Technical and fundamental analysis of shares

When investors put capital in an stock market it is in purpose generating profits on their investment. However some of the investor will not only try to make a fair return, but exploit every market anomalies and information to seek abnormal returns and outperform the market.

But before getting further into the heart of the subject, and highlight the factors that could lead to abnormal returns throughout fundamental or technical analysis, it seems relevant to suggest a brief definition of these key terms, and also consider the efficient market hypothesis which rejects the possibility to beat the market.

The Efficient Market Hypothesis also known as EMH, has contributed for an academic and hypothetical basis for a considerable amount of the financial research during the late seventies and eighties.(www. westga.edu.com)

An efficient market is conventionally defined as one " in which equity prices always fully reflect" all important and available information( K. Pilbeam Finance and Financial Markets p.248/Fama 1970),which implies that stocks are always traded on a fair value, impeding investors to outperform the market by buying or selling over or undervalued stocks.(www. investopedia.com)

The efficient market theory implies three forms of efficiency. The weak form which insinuate that current share prices always are influenced and represent all relevant information of past prices. Secondly the semi strong form, which suggests that present equity prices reflect past price movements and all public obtainable information. Finally the strong form of efficient market which considers and predicate that actual share prices fully include the features of the weak and strong form plus all private and inside information.(K. Pelbeam Chapter 10 p.249).So it fallows that according to the Efficient Market Theory investors cannot gain abnormal returns on their investments, seeing that every investor disposes of the same available information.

This leads us briefly to the Grossman and Stiglitz Paradox which states that a market is efficient if all participants have access to the same information. In the other case, some investor will be willing to pay for privileged information which could give them an advantage an allow them to set up more effective forecasts of future prices.

Hence Efficient Market Theory, considers that investment is a"fair game", therefore seeking higher profits through favoured information according to the EMH is unfair and unsuccessful, and stating that no investor can get ahead of others and enjoy abnormal returns.

Nevertheless, in reality there are some defaults in the hypothesis and market, which suggest that it would be possible to beat the market and make superior returns.

After defining the Efficient Market Hypothesis, it acts crucial to clarify the different trading strategies, which are the fundamental and the technical analysis, which can either be combined or used separately.

The fundamental analysis, is a process which examine precisely the share price based on the underlying business. "Fundamental analysis monitors elements such as earnings, revenue, cash flow, debt, acquisitions, product development and the regulatory environment", to determine a fair value for a share price, seek abnormal returns and beat the market.(Financial Times Lexicon).

However defendants of the semi strong form of efficient market hypothesis argue that it is impossible to beat the market and make abnormal returns thanks to the fundamental analyse strategy"(Handbook of Financial Instruments by Frank. J p.108). Firstly because the new information are incorporated very quickly and accurately in share prices, business features and economic forecasts can't enhance investors performances and allow them to gain an advantage above other investors and seek superior profits. Secondly,it is also due to the fact that a lot of analysts attempt the same analysis with the same available public information, which is already reflected in the share prices.(Handbook of Financial Instruments by Frank.J p.108).

Conversely to the fundamental analysis, the technical analysis tries to determine and predict future prices, by analysing statistics, charts and trends generated by the market. The technical analysis affirms that the previous performances of stocks and markets are indications of future performances ( www.investopedia.com) The technical analysis focus more on a short term basis, while the fundamental analysis mostly operates on a long term perspective.

It is one of the most popular techniques by new investors, but also by insiders. The shares are analysed, and are submitted to many calculations which lead to so-called technical indicators.

But according to the weak form of the efficient market hypothesis it is impossible to determine future share prices by studying past prices using technical analysis. Such form of analysis founded on past movements and practices is unable to predict systematically future price movements and therefore is ineffectual and unsuccessful. For instance a rise of 10% last week will not involve a decrease or increase the following week in the same share.(K. Pelbeam Finance and Financial Markets Chapter 10 p.249). Hence both events are completely separated.

It is noteworthy to mention that either technical or fundamental analysis are called "active strategies", both seeking for abnormal returns

Nevertheless while a series of tests like the "random walk hypothesis" and "the filter rule tests" tend to confirm and be consistent with the Efficient Market Theory, some economists have identified various anomalies, suggesting that markets are not fully efficient, and seeking abnormal returns may be possible thanks to technical and fundamental analysis. Firstly Fran Cross and Gibbons have put forward the "day of the week effect or week-end effect", which poses a challenge to the weak form efficiency and could favour abnormal returns throughout the technical analysis. This effect highlights that prices tend to fall on Mondays and rise on Fridays giving analysts the possibility to anticipate the market by simply buying stocks on Monday and selling them on Friday.

