Stock Price Behavior and Market Efficiency 7-7
There is also a very subtle prediction at work here. That is, no matter how often a
particular stock price path has related to subsequent stock price changes in the
past, there is no assurance that this relationship will occur again in the future.
Researchers have used sophisticated statistical techniques to test whether past
stock price movements are of any value in predicting future stock price
movements. This turns out to be a surprisingly difficult question to answer clearly
and without qualification. In short, although some researchers have been able to
show that future returns are partly predictable by past returns, the predicted
returns are not economically important, which means that predictability is not
sufficient to earn an abnormal return.
In addition, trading costs generally swamp attempts to build a profitable trading
system on the basis of past returns. Researchers have been unable to provide
evidence of a superior trading strategy that uses only past returns. That is,
trading costs matter, and buy-and-hold strategies involving broad market indexes
are extremely difficult to outperform.
B. Random Walks and Stock Prices
Ask your students whether stock market prices are predictable: many of them will
say yes. To their surprise, it is very difficult to predict stock market prices. In fact,
considerable research has shown that stock prices change through time as if
they are random. That is, stock price increases and decreases are equally likely.
When the path that a stock’s return follows shows no discernible pattern, then the
stock’s price behavior is largely consistent with the notion of a random walk. A
random walk is related to the weak-form version of the efficient market
hypothesis because past knowledge of the stock price is not useful in predicting
future stock prices.
We illustrate daily price changes for Intel stock in the text. These daily price
changes are not truly a random walk. To qualify as a true random walk, Intel
stock price changes would have to be independent and identically distributed.
Still, the graph of daily price changes for Intel stock is essentially what a random
walk looks like. It is certainly hard to see any pattern in these daily price changes.
C. How Does New Information Get into Stock Prices?
In its semistrong form, the efficient market hypothesis is the simple statement
that stock prices fully reflect publicly available information. Stock prices change
when traders buy and sell shares based on their view of the future prospects for
the stock. The future prospects for the stock are influenced by unexpected news
announcements. Prices can adjust to news announcements in three ways: