STOCK TRADE FORECASTING: Is it mass psychology or subject to efficient market hypothesis?
It is empirically proven that, the propensity for the stock market to act as an economic indicator, is highly probable. And there is evidence of the stock market, predicting nine out of the last five recessions in the USA economy. Furthermore, there is strong evidence from the U.S. Department of Commerce and Global Financial Data, which indicate that, changes in the stock market often reflect changes in the real GDP, upon available data, which was subjected to panel analysis from 1970 to 2005.
This defines the essence and the necessity to examine the science and art governing forecasting of price in the stock market, under the two major existing theoretical propositions.
In the camp of economists, the question of whether stock market fluctuations are rational or not? Still stands, up to date. Which the conclusion of this article, posits the new theoretical position that addressed such confusion and postulates a new scientific direction of forecasting in the stock market.
According to the efficient market hypothesis, the market price of a company’s stock is fully rational in it valuation given current information about the company’s business prospects. This was empirically justified by P. Samuelson (1965), which rested on two foundations
- Company listed on major stock exchange, is closely followed by many professional portfolio managers, and these managers monitor news stories to try and determine company’s value. The job is to buy stock when the price falls below its value and to sell it, when its price rises above its value.
2. The price of each stock is set by the equilibrium of supply and demand, which is defined as the market price and judged by the typical person within the market, as the stock, which is fairly valued.
It is further argued by F. Eugene (1970), that the stock market is informationally efficient: It reflects all available information about the value of the asset. Stock prices change when information changes. When good news about the company’s prospects becomes public, the value and the stock price rise. When it deteriorates, the value and the price both fall. At any moment in time, the market price is the ‘rational-best-guess’ of the company’s value based on available information.
The EMH theoretical proposition, stood in contrast with J. M. Keynes postulation, which assumes that the stock market is irrational, and disagrees to the fact that movements in stock prices are hard to attribute to news, and exemplifies with his famous analogy to explain the market speculation. Which state, a newspaper held “beauty contests” in which the paper printed the pictures of 100 women and the readers were invited to submit a list of the five most beautiful. A prize went to the reader whose choice most closely matched those of the consensus of the entrants. A naive would simply have picked the five most beautiful women in his eyes. But a slightly more sophisticated strategy would have been to guess the five women whom other people considered the most beautiful. So in the end of the process, judging true beauty would be less important to the winning of the contests, than guessing other people’s opinions. This in his reason defines the stock investors as those who are good in outguessing mass psychology, and concluded that since these stock traders will eventually sell their shares to others, they are more concerned about other people’s valuation of a company, mostly defined as the perception than the company’s true worth. As a result, he had the conviction that, movement in stock prices often reflect irrational waves of optimism and pessimism, which he called the “animal spirits” of investors.
It is worth further examining the implications of efficient market hypothesis as a theory in connection to the realities of the trading floor in the stock market. The underpinning to this hypothesis is, stock prices should follow a random walk. This implies changes in stock prices should be impossible to predict from available information. According to the theory, the only thing that can move stock prices is news that changes the market’s perception of the company’s value. But such news must be unpredictable, otherwise, it wouldn’t really be news. Its proponents point out, it is hard to beat the market by buying allegedly undervalued stocks and selling allegedly overvalued stocks. It must be emphasized, statistical tests show that stock prices are random walks, or at least approximately so. Which was argued by Mankiw (2010, pp.536) as the reason why index funds, which buy stocks from all companies in stock market index, outperform than most actively managed mutual funds run by professional money managers.
I therefore argue that both theoretical position and their propositions, which define to some extent the character of the stock-market system is admitted to be correct but observed to measure the phenomenon from different tangents. While Efficient Market Hypothesis focuses its theoretical analysis on the market products and its reactions in the market system to determine the rise and fall of price, the Keynesian stock market speculation examines the market through the agents’ behaviour in relation to the market system to determine the rise and fall of price. Both model propositions as an instrument for forecasting hold some element of weakness in the trading experiment. As a result, the theoretical forge of both propositions into a unit theoretical discipline, define the contemporary trading art and science that guide the trading profession termed as “Technical Analysis”, which resolves to a large extent the confusion found within the renowned economic thinkers.
[Technical Analysis] as a method of trading, does address the questions raised by the two major theories of the market , to establish a procedure in favour of scientific forecasting of the stocks trade, in any given market.
- Eugene, F. (1965), “The Behaviour of stock market prices.” Journal of Business. 38:34-105
- Samuelson, P. (1965), “The Proof that properly anticipated prices fluctuate randomly”. Industrial Management Review. 6: 41-49
- Eugene, F. (1970), “Efficient Capital Markets; A review of theory and empirical work”. Journal of Finance. 25(2): 383-417
- Mankiw, G. N. (2010) Macroeconomics (7th) ISBN-13:978-1-4292-1887-0; Worth Publishers, 41 Madision, Avenue. New Yourk.
Emmanuel Tweneboah Senzu (Ph.D.), is a Professor of Economics & Investment Banking, Frederic Bastiat Institute, Fellow of International Federation of Technical Analysts; African School of Economics, Republic of Benin; Cape Coast Technical University, Ghana and Monarch University, Zug: Switzerland.