he gave a conference before the econometric society where he studied for 45 professional agencies, the ability of selecting stock or of anticipating the movement of the markets. They do not have better result than the choice made randomly. In 1934 holbrook working publishes ―A random difference series for use in the analysis of time series‖. In the journal of the American statistical Association. He establishes that there is no correlation between the successive variations of prices on the markets. In 1953 Maurice G. Kendall publishes ―the analytics of Economic times series, Part 1 : in which he demonstrates that the fluctuation of stock prices on the market is essentially uncertain. This worried many economists for whom the stock prices changed in order to reflect the modifications in the forces of offer and demand. We were going towards the emergence of the hypothesis of market efficiency for which the uncertain nature of price evolution is a typical symbol of good market behavior. In 1963 during a meeting of the Econometric society, Clive W.J Granger and Oskar Mogenstern present the results of their research on the stock market pricing. They discovered that the short term movements are uncertain but not long term ones. They also specify that economic cycles were of little or no importance. In 1965 Paul A Samuelson publishes ―Proof that properly anticipated prices fluctuate randomly‖ in the magazine industrial management review. Samuelson explains that if stock were predictable and not uncertain, it would therefore be possible to take action in order to generate systematic gains. But these
actions made the stocks uncertain. Therefore, the uncertain nature of the stock markets does not go against the economic forces who to the opposite, work very well. This is how the market efficiency hypothesis was born which, at first, was synonym of uncertain markets. In 1965-1998 in a series of publications, Eugene Fama will become the father of the market efficiency. But the notion of efficiency covers different aspects and clarify the debate, james Tobin suggest in 1984 in ―on the efficiency of the financial system‖, four major forms of efficiency which include, in economics and finance, the principal meaning of the concept: informational efficiency, fundamental, total insurance and behavioral efficiency. Informational efficiency is concerns portfolio management the most. In 1965 in the journal of Business under the title ―the behavior of stock prices ―Eugene fama publishes his entire doctorate thesis in which he concludes that stock prices are unpredictable and follow an uncertain market. In 1970, fama published in the journal of Finance, the beginning of a trilogy entitled‖ Efficient capital market: A review of the theory and empirical work‖. He defines informational efficiency as follows: A market is efficient when in each instant; the prices incorporate all the pertinent and available information. He suggests three types of informational efficiency: the weak form, semi-strong form and strong form. He also specifies that the efficiency test includes two problems: first the cost of the information and the transactions and second the problem of joint hypothesis. The joint hypothesis conditions the efficiency tests. We can never know if it is the market which is inefficient or if it is the model that is false (the model used to evaluate the financial assets). This hypothesis will seriously annoy the researchers.
In 1991 fama published ―Efficient capital market ii‖ in which he suggests an evolution for the tests of the three types of efficiency. To replace the test on the weak form, he suggests foresee ability of returns. For the test on the semi-strong form, he suggests studying events and for the strong form, he suggests tests on private information. In 1998 fama published the third part of the trilogy, in which he concludes that the market efficiency hypothesis has survived all of the challenges, namely by the studies on the market anomalies and by behavioral finance. 1-The issue Burton G Malkiel in his paper ―The Efficient Market Hypothesis and its critics‖ says that: At the outset, it is important to make clear what I mean by the term ―efficiency‖. I will use as a definition of efficient financial markets that they do not allow investors to earn above-average returns without accepting above-average risks. A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, ―Don‘t bother—if it were really a $100 bill, it wouldn‘t be there.‖ The story well illustrates what financial economists usually mean when they say markets are efficient. Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble. Markets can be efficient even if many market participants are quite irrational. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient
because they don‘t allow investors to earn above-average risk-adjusted returns. In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor. According to him, Benjamin Graham (1965) was correct in suggesting that while the stock market in the short run may be a voting mechanism, in the long run it is a weighing mechanism. Fama said that market efficiency per see is testable. In 1978, Michael Jensen declared his belief that "there is no other proposition in economics which has more solid empirical evidence supporting it." In 1953 Maurice Kendall published a study3 in which he found that stock price movements followed no discernible pattern, that is, they exhibited no serial correlation. Prices were as likely to go up as they were to go down on any given day, irrespective of their movements in the past. These results lead to the question of what, exactly, influenced stock prices. Past performance obviously did not. In fact, had this been the case, investors could have made money easily. Simply building a model to calculate the probable next price movement would have enabled market participants to gain large profits without (or with reduced) risk.
2-Meaning of efficient market hypothesis Fama in his classic paper:‖capital market: review of empirical theory‖, define the efficient market as a market where the security prices ―fully‖ reflect all available information. According to Malkiel in 1992, a capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Therefore, more formally the market is efficient with respect to some information set. Moreover efficiency implies that it is impossible to make economic profits by trading on the basis of the defined information set.(paper4you.com,2006). Dyckman and Morse in 1986, state that ―A market is generally defined as efficient if (1) the price of the security traded in the market act as though they fully reflect all available information and (2) these prices react instantaneously, or nearly so, and unbiased fashion to new information‖ As it was said by Malkiel in 1992, if the market is efficient, the company market value should be an unbiased estimate of the true value. Nevertheless it is important to stress on the following points: 1-Market efficiency does not require that market price is equal to the true value. 2-There is an equal probability that stocks are over or under valued at any point in time. 3-And finally, investors should not be able to consistently identify under or overvalued stocks using any investment strategy.(Damodaran 2006).
Nevertheless it is important to stress that markets are not efficient due to their nature but they are driven to efficiency by the actions of the investors.(efficient market hypothesis: myth or reality) Fama (Jan. 1965: ‗The behavior of stock-market prices‘): ‗…an ―efficient‖ market for securities, that is, a market where, given the available information, actual prices at every point in time represent very good estimates of intrinsic values.‘ Fama (Sep.–Oct. 1965: ‗Random walks in stock market prices‘): ‗An ―efficient‖ market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.‘ Fama et al. (1969): ‗…an ―efficient‖ market, i.e., a market that adjusts rapidly to new information.‘ Fama (1970): ‗A market in which prices always ―fully reflect‖ available information is called ―efficient.‖‘ Jensen (1978): ‗A market is efficient with respect to information set θt if it is impossible to make economic profits by trading on the basis of information set θt.‘ [‗By economic profits, we mean the risk adjusted returns net of all costs.‘] Fama (1991): ‗I take the market efficiency hypothesis to be the simple statement that security
prices fully reflect all available information. A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980)). A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)).‘ Malkiel (1992): ‗A capital market is said to be efficient if it fully and correctly reflects all relevant information in determining security prices. Formally, the market is said to be efficient with respect to some information set, φ, if security prices would be unaffected by revealing that information to all participants. Moreover, efficiency with respect to an information set, φ, implies that it is impossible to make economic profits by trading on the basis of φ.‘ Fama (1998): ‗…market efficiency (the hypothesis that prices fully reflect available information)...‘ ‗…the simple market efficiency story; that is, the expected value of abnormal returns is zero, but chance generates deviations from zero (anomalies) in both directions.‘ Timmermann and Granger (2004): ‗A market is efficient with respect to the information set, Ωt, search technologies, St, and forecasting models, Mt, if it is impossible to make economic profits by trading on the basis of signals produced from a forecasting model in Mt defined over predictor variables in the information set Ωt and selected using a search technology in St.‘
B-MARKET CONDITIONS CONSISTENT WITH EFFICIENCY According to fama there are some conditions that might help or hinder efficient adjustment of prices to information. These conditions are: 1-A large number of rational, profit-maximizing investors exist, who actively participate in the market by analyzing, valuing and trading securities. The market must be competitive meaning no one investor can significantly affect the price of the security through their own buying or selling. 2-A market in which there are no transaction costs in trading securities 3-A market in which all available information is costlessly available to all market participants 4-A market in which all participants agree on the implications of current information for the current price and distributions of future prices of each security. In such market, the current price of a security obviously ―fully reflect‖ all available information but a frictionless market in which all information is freely available and investors agree on its implications is, of course, not descriptive of market met in practice. Fortunately, these conditions are sufficient for market efficiency but not necessarily. A market can be efficient if ―sufficient numbers‖ of investors have ready access to available information. And disagreement among investors about the implications of given information does not in itself imply market inefficiency unless there are investors who can consistently make better evaluations of available information than are implicit in market prices.
C-TYPES OF EFFICIENCY Efficiency implies that all resources are being used to the potential. We can have three types namely: 1-Information efficiency implies that the prices of the security reflect all information relevant to pricing security. A pricing efficient market implies efficiency in the processing of information i.e. the prices of capital assets at all times are based on correct evaluation of all available information. 2-Allocation efficiency relates to the ability of the market to direct capital to the projects with the highest risk-adjusted returns. 3-Operational efficiency is achieved when transactions completed on a timely basis, accurately and at low cost. D-FORMS OF EFFICIENCY The term efficient market was coined by fama in 1970 and he classified it into three forms namely: 1-WEAK FORM EFFICIENT MARKET HYPOTHESIS The weak form theory is also known as ―Random Walk‖ says that the current price of the stocks already fully reflect all the information that is contained in the historical sequence of prices. In another words, we can say that the price of the stock already stands adjusted to all the historical information available about it. Therefore there is no benefit so as far as forecasting the future is concerned and technical analysis which the use of the past prices to predict the future price is of no use.
This theory can be explained by a simple example: a close look at the stock prices sometimes reveals that days-of-the week effects (stocks prices may tend to rise on Monday and fall on Friday) and also; "blue Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday morning because of the weekend effect, the tendency for prices to be higher on the day before and after the weekend than for the period of the rest of the week. Another one is the time-of –the year effects(stock prices may tend to rise in January), and small firm effect (small firm prices may typically rise more than large firm prices). Most of the studies agree support the proposition that price changes are random and past prices change were not useful in forecasting future price changes particularly after the transaction costs were taken into account. However, there are some studies which found the predictability of share price changes for example fama and French 1988, poterba and summers 1988 in developed market but they did not reach a conclusion about profitable trading rules. Hudson, Dempsey and Keasy (1994) found that the technical trading rules have predictive power but not sufficient to enable excess return in UK market. Similarly, Nicolaas (1997) also conclude that past returns have predictive power in Australian market but the degree of predictability of the return is not so high. The weak form efficiency of the market on the emerging countries presents controversial result. Most the emerging countries suffer from the problem of thin trading in addition to that in the smaller markets, it is easier for a larger trader to manipulate the market. Though it is generally believe that the markets in the emerging countries are less efficient, the empirical evidence does not always support this thought. There are two types of groups of finding, the first group finds
weak form efficiency in developing and less developed markets are Branes, 1986,(on the Kuala lumpur stock exchange), chan,gup and Pan 1992,(in major Asian markets); Dicknson and Muragu 1994 (on the Nairobi stock exchange) and ojah and Karemera 1999,(on the four latin American countries market) despite the problems of thin trading, on the other hand, the latter group, who evidenced that the market of developing and less developed markets are not efficient in weak form are cheung,wong and ho,(1993) on the market of korea and Taiwan in a world bank study by claessens,Dasgupta and Glen(1995), report significant serial correlation in equity returns from 19 emerging markets and suggest that stock prices in emerging ,markets violate weak form; similar findings are reported by Harvey(1994) for most emerging markets. Nourrendine Kababa (1998) has examined the behavior of stock price in the Saudi financial market seeking evidence that for weak form efficiency and find that the market is not weak form efficient. He explained that the inefficiency might be due to delay in operations and high transaction cost, thinness of trading and illiquidity in the market Roux and Gilberson (1978) and Poshakwale S,(1996) find the evidence of nonrandomness stock price behavior and the market inefficiency on the Johannesburg stock exchange and the Indian market.
Statistical Tests of Independence According to the hypothesis of efficient markets, security returns over time are independent of one another. When testing for autocorrelation, the significance of positive and negative correlation in returns is measured over time. Brown (1979) claimed that it is naive to assume that capital markets are perfect for all securities. He argued that there is negative auto correlation in monthly stock returns, and he also found a link between beta and the level of autocorrelation. However, he admitted that for certain sub-samples of securities, perfect capital markets are valid, and the predictions of the CAPM are close to reality. MacKinlay and Ramaswamy (1988), among others, looked at intra-day arbitrage trading between the futures and spot for the S&P 500 index. They reported some differences in autocorrelation between returns on the futures and spot at short intervals but find that most of this goes away at the daily level. MacKinlay (1988) found significant serial correlation in weekly stock prices, rejecting the random walk hypothesis. Their result did not, however, support any other patterns and would have few implications to market efficiency. Jegadeesh (1990) reported significant negative monthly autocorrelation. The magnitude of abnormal returns was greatest in January. Furthermore, Boudoukh, Richardson and Whitelaw (1994) found that autocorrelation on futures was indistinguishable from zero. They claimed that reports of the death of market efficiency had been premature and greatly exaggerated.
Trading Rules It is not impossible to have trading rules based on price patterns in the stock markets. Some of the trading rules will be presented in the following section.
Filter Rules The filter rule is normally stated as ―purchase stock when it rises by X% from the previous low, and hold it until it declines by Y% from its subsequent high. At this point, sell the stock short, or hold cash. Fama and Blume (1966) conducted an extensive list of filter rules tests. Small filters, typically less than 0.5% seemed to work the best, and no filters larger than 1.5% produced better results than the buyand-hold strategy. The average profits were generally small, but over time, they substantially outperformed buy-and-hold strategies. Nevertheless, when accounting for transaction costs, which are substantial in such a transaction-intensive strategy, all the tested filter strategies became unprofitable. Furthermore, even the most profitable filter rules imply that cash is never idle, to compete with the buy-andhold portfolio. This is very difficult in real life, especially for a world without short selling, although the aid of modern computing powers might have improved the performance. Sweeney (1988) reviewed Fama and Blume‘s tests, and commented that for a sample from 1970 to 1982, some filter rules seemed to work, provided that floor traders‘ transaction costs were used. However, Sweeney concluded that the results were very sensitive to the transaction cost assumptions made as well as biases in closing price listing Elton and Gruber (1995) commented that Jennergren and Korsvold (1974) found some evidence of profitable filter rules in the Norwegian and Swedish markets. We
have not succeeded in finding evidence to whether these opportunities still persist, although one could assume that they are gone now, as the markets have grown more liquid. Often, there will be evidence both for and against a theory. A few of the most serious attacks on market efficiency have come from a few very influential articles. Elton and Gruber (1995) classified these tests under market rationality. This is because they belong to a group of seemingly uncorrected patterns. Under market efficiency, if a pattern is discovered, it should be traded away. Market rationality deals with patterns that have persisted through long time periods
Relative Strength Rules A popular measure of stock performance is relative strength. A general relative strength rule would measure today‘s stock‘s price pi,t against its average price during the past time period pi*. Following the definitions of Levy (1967), relative strength would be defined as pi,t/ pi*. A relative strength strategy would hence imply buying the X% with the highest relative strength ratio, and invest equal dollar amounts in them. Following this, sell the
securities whose relative strength rank is below a cast-out rank K , and use proceedings to invest in the upper X%. In his Ph.D. dissertation, described in Jensen and Benington (1969), Levy tested this strategy on a sample. The results indicated abnormal returns, but lacked a significance
test and proper risk adjustments. The best results were obtained with X=10%,
K=160 and X=5%, K=140 with corresponding returns of 20% and 26.1%, unadjusted for risk. Buy-and-hold returns were given at 13.4%. Jensen and Benington (1969) looked thoroughly into this investigation. After adjusting for risk, the most profitable strategy earned 1.4% on the buy-and-hold strategy, not including transaction costs. A further inclusion of transaction costs would make the strategy unprofitable. Furthermore, Jensen and Benington (1969) claimed that Levy‘s results were attributable to selection bias, as the same data was used for all filters. They finally added that ex post, filters could always be designed to fit a given data set.
EARLY MODELS The fair game model Bachelier (1900) presented the fair game approach in his dissertation Theory of Speculation. In his framework, he distinguished between two sets of probabilities. The first category he called mathematical probability, which is related to a priori probabilities, as studied in games of chance. The second category consisted of probabilities dependent of future events. These latter expectations, Bachelier (1900) argued, are subjective, cannot be observed and should hence not be part of the price. Hence, basing the prices on the a priori expectation, the prices would be fair. In other words, the price should reflect the events known to the market, and not the events that might occur. Following this definition, the stock market should be based on security returns having mathematical expectation equal to zero, using today‘s information in the market. Consequently, all information should be included in the prices at all times. Trading on insider information, however, violates this principle; hence the price would be unfair. Fama (1970), following what Bachelier once started, used a simple fair game model to present the efficient market hypothesis. Defining the set Ωtas the
information known at time t, pj,t+1 as the price, and rj,t+1 as return of security j at time t+1, he presented security prices as follows: E[pj,t+1| Ωt] = [1+ E(rj,t+1| Ωt)]pj,t This is the classical fair game model. A fair game is designed so that the players know their expected gain or loss to playing the game before playing it. The excess gain Ωt+1 from the return game can be defined as follows: Ωt+1= rj,t+1-E[rj,t+1| Ωt] (2)
In accordance to Bachelier‘s condition for a game to be fair, the expected excess gains E[ Ωj,t+1| Ωt] should be zero. The consequences of this simple statement are very important to efficient markets. If the market returns follow a fair game model, then the best return estimate would be the expected return. Hence, there would be no initiative to speculate, as the markets best estimate would already be reflected in the prices. This is in harmony with Fama‘s (1970) definitions, as mentioned in section 2.1. According to these definitions, if returns do not follow a fair game, then the market is not efficient Martingale and submartingale model Let us now consider the price pj,t of security j at time t. The stochastic process in the stock prices where E[pj,t+1| Ωt] Ω pj,t (3) is a martingale, whereas the similar process E[pj,t+1| Ωt] Ωpj,t (4) is a submartingale. Basically, the submartingale could be considered as a martingale with an upward drift. This would imply that Cov(rj,t+1,rj,t) is positive. As long as this autocorrelation is included in Ωt, this does not violate the fair game. We will refer to both as the martingale model, but note that they have some differences. For the martingale model, we can define xj,t+1 as the excess price difference, hence xt+1= pj,t+1-E[pj,t+1| Ωt] (5) and E[xj,t+1| Ωt] should be equal to zero. From (1) and (5) it is easy to deduce that if
prices follow a martingale, then returns follow the fair game. The opposite is not necessarily true, however.
