The Concept of Efficient Market Hypothesis - Assignment Example

? Share Trading Assignment Table of Contents Introduction 4 Construction of Portfolio 4 Portfolio Evaluation 5 Fundamental Analysis 5 Economic Analysis 6 Industry Analysis 7 Stock Markets Analysis 8 Technical Analysis 8 Results 10 Conclusion 13 References 14 Bibliography 16 Appendix – A 17 Table B.1 – List of Companies in Portfolio I (Fundamental Analysis) 17 Table B.2 – List of Companies in Portfolio II (Technical Analysis) 17 Table B.3 – Risk-Return Analysis for Portfolio I 18 Table B.4 – Risk-Return Analysis for Portfolio II 18 Table B.5 – Portfolio Construction and Performance Evaluation for Fundamental Analysis 19 Table B.6 – Portfolio Construction and Performance Evaluation for Technical Analysis 20 Appendix – B 21 Introduction A portfolio is group of securities such as bonds, stocks, commodities, and derivatives where an investor invests his or her money to mitigate the risk of holding a particular asset through diversification. Diversification of investment spreads the risk over many assets. The concept of Efficient Market Hypothesis (EMH) states that since the stock prices reflect all relevant information in the market, it is not possible for the investor to beat the market by purchasing selling stocks at inflated prices or purchasing undervalued stocks. Thus, in order to beat the market the investor will have to be well informed regarding the true fundamentals of the stocks and carefully follow historical trends. Technical analysis helps and investor to predict future movement of stock prices by analysing past trends whereas fundamental analysis considers a top-down approach that analyses not only the fundamental financial position of firms but also macro-economic and industry trends. The objective of this assignment is to invest ?100,000 in UK stock market shares that are listed on FTSE ALL Share index. There will be two portfolios of shares where one will be evaluated by technical analysis and the other by fundamental analysis. The aim is to beat the market with both the portfolio. The study will compare and contrast the two portfolios with explicit reference to EMH. Construction of Portfolio The efficient market hypothesis assumes that in financial markets, the current prices reflect all the information available in the market and thus the true value of the stocks can be reflected from their past security prices. The theory assumes that the market participants behave rationally and try to maximize their returns by processing all information available to them (Jegadeesh, and Titman, 1993, pp.65-91). From above it can be said that the securities are correctly priced provided the information available to public. Considering the above theory it can be said that EMH states it is “not” possible to beat the market since efficiency of stock market causes stock prices to reflect all relevant information. Keeping this argument in mind, the investor will have to allocate investible sum of ?50,000 in two portfolios consisting of equity shares of companies listed in FTSE All Share. The lists of companies for two portfolios are depicted in Appendix - A (See Table B.1 – List of Companies in Portfolio I and Table B.2 – List of Companies in Portfolio II). The best strategy to beat the market is to construct and evaluate the portfolio performance using technical analysis and fundamental analysis. The list of companies mentioned in the two portfolio were selected after considering various macro-economic factors such as currency movements and strengthening of Euro with respect to dollar; general investor sentiments after US Fed chairman announced gradual taper of quantitative easing; misfire of Bank of Japan’s loan support programme; and short term view of investors on junk bonds; expectation of an onset of bull market early 2014 especially in emerging markets where markets are experiencing upward trends (Financial Times, 2013). Portfolio Evaluation Fundamental Analysis Fundamental analysis aims to analyse the various macro-economic factors that might affect the performance of