Predicting The Stock Market And Defeating The Efficient Market Hypothesis - Part I

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Includes: DIA, IWM, QQQ, SPY
by: Yicheng Lin

Summary

Definition and history of the efficient market hypothesis.

Buy the Sell recommendations.

Predicting the stock market using earnings yield, new issuance, and post-earnings announcement drift.

The Establisher of EMH

(Source: The University of Chicago Booth School of Business)

Definition of the Efficient Markets Hypothesis (EMH)

An efficient capital market is a market that is efficient in processing information. In other words, the market adjusts to all information quickly and correctly. In an efficient market, the prices of securities observed at any time are based on "correct" evaluation of all information available at that time. Therefore, in an efficient market, prices immediately and fully reflect all available information.

Reasons to Think the Markets Are Efficient:

There can be biases at individual level, but no biases at aggregate level because of diversification.

Rational investors determine the pricing, while irrational and individual investors have limited roles.

Arbitrageurs: Mispricing would disappear due to arbitrages.

Survival of the fittest: Biases investors will lose in the long term and therefore quit the stock market. Only those who learnt from their mistake will remain.

Reasons to Doubt these Reasons

Human beings are not computers and do make common mistakes with common cognitive limitations.

Limitation of arbitrage: Smart investors do not always help with efficient pricing because the transaction cost of arbitrage may be very high, and there may be no reason to correct the price if they believe noisy traders will continue to push the price further away from its fundamentals.

In terms of survival of the fittest, investors have different life cycles; while the old "losers" may leave the market, new "dumb" investors will join.

Three Forms of EMH

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Three Different Forms

There are three different forms of EMH.

Strong form says prices fully reflect all information, including public and private information. It implies that no one can outperform the market, not even with insider information. This is the easiest form to reject.

Semi-strong form indicates that prices fully reflect all publicly available information and expectations about the future. This suggest that prices adjust very quickly to new public information, such that old public information cannot be used to earn superior returns.

Weak form of EMH gets even smaller, indicating that past prices, returns, volume and other market statistics provide no information that can be used to predict future prices. It basically repudiates technical analysis.

Defeating the Theory and Predicting the Market

Buy the sell recommendation:

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(Source: The Wall Street Journal)

The chart from WSJ shows that when sell-side analysts issue Buy and Sell recommendations, the Sell recommendations frequently outperform those with Buy or Hold ratings. This is an embarrassment for Wall Street, but a valid point that disapproves the semi-strong form of EMH. In theory, investors can buy stocks with the most Sell ratings and outperform the market.

Post-Earnings Announcement Drift

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(Source: Harvard University)

In 1989, Bernard and Thomas found that there is a tendency for stocks to move in the direction of an earning surprise for several weeks or months after the initial earnings announcements.

Earnings Yield:

Earnings yield = Dividend yield + Retained earnings yield or earnings/price

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(Source: University of Toronto)

A small earnings yield actually indicates that the stock market is confident about the future aspects and often produces a good market return for the year. On the other side, a high earnings yield implies pessimism, and the stock market often tanks during the same year.

New Issuances

Using data from 1928-1997, Baker and Wurgler (2000) found that firms issue relatively more equity than debt just before periods of low market returns. Equity issuance is often considered as a better indicator of market returns than dividend yield and even price-to-book.

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(Source: New York University)

Takeaway

Efficient market hypothesis has lost its popularity in recent years, and there are plenty of reasons why. Therefore, investors need to be aware of blindly buying market ETFs and following sell-side analysts who only gives out Buy recommendations. After having a record-breaking IPO year in 2014 and the following year being the biggest M&A year ever, the stock market has likely reached its peak for the near term.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.