Technical Analysis and Efficient Market Hypothesis Arguments

2021-06-08 16:05:08
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Middlebury College
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Literature review
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Efficient Market Hypothesis is one of the most debated theories in the world of business due to its contradictory nature. It is a theory that has attracted many theorists some of whom argue in its support and others argue against it. Since it was first coined by Eugene Fama, there have been a number of debates in regard. A statement in the article by (Osler and Chang, 1995), Technical analysis, the prediction of price movements based on past price movements, has been shown to generate statistically significant profits despite its incompatibility with most economists notions of efficient markets will guide this research. Different ideas of various theorists are to be addressed while at the same time focusing on the various techniques that are used to analysis market dynamics.

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Changes in the prices of assets is highly dependent on the information that is available in the market as well as he changes in discount rates. There are investors who attempt to find loopholes in the market so that they can make high profits (Harder, 2010). It is possible to find a loophole in the market but this only occurs with extensive technical analysis which helps the investor to acquire a lot of information that maybe others have not been able to acquire, but which is available in the market. According to the economist Matthew Bishop, believe when people accept the EMH, it means that their rational behavior does not have any significant effect on the markets. His position has been supported by Michael Green (Justin, 2009). They argued that people have to reason rationally and find any information that is likely to help them gain an advantage in the market. These theorists argue against the EMH theory. However, Adam Smith and John Keyenes have been in support of EMH. They believed in irrational behavior as being significant on the markets.

For instance, they would attempt to buy stocks at an undervalued price or sell them at an overvalued price in order to make abnormally high profits. However, the fact that stocks are always dependent on the information available in the market and that they will always trade at their fair prices makes it difficult for investors to beat the market. According to the efficient market hypothesis, the prices of stocks are a reflection of the information that is available in the market and the discount rates at given times (Chan, Benton and Ming-Shiun, 2003). No stock is too expensive or too cheap. According to Eugene, (1965), in practice, in case a stock becomes too cheap, its demand will increase. When the demand becomes too high, the marketers will tend to increase the prices and the demand lowers again. They will lower the price as well. This makes the prices to stay at a relatively same level. No major changes can occur. In such cases, the law of demand which states that as the demand goes up, the price of a commodity goes up, and as the demand decreases, the price also decreases.

There are people who have often claimed that they have beaten the market by correctly anticipating certain news that end up producing significant changes in prices. These are news that were unforeseen by most of the other investors. Among investors who have often beaten the EMH are Warren Buffett, William Ruane and Walter Schloss. There are also some companies that have highly succeeded by having information that helps them make the right investment decisions (Harder, 2010). For instance, a company like Microsoft has in many occasions been seen to have beaten the market to make big profits. However, the company does not violate the EMH theory. Its share prices are predictable through the historical patterns. For instance, it is said that if a trader buys stocks in January and sell them around March- April, they are likely to make very high profits. This can be deduced from the graphs given. In January, the stocks price is about USD 3,000. Between March and April, the investor sells the stocks at the highest price which is around USD 3,500. The prices then go down slightly throughout the year and start rising again towards the end of the year. Basically, from January, the prices are going up and then go down around June. They stabilize between September and October before starting to rise again towards the end of the year.

As mentioned by Chan, Benton and Ming-Shiun, (2003), in their research, the confusion between EMH and the technical analysis has been explained by a number of theorists. These are the theorists who criticized Eugene Famas EMH theory. For instance, Robert Shiller developed the Price Earning Ratio predictor that can be used by investors to predict the costs of stocks over a long period of time. This proposition was later affirmed by Burton Malkiel who stated that EMH had a consistent correlation the interest rates. This is the lopp hole that has been used by investors such as Warren Buffet to make huge profits. Basically, it is possible to find a loophole in the market but this only occurs with extensive technical analysis which helps the investor to acquire a lot of information that maybe others have not been able to acquire, but which is available in the market.

Being able to predict this kind of trend for any stocks can lead to an investor making high profits. This is the trick that most investors who have been able to make high profits apply. These investors are able to carry out perfect market analysis of the stock prices and then make the right decision regarding when to buy and when to sell stocks (Murphy, 1999). From the graphs given, an investor who buys stocks in January and sells in April is likely to make high profits. If the investor sells the stocks in September or October, the profitability will be lower. Therefore, it is usually not about which stocks one buys. It is about the ability to predict price movements. This is made possible by observing past prices and using moving averages to predict their future behavior.

The analysis of how the securities behave may take two approaches. These are technical analysis or the fundamental analysis. On the fundamental analysis, the investor is interested in the behavior of a company. It is from this behavior that they can estimate the value of the companys stocks and then make their investment decisions. Normally, when a company s performing well financially, there are high chances that its value will be high and so will be the value of its stocks (Murphy, 1999). An investor will in turn be more likely to invest in such a company since the value of its stock is likely to increase. However, there are cases where the behavior of a company is not always a reflection of its value. It is for this reason that the technical analysis is employed. This analysis only focuses on the movement of prices in the market and in most cases it is accurate or nearly accurate.

According to Osler and Chang (1995), the head and shoulders technique is arguably the most reliable technique in predicting the market trends. It is a representation of a natural point of origin for any empirical research and hence it forms the basis of all predictions. In other words, the final prediction will always be influenced by this technique regardless of the technique that the researcher uses. This technique may not always give a true reflection of the future market prices of a given stock. As it has been mentioned earlier, there are situations when the market may be unpredictable due to unforeseen events. In such cases, the head and shoulder technique cannot give and accurate value of the stock process (Chan, Benton and Ming-Shiun, 2003). Different investors value stock differently. This means that the value that one investor assigns to a certain stock is different from the value that another investor will assign. Therefore, even with the head to shoulder technique, it is still not easy to predict the market movements and hence it is difficult to take advantage of the markets.

Reference List

Chan, K C, Benton E, C, Ming-Shiun, P, 2003, International Stock Market Efficiency and Integration: A Study of Eighteen Nations, Journal of Business Finance & Accounting. 24 (6): 803813

Eugene F, 1965. The Behavior of Stock Market Prices". Journal of Business, 38: 34105.

Harder, S. 2010, The Efficient Market Hypothesis and its Application to Stock Markets, GRIN Verlag GmbH, Munchen

Justin F, 2009, Myth of the Rational Market. Harper Business. ISBN 0-06-059899-9.

Murphy, J. J. 1999, Technical analysis of the financial markets: A comprehensive guide to trading methods and applications, New York Institute of Finance, New York

Osler C. L. and Chang P. H. K, 1995, Head and Shoulders: Not Just a Flaky Pattern, Federal Reserve Bank of New York, C, Staff Report No. 4

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