portfolio. The top-down approach is a popular method for fundamental analysis that begins with economic analysis and then considers industry or specific sectors and finally analyse individual companies in each sector. Economic Analysis The Business Cycle – Some of the indicators of business cycle are leading indicators (stock prices and money supply), coincident indicators (industrial production), and lagging indicators (industrial loans). According to portfolio manager of Schroders, this is the perfect time to re-shuffle portfolio as there is an anticipation of significant turning point that might help the investors to beat the market (Financial Times, 2014). GDP – According to a recent report published by BBC News, the GDP of UK has grown fastest for 3 years and the higher the value, the better it is for the economy to expand in future (BBC, 2013). Forbes estimated that US economy grew at 3.6% during third quarter of current year; GDP growth in developing Asia is expected to grow at average rate of 6.5% during 2014. Inflation – According to a report published by the Guardian, the inflation rate in UK is expected to fall whereas US Fed is targeting higher inflation by monthly bond purchase programme to increase growth and productivity; and emerging markets such as Asia naturally has high inflation due to high domestic consumption. High inflation rates reduce the real value of money and hence low inflation rates are favourable for economic prosperity (The Guardian, 2013). Monetary Policy – According to a report published by Bank of England, the money supply in UK is expected an expansion considering the fact that the central bank will continue bond purchase (Bank of England, 2013). Continued quantitative easing will boost business optimism across US and needless to say that a part of bond purchase stimulus programme will flow into emerging Asia mostly to tap potential markets. Hence, there is an opportunity to beat the market by investing in emerging markets stocks especially until these stock are undervalued. Industry Analysis UK economy is the second most affected economy after USA during recent global financial crisis. Sector or industry analysis is important as companies operating within the same industry are generally affected by same market and economic conditions. Hence, it is important for the investors to spot changes as early as possible and make appropriate changes to the portfolio. Banking Sector – According to a report by BBC News, the outlook of Moody’s rating is positive for the banking sector in US, UK, and Asia (excluding Japan). Considering such positive outlook it is expected that the banking stocks will perform better. Markets generally fall as the interest rates rises. This will pull down the stock prices of the individual companies and hence mutual funds and ETFs constituting these funds will perform negatively (BBC, 2013). Oil and Gas Sector – According to a report published by Deloitte, the outlook on Oil and Gas sectors in UK for 2013 is positive and it is expected that the stocks will perform well in near future. According to US Energy Information Administration, the domestic production of natural gas increased over 65 billion per day and natural gas production also swelled. But the developing economies in Asia do not have high reserves of oil and gas due to which they mostly rely on imports from OPEC countries (Deloitte, 2013). Mining and Energy - It is a very unpredictable sector in terms of demand, price elasticity, and availability of raw materials, cheap labour, exploration opportunities, and various clearances (like environmental and FDI). The advantage of investing in stocks in this sector is that it will allow the investor to diversify across different sectors and the investor will also get an opportunity to beat the market by analysing trends in market movements. By carefully leveraging the market volatility it may be possible for the investor to maximise returns (Financial Times, 2014). Stock Markets Analysis The band markets all over the world are experiencing pressure as the bond prices declined to