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Finance

Name

Institution

27th January 2015

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Part A

Technical analysis is a technique utilized when predicting price fluctuations of financial

asset for sound investment decisions. This technique lays its basis on computation of the

prevailing market activities, for example historical volumes and prices, while at the same time

disregarding the organization’s worth and economical conditions. Therefore, technical analysis

does not make an effort to calculate the fundamental worth of financial asset (Jensen et al. n.d.).

Predictability of excess stock returns using technical analysis.

The analysis endeavors to establish what direction the future will take on the overall

market outlook, making forecast models concerning the demand and supply balance. It was

developed by Charles Dow and based on three suppositions: that the market averages everything,

the price fluctuations follow a certain trend, and finally that the past seems to recur (Jensen et al.

n.d.).

The latest studies trying to evaluating the technical analysis’s predictive supremacy were

done by Brock et al. in 1992. In essence, the academics examined simple technical trading

regulations used for DJIA index from 1897 - 1986 with its average of about 6.5. They discovered

that the forecasted returns differed considerably based on the trading indications, shown by the

instruments. For example, “regarding a buy signal, stock proceeds are considerably

less unpredictable as opposed to a sell signal” (Brock et al., 1992). To Brock et al., the moving

base would have permitted an investor to constantly participate in the marketplace and earn an

average return of 12 %, depending on the positive sentiments. Dissimilar to positive trends, the

technique discovered an average net loss for the similar period of –7 % in the downward

movements. They therefore recommended that technical analysis method has a projecting power
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during the upward cycles only. Nevertheless, the scientists were unsuccessful in evaluating the

earned proceeds on statistical importance, thereby making the findings to be unprovable. It is

therefore difficult to determine whether the technical analysis, according to Brock et al., actually

led to the realization of excess returns, or the result is just a statistical error. However, Fong and

Yong in 2005 succeeded in shining light of the majority of trading earnings arising from

technical signals. This research had been specifically committed to evaluation of whether

technical trading regulations as determined by moving averages contributed to every day

proceeds in the time of market growth. This research relied mostly on post data, by performing

analysis in a real time fashion and implementing trading orders based on the existing

information.

Price fluctuations are projected to be absolutely unpredictable if expected proceeds are

zero. In fact, because stock prices move up, there is normally an expected positive proceed.

However, in short time gaps, predicted returns are so minute such that they are wiped by the

downward volatility. Some of the supporters of the efficient market model do not consider that

the certainty means market inefficiency.

Lo (2004) says the degree of stock’s return predictability differs with volatility in the

market conditions. However, he does not propose precise indicators of market situations or any

dispensable predictions concerning the direction of the correlation between stock income

predictability and the pointers of the prevailing market circumstances.

Authors like Fama and French (1988), Roze" (1984), and Campbell and Shiller

(1988a,b) discovered that the valuation ratios are absolutely correlated with succeeding proceeds

and that the disguised predictability of proceeds is significant at longer time periods. At about the

same time, several studies pointed out that returns on long-term and short-term corporate and
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treasury bonds are interrelated with following stock returns [Keim and Stambaugh (1986),

Campbell (1987), Fama and Schwert (1977),and Fama and French (1989)].

The early empirical researches that led to Fama's 1965 notion that prices of stock were

volatile emphasized on simple short-term relationships using data bases that, as a minimum by

modern values, seem minute. Fama's study examined whether there was a predictable correlation

in the daily price changes of the 30 stocks making up the Dow Jones Industrial Average for the

time period 1957-1962. Even though Fama found statistically positive ongoing correlation, he

concluded that the relationships were not of any economic importance. Nonetheless, if the period

is lengthened, and the amount of stocks are increased, new trends emerge. For instance, French

and Roll (1986) reiterated Fama's examinations for all AMEX and NYSE stocks for the duration

of the 1963-1982.

In conclusion, trading strategies relying on technical analysis are extensively utilized in

diverse varieties of financial markets. The model has is fair share of supporters and non-

supporters, whereby the former group seems to be rewarded for using the technical analysis

model to discover investable financial assets. While the latter does not thrive in it. Therefore, the

technical analysis model triumph in making excess proceeds is arguable. A lot of time and

energy was dedicated to coming up with flexible and predictive models whose basis is on long-

established technical models. Amongst 92 models, greater than half confirmed the advantages of

technical analysis model. However, most of them were based on misled major factors, which

thereby reduced the average proceeds level made by technical strategies (Irwin & Park 2004).