Secondly the "January Effect" identified by Keim in 1983. He suggested that returns on small companies tend to outperform the market and generate abnormal returns for investors at the end of January. This theory being totally incoherent with the hypothesis developed by Fama.

Related to the two pre mentioned effects De Bondt and Thaler suggested the "winner-loser probem", which claims that stocks performing poorly and especially small size stocks tend to seriously and consequently outperform the market and realize abnormal returns in the following years.(Richard H. Thaler Advances in Behavioural Finance vol 1 p. 264,265).

According to the Journal of Financial Economics and the Asian Review of Accounting 1996 such an anomaly occurred on the Hong Kong Stock Exchange where investors tended to overreact to good news, but not to bad news in the short run.

By refering to the author of this article Dennis Chan'Winner' stock portfolios making abnormal gains on the event day tend to make abnormal losses in the subsequent test period. On the contrary, abnormal losses persist in the test period for the loser stock portfolios

For winner stocks, larger abnormal gains on day 0 are followed by larger abnormal losses in the subsequent 10-day period."(Journal Article: Short-Run Overreaction in Hong Kong Stock Market)

Hence "Loser" stock portfolios gained abnormal returns on the event, but tended to have registered various losses during the period prior the event."

Debondt and Thaler interpret their evidence as a manifestation of irrational behaviour by the investors, which they term "overreaction" of the market. (Richard. H Thaler Advances in Behavioural Finance vol. 1 p. 265,266)

After having highlighted some anomalies that question the weak form efficiency, it is also crucial to mention some challenges to the semi strong form and hence could favour abnormal returns through fundamental analysis.

Various studies like the one on the "Size Effect" undertaken by Banz 1981 showing and outlining significant yields for small companies quoted on the exchange compared to the returns of larger firms between 1936 and 1977.

Then the "price-earnings effect"(Basu 1977) which highlights that companies with a low price earning ratio tend to allow higher profits than companies with a higher ratio.(K. Pilbeam Finance &Financial Markets p.261,262)

Finally the "earning announcement effect" tend to outline several contradictions with the efficiency theory, inasmuch as the results from this study show that the new information are not correctly reflected into the share price at the time of the announcement and valuable profits could be made months after the announcements, which is in contradiction with the EMH.

For instance, according to an an article from the journal "Managerial Finance", there have been several price changes associated to Standard & Poors Index additions leading to excess yield returs due to important business announcements.

This is explained, among others due to " an increase in trading volumes and significant permanent abnormal returns at the announcement dates that are correlated with subsequent decreases in bid-ask spreads. However there is a fivefold increase in trading volume, but only temporary abnormal returns, around the effective dates. "(Karel Hrazdil Journal of Managerial Finance 2009)

Furthermore opponents of the EMH also evidence for example the crash of the Dow Jones Industrial Index of over 20% in 1987 in a single day, which seriously questions the EMH hypothesis and proofs that share prices can differ from their fair value.

Hence, considering these anomalies and statistical data results obtained throughout these multiple studies, it could be plausible to affirm that there are possibilities to earn above average profits through fundamental and technical analysis.

Likewise famous investors like Warren Buffet and Benjamin Graham are well known for the fact that they have beaten the market. They have experienced a resounding success with fundamental analysis, based on an long term investment horizon, which consists in being always present in the market, even in panic moments(crashes and bubbles) this to benefit from market failures and undervalued share prices.

Another important theory and study which contradicts the EMH is behavioural finance. "Behavioural finance seeks to understand the market implications of the psychological factors underlying the investors decisions and strategies".( Denzil Watson, Anthony Head Corporate Finance Principles & Strategies 4th edition p.40)

In other words behavioural finance identifies and analysis the faults and reactions of investors behaviour and their effects on financial markets, which can lead to mis-pricing phenomenes like under or overvalued stocks. The hypothesis of behavioural finance, thus seeks to detect these market anomalies, to use them in the most effective way to set up investment strategies arbitrage trading and seek abnormal returns.

It so proclaims that there a various psychological factors involved in investment strategies and decisions that could provide acute and clever investors an advantage and to seek higher profits than the average.(www.investorwords.com/450/behavioral_finance.html).

References and Bibliographies

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  • Finance and Financial Markets 2nd edition Chapter 10 p. 247,248,249
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  • (Richard. H Thaler Advances in Behavioural Finance vol. 1 p. 265,266)
  • Asian Review of Acconting 1996 : " A study of short run overreaction on the Hong Kong Stock exchange" by Dennis Chan
  • Journal of Managerial Finance 2009: "The price, liquidity and information asymmetry changes associated with new S&P 500 additions" by Karel Hrazdil

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