historical low after announcement of US Fed chairman’s announcement of tapering of bond purchase program. Hence, this the best time for investors to experience higher returns from equity markets which is also anticipated to experience a bull phase during first quarter of 2014. The sentiments across different stock markets around the world have been found to be improving. As discussed earlier, when the market is efficient the investor will not be able to make super profits and beat the market. However, in a bull market it may be possible for the investors to maximise their return on investment if they invest at right time before trend reversal onsets. This is where technical analysis comes into play because it helps the investor to get an idea regarding direction of stock price movement in future by analysing past trends. Technical Analysis It is the process of identifying stock price movement patterns at a prior stage and then to devise the buying and selling strategy. With the help of several indicators, a technical investor analyse the relationship between price – volume and demand – supply for the overall market as well as the individual stock. The objective of technical analyst is to identify the trend reversal as early as possible and then gain from these movements. To put it more simply, if a technical investor can identify two states of market – not trending or trending, the investor’s analysis is 80 % complete. If there is an uptrend in the movement of stock prices, the technical investor may buy the scrip. Conversely, with the beginning of fall in price, the investor may sell the scrip and avoid loses. The technical analysis is based on three major assumptions about the stock market – one, the stock prices and the stock market factors in everything from natural calamities to psychological behaviours of the market participants; two, by carefully observing the movements in stock prices, it will be possible to identify distinct patterns in the stock price movements; three, the movement of stock prices in the stock markets are repetitive in nature. Momentum Strategy As discussed earlier, the overall objective of this assignment is to invest in stocks of companies that are listed on FTSE All Share index. Out of investible sum of ?100,000, 50% is to be invested in the portfolio of shares which will be selected by technical analysis. The objective of the portfolio will be to maximise returns and try to earn superior returns above the market. In order to achieve the objective ‘Momentum Investing’ will be most appropriate. This is because Momentum strategy will aim to take advantage from analysing continuation of existing trends in market. The best way to do this is to identify movements in stock price and its trends (up or down). Then by employing ‘buy’ and ‘hold’ strategy the investor will be able to beat the market provided investor is able to capitalise investment decision before the onset of trend reversal. The primary reason to believe that momentum strategy might be able to ‘beat the market’ in contrast to EMH theory discussed earlier is that large increase in security prices is generally followed by additional gains (above market) and vice-versa for declining values. The technical analyses using momentum will only those FTSE All Share index listed select stocks that are currently experiencing up trends and sell stocks which are experiencing downtrend during last quarter of 2013. The basic idea is to capture gains by identifying stocks that have established trend (up or down) and is likely to continue movements in respective direction for some times to come in future before trade is executed. Results During the technical analysis it was found that most chart patterns showed high variations in price movements which made difficult to identify the overall trend of stocks. The moving average indicator helped smooth out daily fluctuations and identify stock trends. The RSI was used to decide whether to purchase or sell stock at particular Ask or Bid price respectively. In order to compute the total trading cost it was assumed that investor