The post-cost profitability of momentum trading strategies further evidence from the uk
Studies by Firth , , and in the United Kingdom have compared the share prices existing after a takeover announcement with the bid offer. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient.
However, the market's ability to efficiently respond to a short term, widely publicized event such as a takeover announcement does not necessarily prove market efficiency related to other more long term, amorphous factors.
David Dreman has criticized the evidence provided by this instant "efficient" response, pointing out that an immediate response is not necessarily efficient, and that the long-term performance of the stock in response to certain movements are better indications.
Beyond the normal utility maximizing agents, the efficient-market hypothesis requires that agents have rational expectations ; that on average the population is correct even if no one person is and whenever new relevant information appears, the agents update their expectations appropriately. Note that it is not required that the agents be rational. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs including commissions and spreads.
Thus, any one person can be wrong about the market—indeed, everyone can be—but the market as a whole is always right. There are three common forms in which the efficient-market hypothesis is commonly stated— weak-form efficiency , semi-strong-form efficiency and strong-form efficiency , each of which has different implications for how markets work.
In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. Excess returns cannot be earned in the long run by using investment strategies based on historical share prices or other historical data. Technical analysis techniques will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns.
Share prices exhibit no serial dependencies, meaning that there are no "patterns" to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk. This 'soft' EMH does not require that prices remain at or near equilibrium, but only that market participants not be able to systematically profit from market ' inefficiencies '.
There is a vast literature in academic finance dealing with the momentum effect identified by Jegadeesh and Titman. The momentum strategy is long recent winners and shorts recent losers, and produces positive risk-adjusted average returns. Being simply based on past stock returns, the momentum effect produces strong evidence against weak-form market efficiency, and has been observed in the stock returns of most countries, in industry returns, and in national equity market indices.
Moreover, Fama has accepted that momentum is the premier anomaly  . The problem of algorithmically constructing prices which reflect all available information has been studied extensively in the field of computer science. A novel approach for testing the weak form of the Efficient Market Hypothesis is using quantifers derived from Information Theory.
In this line, Zunino et al. Using a similar technique, Bariviera et al. The methodology proposed by econophysicists Zunino, Bariviera and coauthors is new and alternative to usual econometric techniques, and is able to detect changes in the stochastic and or chaotic underlying dynamics of prices time series. In semi-strong-form efficiency, it is implied that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
Semi-strong-form efficiency implies that neither fundamental analysis nor technical analysis techniques will be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for.
If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.
In strong-form efficiency, share prices reflect all information, public and private, and no one can earn excess returns.
If there are legal barriers to private information becoming public, as with insider trading laws, strong-form efficiency is impossible, except in the case where the laws are universally ignored.
To test for strong-form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. Even if some money managers are consistently observed to beat the market, no refutation even of strong-form efficiency follows: Investors, including the likes of Warren Buffett ,  and researchers have disputed the efficient-market hypothesis both empirically and theoretically.
Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence , overreaction, representative bias, information bias , and various other predictable human errors in reasoning and information processing. These errors in reasoning lead most investors to avoid value stocks and buy growth stocks at expensive prices, which allow those who reason correctly to profit from bargains in neglected value stocks and the overreacted selling of growth stocks.
Behavioral psychology approaches to stock market trading are among some of the more promising [ citation needed ] alternatives to EMH and some [ which? But Nobel Laureate co-founder of the programme Daniel Kahneman —announced his skepticism of investors beating the market: It's just not going to happen. For example, one prominent finding in Behaviorial Finance is that individuals employ hyperbolic discounting. It is demonstrably true that bonds , mortgages , annuities and other similar financial instruments subject to competitive market forces do not.
Any manifestation of hyperbolic discounting in the pricing of these obligations would invite arbitrage thereby quickly eliminating any vestige of individual biases. Similarly, diversification , derivative securities and other hedging strategies assuage if not eliminate potential mispricings from the severe risk-intolerance loss aversion of individuals underscored by behavioral finance. On the other hand, economists, behaviorial psychologists and mutual fund managers are drawn from the human population and are therefore subject to the biases that behavioralists showcase.
By contrast, the price signals in markets are far less subject to individual biases highlighted by the Behavioral Finance programme. Richard Thaler has started a fund based on his research on cognitive biases. In a report he identified complexity and herd behavior as central to the global financial crisis of Further empirical work has highlighted the impact transaction costs have on the concept of market efficiency, with much evidence suggesting that any anomalies pertaining to market inefficiencies are the result of a cost benefit analysis made by those willing to incur the cost of acquiring the valuable information in order to trade on it.
Additionally the concept of liquidity is a critical component to capturing "inefficiencies" in tests for abnormal returns.
Any test of this proposition faces the joint hypothesis problem, where it is impossible to ever test for market efficiency, since to do so requires the use of a measuring stick against which abnormal returns are compared —one cannot know if the market is efficient if one does not know if a model correctly stipulates the required rate of return.
Consequently, a situation arises where either the asset pricing model is incorrect or the market is inefficient, but one has no way of knowing which is the case. The performance of stock markets is correlated with the amount of sunshine in the city where the main exchange is located.
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