Tests conducted on the stock market prices have to a large extent been based on the martingale model, due to its simplicity and testability features. If expected stock prices do not follow the martingale model, this would mean that the stocks are, on average, incorrectly priced, and arbitrage opportunities would exist. Under the efficient market hypothesis, rational investors would exploit this opportunity until it is gone, hence forcing the price back to the martingale model. Random walk The discussions on stock market behavior started with Kendall‘s (1953) discovery that returns appear to follow random walks. The probability density function f t[ Ωt] of the returns (r1,t+1 , r2,t+1 ,…, rj,t+1 ,…, rn,t+1) follows a random walk if: ft[r1,t+1 , r2,t+1 ,…, rj,t+1 ,…, rn,t+1] = ft[r1,t+1 , r2,t+1 ,…, rj,t+1,…, rn,t+1| _t] (6) The return of security j in period t+1 is independent of the information available at time t. Consequently, no good estimate based on today‘s information will explain the future returns. A random walk requires the fair game. Hence, modifying (1), we obtain Et[rj,t+1| Ωt] = Et[rj,t+1] (7) The extensions (or rather the restrictions) from the martingale model are numerous, as the random walk is a stronger assumption than the fair game. Firstly, the random walk implies that returns are identically and independently distributed (i.i.d). LeRoy (1989) claimed this would make the random walk hypothesis far too restrictive to be generated within a reasonably broad class of optimization models, hence martingale models would be more tractable Secondly, the random walk requires variance and skewness to be unaffected by information. Poteba and Summers (1986) reported that even though there is weak serial correlation in volatility, random volatility shocks will occur, and volatilities
change over time. LeRoy (1989) added to this discussion, arguing that security prices are known to have variance patterns of quiet and turbulent periods, not in agreement with the stable variance assumption. Lo and MacKinlay (1988) put the evidence in direct relation to the random walk hypothesis. Conducting a variance bounds test, they found significant serial correlation in stock prices. This would imply a rejection of the random walk hypothesis. Finally, the random walk has several other implications, such as price-value correlation, equilibrium when traded (all information is incorporated), and normality of price changes. Mandelbrot (1963) found that price change distributions were not normally distributed, and suggested that these fat tails could be explained by abandoning a finite variance assumption, and using a more fattailed distribution Schwert and Seguin (1990) claimed that the conditional distribution of security returns is much more fat-tailed than the normal distribution, and indicated that the normality assumption might be violated
2-SEMI-STRONG FORM EFFICIENCY OF THE MARKET The semi-strong form of the market hypothesis suggests that the current price fully incorporate all publicly available information. Public information includes not only past price but also data reported in a company‘s financial statements, earnings and dividend announcements, announced merger plans, the financial situation of company‘s competitors, expectations regarding macroeconomic factors such as inflation, interest rate, GDP, unemployment. Sometimes, the public information does not have to be of a financial nature. For example, for the analysis of pharmaceutical companies, the relevant public information may include the current published state of research in pain relieving drugs. The raison behind the semi-strong is that one should not be able to profit using something that ‖everybody else knows‖ since the information is public. Nevertheless, this assumption is far stronger than that of the weak-form. Semistrong form efficiency of the markets requires the existence of market analysts who are not only financial economists able to comprehend implications of financial information but also macroeconomists, experts adept at understanding processes in product and input markets. Such skills may be difficult to acquire and it requires a lot of time and efforts. In addition to that the public information may be relatively difficult to gather and costly to process. Some tests on the semi-strong Quarterly Earnings Jones and Litzenberger (1970) suggested that trading techniques based on data from quarterly earnings beat the market and that the market does not adjust immediately to these types of announcements. This slow adoption to unexpected
statements in the quarterly earnings is not consistent with the theory that security prices adjust rapidly to the release of public information. A later study by Jones and Latané (1979) drew approximately the same conclusion as Jones and Litzenberger. Jones and Latané found that the adjustment to unexpected earnings, published in for instance quarterly earnings, was relatively slow, and that it extends beyond the earnings report date. Predicting Cross-Sectional Returns The cross-sectional approach is simple. Stocks are ranked, and sorted into number of (usually five or ten) quantiles. For each of these quantiles, the returns are regressed against risk, estimated by some model, and the results are compared across the different sections. Hence the name cross-sectional returns. Regressions are usually done using an approach defined in Fama and MacBeth (1973). The goal is to determine if any factors can be used to explain returns, after the adjustment for risk. Studies gathered under cross-sectional return predictability and market efficiency use a diversity of publicly available statistics, such as accounting data, to rank stocks. Typical ranking criteria are accounting ratios such as Price/Earnings, Book/Market value and size (market capitalization). The cross-sectional tests involve a joint hypothesis problem, because they test not only the EMH, but also the model used to estimate risk. The conclusions from tests concerning these apparent anomalies have given rise to a discussion on the adequacy of beta as a risk measure. If beta does not adequately describe risk, this would have implications to the use of the CAPM, and favor APT models. Fama (1991) pointed out that correlation observed between fundamental variables and
returns could be consistent with the EMH, provided they were proxies for omitted risk factors.
Event studies Event studies examine how the market responds to certain economic events and if the stock prices adjust rapidly to these events. The type of economic events can be either company specific or general for the economic or political situation.
3-STRONG FORM EFFICIENCY OF THE MARKET The strong form efficiency states that the current prices of the security fully incorporate or reflect all existing information; both public and private (sometimes called insider information). So not only the public information which is useless to the investor but all the information. The differences between the semi-strong form and the strong form efficiency are that in the latter, nobody should be able to systematically generate profits even if trading on information not publicly known at the time. In other words, the strong form states that a company‘s management (insiders) are not able to systematically gain from inside information by buying company‘s shares ten minutes after they decided(did not publicly announce) to pursue what they perceive to be very profitable acquisition. Similarly, the members of the company‘s research department are not able to profit from the information about the new revolutionary discovery they completed half an hour ago. The rationale for strong form market efficiency is that the market anticipates in an unbiased manner, future development and therefore the stock price may have
incorporated the information and evaluated in a much more objective and informative way than the insiders. Since the first event studies, numerous papers have demonstrated that early identification of new information can provide substantial profits. Insiders who trade on the basis of privileged information can therefore make excess returns, violating the strong form of the efficient markets hypothesis. Even the earliest studies by Cowles (1933, 1944), however, make it clear that investment professionals do not beat the market. While there was evidence on the performance of security analysts, until the 1960s there was a gap in knowledge about the returns achieved by professional portfolio managers. With the development of the capital asset pricing model by Treynor (1961) and Sharpe (1964) it became clear that the CAPM can provide a benchmark for performance analysis. The first such study was Treynor's (1965) article in Harvard Business Review on the performance of mutual funds, closely followed by Sharpe's (1966) rival article. The most frequently cited article on fund managers' performance was to be the detailed analysis of115 mutual funds over the period 1955-64 undertaken by Jensen (1968). On a risk-adjusted basis,he finds that any advantage that the portfolio managers might have is consumed by fees and expenses. Even if investment management fees and loads are added back to performance measures, and returns are measured gross of management expenses (ie, assuming research and other expenses were obtained free), Jensen concludes that "on average the funds apparently werenot quite successful enough in their trading activities to recoup even their brokerage expenses."Fama (1991) summarises a number of subsequent studies of mutual fund and institutional portfolio managers' performance. Though some mutual funds have achieved minor abnormal gross returnsbefore expenses, pension funds have underperformed passive benchmarks on a risk-adjusted basis. It
is important to note that the efficient markets hypothesis does not rule out small abnormal returns, before fees and expenses. Analysts could therefore still have an incentive to acquire and act on valuable information, though investors would expect to receive no more than an average ne return. Grossman and Stiglitz (1980) formalise this idea, showing that a sensible model of equilibrium must leave some incentive for security analysis.To make sense, the concept of market efficiency has to admit the possibility of minor market inefficiencies. The evidence accumulated during the 1960s and 1970s appeared to be broadly consistent with this view. While it was clear that markets cannot be completely efficient in the strong form, there was striking support for the weak and semi-strong forms, and even for versions of strong form efficiency that focus on the performance on professional investment managers Some tests on strong form efficiency Corporate Insiders Some of the studies of corporate insiders, like Finnerty (1976), have examined corporate insiders and tried to determine how well they do relative to the market in general. Other studies, for example Rozeff and Zaman (1988), examined the returns for the corporate insiders as well as returns for outsiders basing their decisions on publicly available information concerning insider trades. The aspect of trades from corporate insiders has been studied since the 1960s. Rogoff (1964) concluded in his dissertation that insiders have an advantage over outsiders when they are trading in their own companies. But he also stated that the variability of the excess returns was too high to conclude that they had a persistent advantage compared to speculators