However, amidst all these, there were few statistically proven results of surplus returns

achieved through the use of technical models, for instance Han’s et al “A new anomaly”.

Consequently, it may be concluded that with proper risk review and operational costs in mind,
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technical analysis models used for the stock market can generate positive, however not excessive

profits. Having in mind the amount of historical data now available, forecasts of stock proceeds

moving forward may have greater weight on the available data, and minimal burden on

speculative restrictions, as compared to methods that successfully forecasted stock profits during

the 20th century, Warusawitharana and Wachter (2006).

So long as stock markets are present, the shared conclusion of investors will at times

make errors. Without a doubt, some market members are proven to be less rational. Therefore,

pricing anomalies coupled predictable trends in stock proceeds can emerge over time and remain

the same for small periods of time. On the other hand, the market cannot be ideally efficient, and

therefore there would be no enticement for specialized stock personnel to discover the

information that promotes the predictability of the market prices (Grossman and Stiglitz, 1980).

Undoubtedly, as time passes by and with the escalating complexity of databases and empirical

techniques, a departure from the efficiency and predictable patterns of stock returns is eminent.

Part B

Predictability and market efficiency

In stock markets the EMH is cherished but not worshipped. It is acknowledged that

markets are probably efficient most of the time but always. Lack of efficiency may arise mostly

during periods of significant technological and institutional changes. It is not feasible to know

where and when these market inefficiencies may arise before hand- but it is supposed that they

may arise from within a given time cycle. Market players prefer the volatility predicts news and

changes with options to take advantage. Recognition of advantageous predictability tends to get

fully varied across different markets for foreign exchange, bonds, and stocks. Misalignments
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within a diverse spectrum of markets for different countries and assets often offer the majority

significant opportunities. Market liquidity and predictability are closely correlated. Majority of

less liquid markets are prone to be more predictable. Market certainty and liquidity are jointly

considered in developing beneficial trading models. Return predicting models used in the stock

market seem to be adaptive and recursive next to the lines outlined in Pesaran and Timmermann

(1995) and newly reviewed in Pesaran and Timmermann (2005).

Economists have for a long time been mesmerized by the source of disparities depicted in

the stock market. In the early 1970’s an agreement had surfaced between financial economists

proposing that stock prices can approximated through the random walk model and that

alterations in stock proceeds were essentially unpredictable. Fama (1970) provides an before

time, an ultimate statement of this arrangement. Previously, the ‘random walk’ theory of stock

prices was headed by presumptions relating fluctuations in the stock markets to the business

cycle. A famous example is the attention revealed by Keynes in the disparity in stock profits over

the entire business cycle. According to Skidelsky (1992) “Keynes initiated what was called an

‘Active Investment Policy’, which united investing in real assets - at that time considered

revolutionary - with regular switching between short-term and long-term financial assets, having

in mind the predictions of variations in the interest rate” (Skidelsky (1992, p. 26)). Lately, a great

number of researches in the finance have asserted that stock proceeds can be forecasted to some

extent through, dividend yields and interest rates, an assortment of macroeconomic factors

demonstrating clear business cycle changes.

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References

FAMA, E. (1998) “Market Efficiency, long-term returns, and behavioural finance”, Journal of
Financial Economics, Vol. 49, pp. 283-306

ARIEL, ROBERT A. (1990). "High Stock Returns Before Holidays: Existence and Evidence on
Possible Causes." Journal of Finance. December, 45:5, pp. 1611-626.

DE BONDT, W., THALER, R. (1989) “Anomalies: A Mean-Reverting Walk Down Wall Street”,
Journal of Economic Perspectives, Vol. 3, No. 1, pp. 189-202

FAMA, EUGENE AND KENNETH FRENCH.(1992). "The Cross-Section of Expected Stock

Returns." Journal of Finance. June, 47, pp. 427-65.

SKIDELSKY, R. (1992) JOHN MAYNARD KEYNES. The Economist as Savior. Allen Lane,
The Penguin Press.

ASNESS, C., MOSKOWITZ, T., PEDERSEN, L. (2013) “Value and Momentum Everywhere”,
Journal of Finance, Vol. 68, No. 3, pp. 929-985

CAMPBELL, J. Y.(1987). “Stock Returns and the Term Structure,” Journal of Financial
Economics, 18, 373—399.

CAMPBELL, JOHN Y., AND ROBERT J. SHILLER.(1998) "Stock Prices, Earnings, and
Expected Dividends," Journal of Finance, 43, 661-676.