has to pay Stamp Duty of 0.5% whenever shares are purchased (as there is no stamp duty when shares are sold). It is also assumed that shares are bought online through internet broker that charges a flat fee of ?7.50 when shares are sold. The stock movement trends are depicted in Appendix - B (See Table – B.1 to Table – B.11). The results/performance of portfolio of assets which was constructed and evaluated using Technical Analysis is shown as follows, Performance Evaluation Of Portfolio I Securities Ticker Symbol Number of Shares Bought / (Sold) % allocation to individual assets Investment Allocation (?) Beta (?) Beta x Weight Return (%) Return x Weight Gross Portfolio Return THOMAS COOK GROU TCG LN Equity 538 45 2239119 -0.06 -2.52 0.26 11.46 ? 279,090.25 CARR'S MILLING CRM LN Equity 60 -3 -148047 0.65 -1.93 0.20 -0.59 -? 603.75 ROBERT WALTERS RWA LN Equity -74 -16 -821292 0.09 -1.40 -0.05 0.84 -? 15,093.03 LLOYDS BANKING LLOY LN Equity 6 -8 -421695 0.01 -0.11 0.10 -0.83 -? 731.55 AGA RANGEMASTER AGA LN Equity 197 11 533858 -0.01 -0.06 0.45 4.85 ? 31,216.99 PENDRAGON PDG LN Equity 40 -5 -249508 0.02 -0.10 0.16 -0.81 -? 478.05 PHOTO-ME INTL PHTM LN Equity 264 17 869405 0.12 2.15 0.58 10.07 ? 96,223.26 CLARKSON PLC CKN LN Equity -165 -26 -1277291 -0.64 16.34 -0.221 5.65 -? 84,883.95 TED BAKER PLC TED LN Equity 112 2 109830 -0.61 -1.34 0.30 0.65 ? 1,812.41 GOODWIN PLC GDWN LN Equity -23 -11 -566383 0.00 -0.01 0.044 -0.50 -? 2,840.88 KIER GROUP PLC KIE LN Equity 46 -4 -217997 0.45 -1.96 0.17 -0.76 -? 526.18   TOTAL 1000 1 50000 0.03 9.06 1.99 30.03 ? 303,185.53 Similarly, when the performance of Portfolio II evaluated using concepts of Fundamental Analysis the following results were found, Performance Evaluation of Portfolio II Securities Ticker Symbol Number of Shares Bought / (Sold) % allocation to individual assets Investment Allocation (?) Beta (?) Beta x Weight Return (%) Return x Weights Gross Portfolio Return Hansa Trust PLC HAN LN Equity 538 37.84 1892028 0.3002 1135.8636 0.0013 4.9231 ? 9,314,714 International Ferro Metals Ltd IFL LN Equity 60 20.49 1024278 0.0026 5.2239 0.0032 6.6363 ? 6,797,378 Manchester & London Investment Trust PLC MNL LN Equity -74 -30.43 -1521698 0.0372 -113.2872 -0.0016 4.8703 -? 7,411,173 S&U PLC SUS LN Equity 6 9.39 469696 0.2113 198.4942 0.0022 2.0528 ? 964,193 Majedie Investments PLC MAJE LN Equity 197 7.47 373603 0.0854 63.7784 0.0020 1.4963 ? 559,039 BATM Advanced Communications BVC LN Equity 40 12.98 648976 0.0109 14.1547 0.0025 3.2787 ? 2,127,794 Alternative Investment Strategies Ltd AIS LN Equity 264 -14.49 -724454 0.0105 -15.2485 -0.0001 0.1228 -? 88,982 City of London Investment Group PLC CLIG LN Equity -165 -32.68 -1633855 -0.0755 246.8485 -0.0018 5.9260 -? 9,682,212 Jupiter Second Split Trust PLC JSS LN Equity 112 -16.32 -815896 0.0082 -13.3452 -0.0003 0.4220 -? 344,291 Town Centre Securities PLC TCSC LN Equity -23 -9.38 -468942 -0.0205 19.1998 0.0004 -0.3760 ? 176,340 JKX Oil & Gas PLC JKX LN Equity 46 16.13 806264 0.0501 80.7405 0.0028 4.5555 ? 3,672,917   TOTAL 1000 100 50000     0.0107 33.91 ? 6,085,717.80 From the above findings it can be said that both the portfolio performed well and both was able to beat the market by earning superior returns. For instance, the weighted returns of portfolio 1 (technical analysis) is 30.03% compared to 19.95% market return (FTSE All Share Index). Similarly, the weighted return of Portfolio 2 (fundamental analysis) is 33.91%. Conclusion The findings of this assignment argue that although EMH is cornerstone of modern financial theory, the results were highly controversial. This is because EMH states that it is pointless to predict market trends through technical or fundamental analysis because efficiency of market will not let the investor make superior returns above the market (Fama, 1991, pp.1575-1617). Meanwhile, the findings of this assignment have revealed that it is possible to beat the market by formulating appropriate investment strategies (such as identifying trend reversal at early stage and choose appropriate course of action). It was found