Jaffe (1974) concluded that insiders did possess special information, but that the excess profits were substantially affected when including transaction costs. He was also aware of the limitations of his study, caused by the fact that it only contained trades that had to be reported. Insiders could always leak information to others or they could trade in companies that were affected by decisions in their own company. Finnerty (1976) published a study that investigated insider trades for the New York Stock Exchange firms during the time period from January 1969 to December 1972. Based on a methodology developed by Jensen (1968), which described the risk premium of an individual security above the market return, Finnerty (1976) evaluated both buy and sell portfolios. For the buy portfolios, results were evaluated for up to 12 months after the trade. The returns were consistently positive and significantly different from zero. For the sell portfolios, results were similar, indicating that securities sold by insiders fell more than the market in the months following the trade. When comparing the post-trade months, the first month showed the greatest abnormal return. This might have been caused by the fact that the insiders‘ trades became public information soon after the trade. The conclusion from this study was that insiders were able to identify profitable or unprofitable situations in their own company in the short-run. Although his methodology was somewhat different, Finnerty‘s (1976) results were aligned with the results of Jaffe (1974), and both studies refuted the strong-form of the efficient market hypothesis Rozeff and Zaman (1988) considered both the potential excess returns for corporate insiders as well as the possibilities for outsiders to make above average returns based on publicly available information considering insider trades. A possible above average return based on publicly available information will violate
the semi strong-form of the efficient market hypothesis. This violation is referred to as the insider-trading anomaly, because it is based on insider trades. Rozeff and Zaman (1988) also investigated whether positive abnormal returns linked to insider trades could be explained by other factors such as size or P/E ratios. For the 1973 – 1982 period, an insider-trading anomaly was present. Although the excess returns for shorter periods disappeared after including transaction costs (2%), the returns for the 12-month horizon was significantly higher than the market return. When adjusting the market model for the size and P/E effects, the excess return for the 12-month horizon became insignificant. These results suggested that the abnormal returns experienced by outside traders, basing their activities on the trades of corporate insiders, were mainly caused by size and P/E effects. For the insider trades, the results were positive also after adjusting for both transaction costs and the size and P/E effects. The study by Rozeff and Zaman (1988) indicated a profit level of 3.12% per year. Furthermore, they suggested an upper limit of possible insider trade profits of at most 5% annually. The suggestion that the size effect is responsible for a great deal of the abnormal returns is further supported by Gregory et al., 1994). Their findings supported the conclusion that when you include the size effect, the abnormal returns for insider trades will become insignificant. Kara and Denning (1998) based their empirical test of the strong-form efficiency on insider trades in the period ranging from March 1979 to July 1980. Based on these data they indicate a rejection of the strong-form hypothesis
Stock Exchange Specialists Because of the monopolistic access to certain information, one would intuitively expect that stock exchange specialists are able to earn above-average returns. Niederhoffer and Osborne (1966) found that specialists' monopolistic power over information provided an edge for them to earn abnormal returns. A study by the SEC (Securities and Exchange Commission) in the early 1970s also supported this belief and contradicted the theory of strong-form efficiency. More recent studies have showed that abnormal returns for specialists are decreasing
Security Analysts Security analysts have experience and practice in finding undervalued stocks. The studies of security analysts will therefore give a more meaningful approach to the strong-form testing, independent of the possession of some specific position. The evaluation of security analysts preceded the hypothesis of efficient markets. Cowles (1933) concluded that neither the 16 financial services nor the 24 financial publications engaged in forecasting the stock market were able to outperform a random selection of stocks. Even the best records in each of the groups failed to present results that were significantly better than random performance. Cowles continued his study and reached the same conclusion in a later paper (Cowles, 1944). The results indicated that leading financial periodicals and services failed to successfully predict the future course of the stock market. Holloway (1981) investigated both buy-and-hold strategies and active trading based on the Value Line ranking. The buy-and-hold strategy accepted the rank-1 stocks from Value Line at the beginning of the year. The portfolio is held
unchanged for one year and then adjusted based on the ranking for the next year. This strategy gave abnormal returns even after the adjustment of transaction costs. The active strategy version of the Value-Line ranking strategy changed the portfolio consistently when the stocks weekly moved in or out of the rank-1 category. This strategy was able to earn positive abnormal returns without transaction costs, but the returns were consumed when adjusting for trading. Holloway (1981) was also taking into consideration whether the results were explainable by a failure to adjust for risk. His investigation suggested no such evidence. Hunerman and Kandel (1990) tried to reconcile the Value Line record with the efficient market hypothesis. They claimed that their model showed that Value Line‘s rankings predicted systematic market-wide factors, and that the alleged abnormal returns from positions based on Value Line were compensation for the systematic risk associated with these positions. Womack (1996) presented some evidence on the ability of analysts to predict or influence stock prices. He evaluated buy and sell recommendations made by analysts and concluded that they had a substantial impact on both an immediate and a long-term basis. He claimed that this was consistent with the expanded view on the efficient market hypothesis suggested by Grossman and Stiglitz (1980). They advocated that there had to be returns to costs induced by information search.
Chapter 5 TECHNICAL ANALYSIS AND EFFICIENT MARKET HYPOTHESIS The theory that past prices could be used to guide future investment decisions was first formalised by Charles Henry Dow (1985-1902), the founder of Wall Street and Dow Jones Company. His early work gave rise to a number of theories and techniques which are now employed everywhere by investors in their trading decisions. The term technical analysis refers to a myriad of trading techniques. ―Technical analyst attempt to forecast prices by the study of past prices and a few other related summary statistics. They believe that shifts in supply and demand can be detected in charts of market action‖ (Brock et al 1992). A-PRINCIPLE OF TECHNICAL ANALYSIS Neely in 1997 describes three principles which guide the behaviour of technical analysts. The first is that ―market discounts everything‖. In other words, all prices movement are ―a reflection of the trend in the hopes, fears, knowledge, optimism and greed‖ [pring, 2002]. As Drew in 1968 noted that the price level is ―never what they [stocks] are worth, but what people think they are worth‖. As such there is no need to forecast the fundamental determinants of an asset‘s value. In fact Murphy in 1986 claimed asset price changes often precede observed changes in fundamentals. The second principle states that the ―trend is your friend‖. Technical analysts maintain that asset prices move in trends and typically do not believe that price fluctuations are random and unpredictable.
Neely provides an example of what markets may be inclined to trend. First we assume that there is asymmetric information in the market i.e. some participants will have more information than others. It is likely that the trading behaviour of these participants will reveal some of their private information to uninformed participants. Let us assume that some investors have obtained some information about the fundamental determinants of a company which is likely to push the price of the share to go up. They will buy the share of the company which will raise the price of the share as they purchase more. When uninformed investors notice this behavior, they also will buy the same share increasing more the price of the share as they also buy. This is known as selffulfilling prophecy. Individuals believe that the share price is going to rise, and acting upon this belief, will cause the share price to rise independent of other factors. Therefore, the market is predisposed to trends. Some practionners even appeal to Newton’ law of motion to explain the existence of trend:‖trends in motion tend to remain in motion unless acted upon by another force.‖ Predictable trends are essentials to a technical analyst. They are what allow traders to profits by buying assets when the price is rising and selling when the price is falling. The third and final principle is that history repeats itself. The assumption is made that the emotional make-up of investors will not change. As such asset traders will tend to react the same way to the same market conditions and therefore, the subsequent price movements are likely to be similar. ―Technical analysts do not claim their methods are magical; rather that they take advantage of market psychology‖[Neely, 1997]. The objective is therefore to uncover signals given off in a current market by examining past market signals.
Technical analysis employs two main analyses: charting and Mechanical rules. A-TECHNICAL ANALYSIS TECHNIQUES: CHARTING Charting involves graphing the history of prices over some period determined by the analyst to predict future patterns in the data based upon past patterns. This method is much more subjective than the mechanical technique. It requires the analyst to use judgment and skills in finding and interpreting patterns. It is the process of establishing patterns within a series of data by visual inspection. To identify trends it is first necessary to find the maximum called peaks and the minimal also called troughs in the data. Peaks and troughs allow us to establish the uptrend and the downtrend respectively. Once technicians have identified the trend line, they will trade as necessary as possible. Buying at one level and selling at another level. Detecting the reversal of an established trend is just as important as identifying the trend itself. If a trend reversal is indicated, a trader can profit by reversing hi/her position. Peak and trough are also used for this purpose. Local peaks are called resistance levels and the local troughs are called support levels. A price failing to break a support level during a downtrend is thought to be an early indication that the trend may soon reverse. Another useful patterns identified the future movement of price are head and shoulders which are considered by the technicians are the most reliable of all chart pattern.
B-TECHNICAL ANALYSIS TECHNIQUES: MECHANICAL RULES Mechanical trading rule avoids the subjectivity such fear or greed and provides a consistent and disciplined approach to technical trading. Mechanical rules use statistical rules in order to obtain buy and sell signals. We can have three subcategories of mechanical rules namely: Filter rule, Moving average rules and oscillators. FILTER RULES Alexander formulated the filter rules to test the belief held among the professionals that prices adjust gradually to new information. For him the filter rules means that ―if the stock price has moved up more than further before it moves down percent it is likely to move up percent.‖
MOVING AVERAGE RULES The moving average is a lagging indicator which is easy to construct and it is one of the most widely used. A moving average, as the name suggests, represent an average of a certain series of data that moves through times. The most common way to calculate the moving average is to work from the last 10 days of closing prices. Each day, the most recent close (day 11) is added to the total and the oldest close (day 1) is substrated. The new total is then divided by the total number of days (10) and the resultant average computed. The purpose of the moving average is to track the progress of a price trend. The moving average is a smoothing device. By averaging the data, a smoother line is produced, making it easier to view the underlying trend. A moving average filters out random noise and offers a smoother perspective of the price action.
OSCILLATORS Oscillators are used as overbought or oversold indicators. A market is said to be overbought when prices have been trending higher in a relatively steep fashion for some time, to the extent that the number of market participants long of the market significantly outweighs those on the sidelines or holding short positions. This means that there are fewer participants to jump onto the back of the trend. The oversold condition is just the opposite. The market has been trending lower for some time and is running out of fuel for further price declines. Oscillators indicators move within a range, say between zero and 100, and signal periods where the security is overbought (near 100) or oversold (near zero). Oscillators are the most common type of technical indicators. The technical indicators that are not bound within a range also form buy and sell signals and display strength or weakness in the market, but they can vary in the way they do this.
FUNDAMENTAL ANALYSIS STRATEGY FOR PRDICTING THE STOCK RETURNS According the efficient market hypothesis, publicly available information cannot be used to predict returns and systematically generate abnormal profits. According to fundamental analysis, stock price reflects the firm‘s ability to generate positive future earnings therefore to earn abnormal returns using historical accounting data, researchers suggest that financial statements data should inform on firm‘s future earnings performance. OU & Penman in 1989, the pioneers in this research area, document the existence of significant abnormal returns to a trading strategy that is based on the prediction of the sign of future changes in annual earnings per share (EPS). Piotroski 2000 provides evidence supporting the predictive ability of historical accounting signals with respect to future stock price adjustments for a sample of value stocks characterized by high Book-to-Market value (BM). They remark that less than 44% of all high BM firms earn positive return. International Research Journal of Finance and Economics - Issue 30 (2009). Market-adjusted returns in two years following portfolio formation and suggest that investors could benefit by discriminating ex-ante between the eventual strong and weak companies. Using nine fundamental signals relating to three areas of the firm‘s financial condition: profitability, financial Leverage, liquidity and operating efficiency, they classify firms in ten portfolios depending on the signals‘ implication for future prices and profitability. Their results show that the mean returns earned by a high book to market investor can be increased by at least 7, 5% annually through the selection of financially strong high BM firms. Moreover, an investment strategy that buys expected winners and shorts expected losers
generates a 23% annual return. Like AB 1997, 1998, their results support the ability of historical accounting information to predict future firm performance and the market‘s inability to recognize these predictable patterns.
FUNDAMENTAL SIGNALS Twelve fundamental signals have been chosen from previous fundamental research. The selection criteria of these signals have been relied on the predictive ability with respect to future earnings performance and returns. Each firm‘s signal realization is classified as either good or bad according to its expected implication for future earnings and then prices. A binary variable is created for each signal that is equal to one if the signal‘s realization is good and zero if it is bad. 1-inventory (INV) This ratio measures the percentage change in sales relative to the percentage change in inventory. Inventory increases faster than sales is considered a negative signal because it suggests difficulties in generating sales or the existence of slowmoving or obsolete items that will be written off in the future. All these factors affect negatively future earnings 2-Account Receivable (AR) This signal represents the percentage change in sales less an analogous measure of accounts receivable. A disproportionate increase in accounts receivable relative to sales suggests cash collection difficulties and problems in selling the firm‘s products. Also, it may likely provoke future earnings decreases as provisions of future receivables experience an eventual increase. These arguments imply future
earnings decreases. So a positive value to this signal is considered good news. It is attributed one (zero) to this ratio when it is positive (negative)
3-INVESTMENTS (INVES) This signal measures the percentage change in capital expenditures relative to the percentage change in sales 2. A negative value of this ratio is considered bad news by analysts. In fact, capital expenditures are largely discretionary. So an unusual decrease is generally suspect. This decrease may indicate managers‘ concerns with the adequacy of current and future cash flows to sustain the previous investment level. Moreover, analysts associate this decrease with a short-term managerial orientation. The binary variable associated to this signal takes the value of one (zero) if this signal‘s realization is positive (Negative).
4-GROSS MARGINS (GM) This signal is defined as the percentage change in gross margin less an analogous measure for sales. A decrease in gross margin relative to sales is considered bad news. In fact, it indicates a deterioration of the firm‘s terms of trade or lack of cost‘s production control. According to Lev & Thiagarajan 1993, variations in this fundamental signal affect long-term performance of the firm and it is therefore informative with respect to earnings persistence and firm values 5-LABOUR FORCE (LF)
This ratio is defined as the change in sales per employee. It is used by analysts to appreciate the effects of restructuring decisions. In fact, decisions of labor force reductions are generally associated with increases in wage related expenses that
affect negatively current earnings but bode well for future earnings. That‘s why a similar signal is generally used to better assess future earnings.
6-7- RETURN ON ASSETS (ROA) AND VARIATIO IN RETURN ON ASSETS (ΔROA).
ROA is defined as net income before extraordinary items scaled by beginning of the year total assets and ΔROA is defined as the current year‘s ROA less the prior year‘s ROA.
This ratio is defined as cash flow scaled by beginning of the year total assets. Where cash flow = Earnings before extraordinary items – Accruals, And Accruals are defined as is common in the earnings‘ management literature (Dechow, Sloan & Sweeney 1995, Sloan 1996): Accruals = (ΔCA - Δ Cash) - ΔCL – Dep Where: ΔCA: change in current assets Δ Cash: change in cash/cash equivalents ΔCL: change in current liabilities Dep: depreciation and amortization expense According to Piotroski 2000, the three preceding signals provide information about the firm‘s ability to generate funds. Firm that realizes positive earnings or cash flow is demonstrating a capacity to generate some funds through operating activities. Similarly, a positive earnings trend is suggestive of an improvement in the firm‘s underlying ability to generate positive future cash flows. So, the binary
variable associated to each signal equals one if the signal‘s realization is positive and zero otherwise
This signal is defined as accruals scaled by beginning of the year total assets. This signal measures earnings persistence. Authors like Sloan , Bradshaw, Richardson & Sloan  and Collins & Hribar  show that persistence of current earnings is decreasing in the magnitude of the accruals component of earnings. That is firms with high accruals are more likely to experience declines in subsequent earnings performance and others with low accruals are more likely to experience subsequent earnings increase. Consistent with the negative relation between accruals and future earnings, I attribute the value of one to the binary variable if the accruals‘ signal is negative and zero if it is positive.
This signal represents change in the ratio of total long-term debt to average total assets. Literature review interested on financial leverage‘s impact on firm value has been controversial. Theoretical studies leaded for example by Harris & Raviv , Stulz  and Hirshleifer & Thakor  show that leverage is positively related to firm value. However, Myers & Majluf  and Miller & Rock  consider that leverage increases can negatively impact firm value.
11-LIQUIDITY (ΔLIQUID) This signal measures the change in the firm‘s current ratio between the current and prior year. current ratio is defined as the ratio of current assets to current liabilities at the fiscal year end. Liquidity increases signals the firm‘s ability to service current debt obligations. So the binary variable attributed to this signal equals one if ΔLIQUID is positive and zero if it is negative. 12-ASSETS TURNOVER (ΔTURN) This signal is defined as the firm‘s current year asset turnover ratio less the prior year‘s asset turnover ratio. The asset turnover ratio is defined as total sales scaled by beginning of the year total assets. A positive ratio may imply improvement in asset‘s use that is less assets generating the same levels of sales, or an increase in firm‘s sale.