that even though FTSE All Share Index (representing market) returned 19.95%, the returns of both portfolios were above 30%. Further, investors like Warren Buffett have been found to consistently beat the market over time which is impossible according to the definition of EMH. References Bank of England, 2013. The UK recession in context — what do three centuries of data tell us?. [Pdf]. Available at: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb100403.pdf. [Accessed on January 3, 2014]. BBC, 2013. Ratings agency Moody's upgrades UK banking sector outlook. [Online]. Available at: http://www.bbc.co.uk/news/business-23252103. [Accessed on January 3, 2014]. BBC, 2013. UK GDP: Fastest growth for three years. [Online]. Available at: http://www.bbc.co.uk/news/business-24668687. [Accessed on January 3, 2014]. Deloitte, 2013. 2013 Outlook on Oil & Gas. [Online]. Available: http://www.deloitte.com/view/en_US/us/Industries/d687f0575368b310VgnVCM3000003456f70aRCRD.htm. [Accessed on January 3, 2014]. Fama, E. F., 1991. Efficient Capital Markets: II. [Pdf]. Available at: http://thefinanceworks.net/Workshop/1002/private/2_Market%20efficiency/Articles/Fama%20on%20efficient%20capital%20markets%20II%20JF%201991.pdf. [Accessed on January 03, 2014]. Financial Times, 2013. The Short View. [Online]. Available at: http://www.ft.com/intl/markets/the-short-view. [Accessed on January 3, 2014]. Financial Times, 2014. Energy. [Online]. Available at: http://www.ft.com/intl/companies/energy . [Accessed on January 3, 2014]. Financial Times, 2014. Investment Strategy: the Turn of the Business Cycle – Cazenove Snaps up Racy Sectors. [Online]. Available at: http://www.ft.com/intl/cms/s/0/9aabed64-4632-11e3-9487-00144feabdc0.html#axzz2pDtN91CO. [Accessed on January 3, 2014]. Jegadeesh, N. and Titman, S., 1993. Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. [Pdf]. Available at: http://www.business.unr.edu/faculty/liuc/files/BADM742/Jegadeesh_Titman_1993.pdf. [Accessed on January 03, 2014]. The Guardian, 2013. UK inflation rate expected to fall in new CPI report. [Online]. Available at: http://www.theguardian.com/business/2013/nov/11/uk-inflation-rate-fall-cpi-ons-petrol-prices. [Accessed on January 3, 2014]. Bibliography Arnold, G., 2012. Corporate Financial Management. 5. New Jersey: Pearson Education Limited. Morning Star, 2014. HSBC FTSE All Share Index Retail Accumulation. [Online]. Available at: http://www.morningstar.co.uk/uk/funds/snapshot/snapshot.aspx?id=f0gbr04cpq&tab=1. [Accessed on January 3, 2014]. Yahoo Finance, 2014. City of London Investment Group PLC (CLIG.L): Technical Analysis. [Online]. Available at: http://uk.finance.yahoo.com/q/ta?s=CLIG.L&t=3m&l=on&z=l&q=c&p=m5&a=r14&c=. [Accessed on January 3, 2014]. Yahoo Finance, 2014. FTSE ALL-SHARE (^FTAS): Historical Prices. [Online]. Available at: http://uk.finance.yahoo.com/q/hp?s=%5EFTAS&b=01&a=09&c=2013&e=11&d=11&f=2013&g=d. [Accessed on January 3, 2014]. Yahoo Finance, 2014. JKX Oil & Gas PLC (JKX.L): Technical Analysis. [Online]. Available at: http://uk.finance.yahoo.com/q/ta?s=JKX.L&t=3m&l=on&z=l&q=c&p=m5&a=r14&c=. [Accessed on January 3, 2014]. Appendix – A Table B.1 – List of Companies in Portfolio I (Fundamental Analysis) Table B.2 – List of Companies in Portfolio II (Technical Analysis) Table B.3 – Risk-Return Analysis for Portfolio I Table B.4 – Risk-Return Analysis for Portfolio II Table B.5 – Portfolio Construction and Performance Evaluation for Fundamental Analysis Table B.6 – Portfolio Construction and Performance Evaluation for Technical Analysis Appendix – B Table B.1: Technical Analysis of HAN LN Equity Table B.2: Technical Analysis of IFL LN Equity Table B.3: Technical Analysis of MNL LN Equity Table B.4: Technical Analysis of BLZ LN Equity Table B.5: Technical Analysis of SUS LN Equity Table B.6: Technical Analysis of BVC LN Equity Table B.7: Technical Analysis of MAJE LN Equity Table B.8: Technical Analysis of CLIG LN Equity Table B.9: Technical Analysis of JSS LN Equity Table B.10: Technical Analysis of JSS LN Equity Table B.11: Technical Analysis of JKX LN Equity Read More