MARKET ANOMALIES A market anomaly is any event or time period that can be used to produce abnormal profits on stock markets. Stock market anomalies occur across the world. They do not correspond with existing equilibrium models, where risk is the only factor which is likely to cause possible variations in stock market excess returns. The occurrence of pattern in time series of stock market returns, independent of time varying risk, would indicate that not all relevant information is captured in stock prices, which is inconsistent with the efficient market hypothesis. Stock market anomalies exist in every form of the efficient market hypothesis and can be classified in different categories, like for example firm anomalies, accounting
anomalies, events anomalies, weather anomalies and calendar anomalies.(levy and Post 2005)
1-FIRMS ANOMALIES: are consequences of firm-specific characteristics (levy and post 2005). One well-known firm anomaly is the SIZE EFFECT, which states that returns on small firms are higher compared to returns on large firms, even after risk-adjustment. Banz in 1981 discovered this size effect especially for the smallest firms in his sample based on total market value of NYSE from the period 19361975. Kein in 1883 presented the same conclusion for NYSE and AMEX firms in the period 1963-1979. The research of Banz in 1981 and Keim in 1983 in relation to the JANUARY EFFECT, is discussed in the later section. Another firm anomaly is the effect that firms which are followed by only a few analysts earn higher returns. This effect is known as NEGLECTED FIRM EFFECT. Arbel, carvel and srebel in 11983 looked at 510 firms from the NYSE, the AMEX and the over-the –counter markets and divided them into three groups of institutional holding (intensively held, moderately held and institutionally neglected) and three groups of size (small, medium and large). For the period 1971-1980 they found that the neglected firms earn significantly higher returns than firms intensively held by institutional investors for both the small and the medium size firms. 2-Accounting anomalies: accounting anomalies relate to stock price movement after the release of accounting information. An example of an accounting anomaly is the earning momentum anomaly, which implies that firms with a rising growth rate of earning are likely to have stocks that outperform the market. Another accounting anomaly is that if the market-to-book value (M/B) ratio is low, the stocks are likely to outperform the market.(levy and Post 2005). This phenomenon
is investigated by fama and French In 1992. They divided their total sample of stocks on the NYSE, AMEX and NASDAQ into ten groups based on M/B ratio and found that the group with lowest M/B ratio had an average monthly return of 1.65%, while the group with the highest M/B ratio only had an average monthly return of 0.72%. 3-EVENT ANOMALIES: relate to price movements after an obvious event. This can be for example the announcement that a firm will be listed on a major stock exchange. After such an announcement, the price of the stock rises. The recommendation of an analyst is another example of an event anomaly. Depending on the type of recommendation, the stock price will rise or fall (levy and post 2005). 4-WEATHER ANOMALIES: relate to price changes during certain weather conditions. Yuan, Zhen and Zhu in 2006 for example, find a relationship between stock returns and lunar cycles, looking at stock indices of 48 countries around the world for the period of January 1973 to July 2001. Their condition is that stock returns are higher on days around a new moon compared to days around a full moon. Furthermore, they looked at other explanations for this lunar effect, like macroeconomic announcements, trading volumes, returns volatility and other anomalies, but none of them appear to be valid. Another investigation concerning weather anomalies comes from Saunders in 1993. He explores whether the stock returns on the Dow-jones industrial average and NYSE/AMEX for the period of 1927-1989 are affected by weather conditions. His results suggest that the weather does not have significant influence on the stock market returns. This is especially the case for 100% cloudy days and for sunny days (with 0-20% clouds), where the mean return for the latter group differs most from the overall mean for all days. Saunders (1993) states that his results are robust to other anomalies like the
January effect, the weekend effect and the size effect. Cao and Wei (2005) investigate the possible relationship between stock market returns and temperature. They test whether lower temperatures lead to higher stock market returns due to aggression and therefore risk-taking and higher temperatures lead to higher or lower returns depending whether aggression (which causes risk taking) or apathy (which causes risk-aversion) dictates. Returns on nine stock market indices around the world between 1962 and 2001 are used. Overall, Cao and Wei (2005) find that stock returns are significantly negatively correlated to temperature. The four categories of stock market anomalies discussed above are not further captured in this research for several reasons. First, in general, there is considerably less research on these anomalies compared to calendar anomalies like the January effect, the day-of-the-week effect, turn-of-the-month effect and Halloween effect and the theoretical foundation for these anomalies is far from solid. Besides that, for some of the anomalies, like the weather anomalies, the data are more difficult to obtain and are beyond the scope of this project.
2.3 Calendar anomalies If a stock market anomaly depends solely on certain periods in a calendar year, it refers to a calendar anomaly. The followings are calendar namely the January effect, the day-of-the-week effect, the turn-of the- month effect and the Halloween effect.
2.3.1 January effect The January effect is one of the most well-known anomalies. In 1976, Rozeff and Kinney reported seasonality in stock returns, using monthly rates of return of the New York Stock Exchange from 1904-1974. The seasonality that they found was mainly caused by large returns in January, compared to the remaining months of
the year. In their research they focused on the existence of seasonality, they did not test possible explanations for it. Later on, others looked for possible explanations of the January effect. A selection of those articles is described in this section, categorized by their main Explanation for the January effect. The size effect Banz (1981) discovered that risk-adjusted returns are higher for small firms than for large firms based on total market value by using return data from stocks on the NYSE from 1936 – 1975. By defining sub-periods of ten years, he found that this ‗size effect‘ is not a linear function, so this does not mean that the returns increase when firm size decreases. Nevertheless, for the smallest firms in his sample, the effect is strongest. Keim (1983) also investigated the negative relation between firm size measured in total market value of equity and abnormal risk-adjusted returns. With data of firms on the NYSE and AMEX from 1963 – 1979, he defined different portfolios based on firm size and found that the smaller the firm size, the more excess return increased. Furthermore, his results showed that this effect is much stronger for January than for the remaining months of the year. In his further research, Keim (1983) found that approximately half of the size effect is caused by January returns and roughly a quarter is caused by the first five trading days of January. The findings of Banz (1981) and Keim (1983) suggest that the January effect found by Rozeff and Kinney (1976) should be more pronounced on small capitalization indices.
4-DAYS-OF –THE-WEEK EFFECT The day-of-the-week effect comes down to the difference in returns between a particular trading day a couple of trading days compared to the rest of the trading week. The weekend effect focuses on Monday and Friday returns, stating that
Monday returns are low and negative and Friday returns are high compared to the remaining trading days of the week. Extensive research has been done to find explanations for this anomaly. Here are the most important research that was made in the last few decades regarding the day-of-the week effect and the weekend effect. Cross (1973) was one of the first to report differences in returns on Fridays and Mondays compared to the rest of the week. With daily return data from 1953 – 1970 on the S&P 500, he found a statistically significant difference between Friday and Monday returns for almost every year in the sample period in both mean returns and in percentage of time that the index rose on that day. Moreover, his results showed that Monday indices following a decline on Friday rose in approximately 24% of the cases, which is significantly different from the reaction of the remaining trading days of the week following a decline of the previous trading day. Subsequent to Roll (1973), French (1980) reported that Monday returns were negative and lower than returns for other days in the week, using daily returns from the S&P 500 composite portfolio for the period 1953 – 1977. In his research, he examined if this is the consequence of the weekend prior to each Monday or the consequence of every non-trading day (Holiday). His results illustrated that the return on every weekday on its own (with the exception of (Tuesday) is higher when the day follows a holiday compared to when the day follows a trading day. This is different for Tuesday, because Tuesday is the first trading day after the weekend when Monday is a holiday. Therefore, French (1980) concluded that the negative Monday returns are caused by a weekend effect. Cross (1973) and French (1980) did not look for possible explanations for the weekend effect, although other authors did. Below a selection is given of the articles of those authors and their findings regarding the weekend effect.
Settlement period By using mean returns and variances for the S&P 500 and the CRSP value- and equally-weighted portfolios from July 1962 – December 1978, Gibbons and Hess (1981) also found negative Monday returns, although no Monday effect in variances. Moreover, they searched for possible explanations for the Monday effect. The settlement period explains the more negative Monday returns before 1968 compared to the returns after 1968, because the settlement period was four business days before February 1968 and five business days after February. Nonetheless, it does not explain the negative Monday returns from February 1968 – December 1978. Apart from that, the settlement period is nowadays three business days for stocks. Release of information French and Roll (1986) investigated the return variances of weekdays, weekends, holidays and holiday weekends by means of daily returns on the New York and American Stock Exchanges from 1963 –1982. They found that the returns are more volatile during exchange trading hours compared to non trading hours. The three possible explanations that were given for this are that public information (Which causes the volatility) is announced more frequently during business days (weekdays), private information probably influences prices more when the stock markets are open and the process of trading itself causes volatility. French and Roll (1986) concluded that their results showed that only a small part of the difference in variances between trading hours and non-trading hours is caused by mispricing occurring during trading. The reason for this mainly lies in the difference in quantity of information announced between trading hours and non-trading hours.
The days-of-the-week effect internationally Jaffe and Westerfield (1985) contributed to the literature by investigating the dayof-the-week effect internationally. In all countries in their research, namely the U.K., Japan, Canada and Australia, they found a day-of the-week effect with significant negative Monday returns and high Friday returns. Correlations tests suggest that there is a strong correlation between the returns of the four foreign countries and those of the U.S. Nonetheless, independent of the day-of-the-week effect in the U.S. Jaffe and Westerfield (1985) found a day-of-theweek effect in each of the four countries on their own. Similar to Gibbons and Hess (1981), they looked at settlement periods to explain the day-of-the-week effect. They only found little evidence for the higher Thursday and Friday returns in Australia, but for Canada, the U.K. and Japan the settlement period did not explain the day-of-the-week effect at all. In addition, Jaffe and Westerfield (1985) investigate the opportunity that measurement errors cause the day-of-the-week effect. They state that if Monday returns would be influenced by mainly negative random errors and Friday returns by mainly positive random errors, the correlation between Monday and Friday returns should be low. Nonetheless, they found a higher than average correlation between Monday and Friday returns and therefore conclude that measurement errors cannot explain the day-of the-week effect. In their exploration of different anomalies on stock market indices in eighteen countries across the world, Agrawal and Tandon (1994) captured the day-of-the week effect as well. They found negative returns on Mondays for thirteen countries (of which seven are statistically significant), but also negative returns on Tuesdays in twelve countries (of which eight are statistically significant). Furthermore, they found Tuesday returns to be lower compared to Monday returns in eight countries. Contrary to these negative Monday and Tuesday returns, they revealed positive Wednesday and Friday returns in the majority of the countries. After reporting the
day by day returns, Agrawal and Tandon (1994) discussed possible explanations for the negative Tuesday returns. They stated that the time zone hypothesis (which argues that Tuesday returns are low in some countries due to time-differences that exceed twelve hours) can explain the negative Tuesday returns in three of the five countries, but cannot explain the negative Tuesday returns in European countries. Furthermore, the difference between trading days and non-trading days is not an explanation for the negative Tuesday returns. After running day-of-the-week correlation tests and regressions, the null hypothesis that day by day variances are dependent on the US can be rejected for the majority of the countries. Moreover, Agrawal and Tandon (1994) argued that the settlement procedure explains a part of the day-by-day differences (mainly the higher returns on Wednesday, Thursday and Friday) in returns, but cannot explain the negative Monday and Tuesday returns for most of the countries. Furthermore, they divided their total sample period into two sub-periods and found that in the seventies Monday returns are significantly negative in seven countries and Tuesday returns are significantly negative in nine countries, while in the eighties the Monday and Tuesday returns are not significantly negative in the majority of the countries. Finally, they found that Monday returns are negative in almost all countries if the market declined the previous week, but mainly positive when the market went up the previous week. However, this is not found for Tuesday returns.
4-TURN-OF-THE-MONTH EFFECT The turn-of-the-month effect refers to higher stock market returns for the trading days surrounding the turn of the month compared to the remaining days of the month. In the past decades, many researchers discussed the turn-of-the-month effect, all with their own approach. By looking at the stock returns of the CRSP
value-weighted and equally-weighted index for the period (1963 – 1981, Ariël (1987) concluded that the mean cumulative return of the first half of trading months is significantly higher than the mean cumulative return of the second half of trading months. For this, he added the last trading day of the month to the first half of the following month. In the entire period he examined, the mean return of the first half of the month was positive and the mean return of the last half of the month was equal to zero. At five percent significance level, he did not find unequal variances between the first half of trading months and the last half of trading months. This effect is not induced by outliers either. After reporting this effect, Ariël (1987) looked for possible causes of the difference in mean returns between the two periods. He reported that the effect is not caused by a concentration of dividend payments, holidays or weekends in the first or last half of the month. Furthermore, the effect still held after correcting for returns in January and therefore was not caused by the January effect. Moreover, the effect is not induced by a few months where the effect is strongest.
5-halloween effect The Halloween effect refers to lower stock returns during the period May – October compared to the returns during November – April. It was first presented by Bouman and Jacobsen (2002). They concluded, using monthly stock returns of value-weighted market indices of 37 countries for the period January 1970 – August 1998 that the Halloween effect is present in 36 countries and is particularly economically significant in many European countries. After using the regression technique, Bouman and Jacobsen (2002) concluded that there is a statistically significant Halloween effect at 10-percent level in 20 of the 37 countries. These
results, they said, are also robust over time. Besides finding the Halloween effect in their sample, they looked for possible explanations for it. After running different tests, they rejected data mining, difference in risk, the January effect, differences in interest rates and trading volumes as possible explanations. Furthermore, they did not find any seasonal effect in the news which could explain the Halloween effect. While Bouman and Jacobsen (2002) did not find an explanation for the Halloween effect; other articles did present possible explanations.
BEHAVIORAL FINANCE AND EFFICIENT MARKET HYPOTHESIS The behavioral finance is a new area of financial research that explores the psychological factors affecting investment decisions. It attempts to explain market anomalies and other market activity that is not explained by the efficient market hypothesis. The fundamental basis of behavioral finance is that psychological factors, or behavioral biases, affect investors, which limits and distorts their information and may cause them to reach incorrect conclusions even if the information is correct. Behavioral Biases Behavioral biases can be categorized in many ways, and many of these categories may be overlapping or indistinguishable. The following factors have been published as having some impact on the market. Contrarian and momentum strategies take advantage of some of these psychological factors.
Emotional Factors Emotion often overrules intelligence in decisions and can filter facts, where the investor may give too much weight to facts that are agreeable and may tend to ignore or underweight facts that are antithetical to one's predisposition. There is the fear of regret, or regret avoidance, which causes investors to hold losing positions too long in the hope that they will become profitable or sell winners too soon to lock in profits lest they turn into losses. Overconfidence in one's abilities can lead to higher portfolio turnover and to lower returns. Despite the fact that few investors or even professional portfolio managers beat the market over an extended time, there is still a considerable amount of active portfolio management. One study has shown, on the average, that men have lower returns than women because they trade more actively, presumably because they have greater confidence in their abilities. Conservatism is the hesitation of many investors to act on new information, where such information should dictate an action or a change to one's strategy. This hesitation to news, for instance, eventually leads to action at different times for different investors, leading to momentum as more investors start reacting to the news. Belief perseverance is the persistence of one's selection process and investment strategies even when such strategies are failing or are suboptimal, causing the investors to ignore new information that may contradict one's decisions. Loss aversion is the propensity for people to avoid losses even for possible gains. Hence, people often hang onto losing stocks longer than they should, since selling
would actualize the loss; otherwise, it is still just a "paper loss". Loss aversion is related to the marginal utility of money, where the 1st dollars are more valuable than additional dollars. For instance, most investors would avoid an investment where there was a 50% chance of either earning $50,000 on a $100,000 investment, or an equal chance of losing the same amount, because the $50,000 lost would have greater marginal utility, and therefore be more valuable to the investor, than the $50,000 potentially gained. Misinformation and Thinking Errors Misinformation and thinking errors probably account for most market inefficiencies, since no one knows everything and, even if they did, they may not make the best decisions based on that information. Forecasting errors are a typical example, since even stock analysts are frequently wrong about future earnings and prospects for the companies that they cover. Representativeness is the extrapolation of future results based on a limited set of observations or facts; hence, this is sometimes known as small sample neglect. This is best illustrated by investors seeking a fund in which to invest, and basing their decision on the fund's most recent performance rather than covering a longer period of time, especially during bear markets. Often, this is the result of the lack of due diligence, where the investor relies on brochures or other advertising materials put out by the company or fund instead of doing independent research. Narrow framing is the evaluation of few factors that may affect an investment. For instance, an investor may buy a security because of its past performance without considering economic factors that may be changing that could change the performance of the security. Mental accounting is a specific kind of narrow
framing in which different investments are mentally segregated, applying different criteria and due diligence to different investments where the different consideration may be unwarranted. For example, treating separate investments as if they were the only investment rather than as part of one's portfolio. Biased information gathering and thinking is the distortion of personal bias on facts and thinking to conform with one's current opinions or actions. Limits to Arbitrage So if behavioral bias misprices stocks, why don't arbitrageurs take advantage of the mispricing, by buying and selling until the mispriced stocks are equal to their intrinsic value? Behavioral advocates have argued that mispricing persists because there are limits to arbitrage. First, there is the risk that the mispricing will get worse, and, therefore, present a risk to arbitraging. The market influence of behavioral bias may be greater than the influence of arbitrageurs, especially since arbitraging behavioral bias is not riskfree. And even if prices do trend toward their intrinsic prices, it may take longer than arbitrageurs think—maybe longer than their investment horizon. Secondly, financial models may be inaccurate, making arbitrage risky. Thirdly, much of the arbitrage activity would require short selling, which, with stocks, is very risky, and many institutional investors are not permitted to sell short.
Herding Behavior An explanation for momentum strategies is called herding behavior. Banerjee (1992) defined herding as doing what everybody else is doing, even when evidence (i.e. private information) implied it might be cleverer not to. His theory was supported by the momentum patterns discovered in the empirical research of Jegadeesh and Titman (1993). Grinblatt, Titman and Wermers (1995) investigated mutual fund behavior, finding that funds did have a tendency of buying past winners, and, more specifically, engaged in herding. The evidence was not, however, particularly strong. Since institutional holdings comprise a large percentage of total equity holdings, at least in the US, this is, at least partially, compelling evidence for a momentum factor. Herding behavior, as described, should result in intermediate term momentum, and a long-term reversal pattern, and its effects are hence, very similar to the theories of noise trading. Why do people engage in herding? As commented in section 6.2.1, fund managers might engage in window dressing to take care of agency problems. Furthermore, tax-loss selling might explain some of the herding behavior. Herding is not, however, consistent with Markowitz-rationality. As already mentioned, Black (1986) claimed that true value is not observable. Hence, it would be difficult to measure whether a stock price really is in equilibrium. A direct test of herding might therefore be difficult to design. However, the momentum effects of Jegadeesh and Titman (1993) could be interpreted as evidence supporting crowd Of course, true fundamental value is not known (Black 1986).
As already mentioned, Black (1986) claimed that true value is not observable. Hence, it would be difficult to measure whether a stock price really is in
equilibrium. A direct test of herding might therefore be difficult to design. However, the momentum effects of Jegadeesh and Titman (1993) could be interpreted as evidence supporting crowd overreaction. Furthermore, DeBondt and Thaler‘s (1985) results on long-term reversals might also indicate that there has been an overreaction. In retrospect, however, it is easy to use herding to explain under- and over-reactions. The counter argument could be that the theory was fitted to explain empirical results, hence indicating a data-mining bias. The persistence of the effect is one of the serious challenges to the EMH.
Chapter 6 DATA AND RESEARCH METHODOLOGY The monthly price indices are examined for the empirical analysis from Ghana stock market for a period of two years starting January 2007 to December 2008. The whole sample includes 24 monthly observations. This sample takes in account all the trading days except the holidays and the weekends. Some information was collected through direct interview and questionnaires with brokerage houses which are buying and selling in the Ghana stock market. Other information was collected through direct interview with the research department of the Ghana stock exchange and through reading materials in the library of the Ghana stock exchange. RESEARCH METHODOLOGY This paper investigates the weak form efficiency of the Ghana stock market by employing a statistical test or regression test. Indeed, the hypothesis that stock market price index follow a random walk is tested. Accordingly to the null and alternative hypotheses for weak form efficiency test are: Ho = Ghana stock market‘s price indices are weak form efficient H1 = Ghana stock market‘s price indices are not weak efficient or are inefficient
TABLE 1 Data MONTH NUMBE GSE ALL R SHARE INDEX JANUARY 1 5012.16 MEAN 7559.5762 5 FEBRUAR Y MARCH 3 5092.25 STD DEVN APRIL MAY JUNE 4 5 6 5139.65 5224.47 5294.58 MAX MIN SKEW 2368.7738 92 10890.8 5012.16 0.3708870 63 JULY 7 5341.76 KURTOS IS 1.7249105 55 AUGUST SEPTEMB ER OCTOBER NOVEMBE R DECEMBE 12 6599.77 10 11 5839.62 6387.16 8 9 5557.38 5676.77 2 5044.89 MEDIAN 6664.385
R JANUARY FEBRUAR Y MARCH APRIL MAY JUNE JULY AUGUST SEPTEMB ER OCTOBER NOVEMBE R DECEMBE R 24 10431.64 22 23 10788.29 10573.43 15 16 17 18 19 20 21 7848.14 9349.59 9815.22 10346.3 10650.72 10790.95 10890.8 13 14 6729.00 7005.29
REGRESSION 1-THE REGRESSION ANALYSIS Regression analysis is a statistical tool for the investigation of relationship between variables. Usually the investigator seeks to ascertain the causal effect of on variable upon another. The investigator also assesses the statistical significance of the estimated relationships, that is, the degree of confidence that the true relationship is close to the estimated relationship. Steps in regression analysis: 1-State the hypothesis If there is a significant relationship between the variables, the slope will not be zero Ho: B1 = 0 Ha: B1≠ 0 The null hypothesis states that the slope is equal to zero and the alternative hypothesis states that the slope is not equal to zero. 2-Formulate an analysis plan The analysis plan describes how to use the sample data to accept or reject the null hypothesis. The plan should specify the following elements. a- Significance level. Often researchers choose significance levels equal to 0.01, 0.05 or 0.10, but any value between 0 and 1 can be used. b- Test method. Use a linear regression t-test to determine whether the slope of the regression line differs significantly from zero.
3-Analyze sample data Using the sample data, find the standard error of the slope, the slope of the regression line, the degrees of freedom, the test statistics, and the p-value associated with the test statistic. a- Standard error. It could be referred to as the standard deviation b- Slope. Like the standard error, the slope of the regression line will be provided. c- Degrees of freedom. The degrees of freedom(DF) is equal to: DF = n – 2 Where n is the number of observations in the sample. d- Test statistic. The test statistic is a t-test (t) defined by the following equation. t = b1 / stdev Where b1 is the slope of the sample regression line, and the stdv is the standard deviation of the slope e- P-value. The p-value is the probability of observing a sample statistics as extreme as the test statistics. Since the test statistic is a t-test, use in the t-distribution to assess the probability associated with the test statistic. Use the degrees of freedom to compute above 4-Interpret result if the sample findings are unlikely, given the null hypothesis, the researcher rejects the null hypothesis. Typically, this involves comparing the pvalue to the significance level, and rejecting the null hypothesis when the p-value is less than the significance level
Table 2 REGRESSION TABLES
Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 765.6702638 24 0.948715909 0.900061876 0.895519234
Table 3 ANOVA table
ANOVA df SS MS F Significance F Regression 1 116157543.3 116157543.3 198.1362124 1.75272E12 Residual Total 22 12897520.96 586250.9529 23 129055064.3
Table 4 INTERPRET REGRESSION COEFFICIENT TABLE
Intercept X Variable 1
3586.885109 322.6155376 11.11814123 317.8152913 22.57838429 14.07608654
Testing the significance or efficiency Hypothesis Ho : r = 0 (There is no correlation between the prices or ) Ha : r ≠ 0 (There is correlation between the prices)
Where : r = 0.900061876 n = 24 t= t = 9.688002 Degree of freedom (Df) = n-2 =24-2= 22. This is because of two tailed test. Using a significance level (α) of 5%. Therefore the t critical from a t-table is listed below: t α,(n-2) = t 0.05,(24-2) = t0.05,22 = 1.717
T = 9.688002 and the DF = n-2 = 24-2 = 22
α = 0.05 and the value in the table is 1.717
RESULTS The test of regression was performed on two years trading result from the Ghana stock exchange all-share index to determine whether the market is weak form efficient or to see whether the prices can be predicted. The t-test statistic for the slope was significant at 0.05 critical level. The t (24) = 9.688 and the p = 1.717. Thus we reject the null hypothesis and conclude that the market is inefficient which means that the prices can be significantly predicted. Also if the value of the test statistic is greater than 1.717 or less than – 1.717, we reject the null hypothesis (Ho), that there is no correlation and we accept the alternative hypothesis that the correlation is significant which means that the prices are predictable and the market is inefficient in short term. From the result, it concludes that the regression coefficient is significant; this also indicates that the market is inefficient and the market is predictable from the above result with margins of error.
REASONS BEHIND INEFFICIENCY One of the main purpose of the main inefficiency in the Ghana stock market is that most of the investors are not educated enough concerning the pattern of the market, meaning investors lack adequate knowledge to verify quality shares based on fundamentals analysis and consequently carrying the transaction or trading based on speculation or rumor only. The flow of information is not asymmetric to all the investors at a time resulting into an advantage to a group of investors acquiring the information early ahead to make abnormal profit. Another issue is the inequality between the demand and the supply of shares in the market. First lack of quality shares instigates instability in the market. Second reason could be the approval of 0% income tax on capital gain encourages investors to invest in the market which increases the demand where as the supply remains the same. Another reason could be the volume of shares traded in the market and also the size of the market. In addition to the small number of participants and products in the market, there is also lack of adequate research to improve the efficiency of the stock market. There is lack of professionalism in the part of the brokers some of which are only graduated from the Ghana stock exchange.
SOLUTIONS FOR THE MARKET EFFICIENCY In order to make the market efficient, investors must believe that the market is inefficient and that it is possible to outperform it or beat the market. Ironically, investment strategies intended to take advantages of the market inefficiency are the fuel that keep the market efficient. The market must be large and liquid and must also have large number of participants. In addition to that the information must be available to all the investors in the market. Plus the transaction cost must be cheap as compared to the expected returns and investors must have enough funds at their disposal.
Chapter 7 CONCLUSION AND RECOMMENDATIONS CONCLUSION Referring to the test that has been conducted, it is concluded that the Ghana stock exchange is not efficient at its weak form. Therefore there is a need to take actions to improve the efficiency of the market. First, it is important to ensure symmetric information among all the investors. In addition to the existing awareness creation policy it is also important to improve on continuous basis to enlighten the investors about market structure, trading pattern, financial analysis of the listed companies. Proper implications of the rules of regulatory commission are also needed to be ensured so that there will not be any scope to violate the market structure to gain abnormal profit. It is also important that the regulatory commission enforces policies to ensure improved quality of the stock market. Finally to make more efficient it is expected that the authority of the market would introduce sophisticated means of investment and tools in the near future and above all the campaigns to sensitize people about the importance of the stock market and how to invest in the stock market and what are the benefits.
RECOMMENDATION FOR FURTHER RESEARCH As a result of the inefficiency of the Ghana stock exchange, the following points should be considered for future research. 1-The Ghana stock exchange should be opened to foreign investors. 2-The foreign investors holding in the GSE should be increased 3-Improve on the clearing and settlement system 4-Improve on the volume traded and participants on the market through the listing requirement. 5-Campaign to sensitize investors about the importance of the stock market. 6-improve professionalism on the part of the brokers through organizing training 7-Strategies to improve the role of information to make the make efficient 8-High cost of listing on the stock exchange 9-Small float of shares 10-Non-performing companies 11-Impact of the macroeconomic variables
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.