Financial Education

The strong-form efficient market hypothesis assumes that stock prices reflect all information, whether public or private. As such, it encompasses both the weak-form EMH and the semistrong-form EMH. If a market is strong form efficient, it is also weak- and semistrong-form efficient.

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

In essence, the strong form efficient market assumes a perfect market in which all information is cost-free and universally available to all market participants simultaneously.

A securities market is informationally efficient when prices adjust rapidly to new information and thereby reflect all available information. In order for a market to be efficient, several conditions are necessary:

• A large number of profit-maximizing participants independently analyzing and valuing securities
• New information arrives randomly, and announcements are independent of each other
• Investors rapidly assimilate the new information and adjust security prices accordingly

Security prices are not necessarily perfect reflections of value in an efficient market, but the implication of the conditions above are that security prices reflect an unbiased estimate of the true value, and that there are no predictable variations between the true value and the market price.

When investing or considering investments in International assets, investors should consider the following special issues:

Currency risk: This affects both return and volatility. Investors must decide whether to hedge this risk.

Correlations with other assets: Although international assets frequently have low correlations with domestic assets, the correlations increase during times of stress. Times of stress are exactly the times in which a low correlation (higher diversification benefit) is most needed.

Emerging markets: Emerging markets tend to be less liquid and less transparent than developed markets. Their investment return distributions tend to be non-normal, which is significant for investors employing mean-variance optimization strategies.

Cash

Cash managers can earn higher returns by accepting longer-dated maturities or credit risk. The yield curve reflects the consensus expectation for future interest rates. Managers must distinguish between future events that are reflected in the yield curve adn those that will surprise the market.

Nominal Default Free Bonds

Conventional government bonds of developed countries have little or no default risk. Return can be disaggregated into real return and an inflation premium. The investor must compare his own forecast for inflation with that imbedded in the yield. If the investor believes inflation will be lower than expected, the bonds are a good buy.

Defaultable Debt

Default risk in commercial bonds is reflected in a premium yield relative to Treasuries. This spread tends to widen in recessions as economic stresses increase the likelihood of default. Understanding when a bond is pricing in greater default risk than is necessary can help determine whether securities are attractively priced.

Emerging Market Bonds

The sovereign debt of non-developed countries is often priced in foreign currencies. Since the issuer cannot print the money needed to cover repayment such bonds are subject to default risk, similar to corporate debt of similar ratings. A country risk analysis often involves an understanding of local politics.

Inflation Indexed Bonds

Inflation indexed bonds allow investors to directly observe the consensus inflation forecast by comparison with the yield of conventional bonds. The yield curve will still vary with the real economy and according to supply and demand. However, higher volatility of inflation will increase their hedging value and can result in lower real yields.

Common Stock

The economy affects earnings (cash flows) and interest rates in opposite directions. Trend growth depends on labor growth, investment and productivity while the business cycle affects profitability. In emerging economies, ex-post risk premia have been higher and more volatile than in developed countries.

Real Estate

Returns are affected by growth in consumption, real interest rates, the term structure of interest rates and unexpected inflation. Economic cycles can also affect the cost of building materials and construction labor, but the net effect of lower interest rates is positive for real estate valuations.

Currencies

Exchange rates reflect the balance between supply and demand. Imports increase currency supply, usually reducing its value. Capital flows for investment purposes, however, may outweigh the effect of trade imbalances. Differences between local interest rates can also affect exchange rates, as the higher yielding currencies attract capital and thus the currency value.

Historical averages incorporate many different types of economic environments, only some of which may be relevant to current conditions. One of the most important areas for investors to apply subjective judgment and insights is in “conditioning” historical data or choosing the periods that best reflect current conditions.

Even when using conditioned data, it is important for the analysis to incorporate any new facts that may be relevant to the decisions being made.

Secondary markets are those in which securities that have already been issued trade. Transactions occur between investors, and the proceeds do not affect the issuer. Instead, one investor gives another investor cash in exchange for the securities.

Secondary markets provide liquidity to the investors who initially buy the securities. Investors value liquidity because changes in their circumstances may require them to sell the security in order to use the cash for other purposes. By having a liquid secondary market, investors are willing to pay more (accept a lower return) when buying primary issues. This helps issuers raise money at more favorable rates.

Secondary markets also offer issuers price discovery – new issues can be priced according to the value of other similar securities.

A Monte Carlo approach takes the probability distribution to generate multiple “paths” of possible return outcomes over time. It is superior to steady-state (deterministic) approaches to forecasting because it incorporates variability over long time horizons and illustrates how the resulting paths affect ending wealth.

Monte Carlo simulations generate probability estimates of ending wealth rather than a single point estimate. As a result, they more closely approximate likely investment outcomes.  They also provide insight as to the trade-off between short term risks and long-term potential of failing to meet the investment objective. The simulations can also incorporate multiple tax scenarios.

Technical analysts classify price movements as primary, intermediate or short-term.

Primary movements tend to be major cyclical movements that last 1-3 years. They represent the general bear or bull markets in effect.

Intermediate movements are short term reversals in the primary trend, usually lasting anywhere from a few weeks to a few months.

Short term movements typically last less than one month and are of a random nature.

Over time, small capitalization stocks have been shown to outperform large-capitalization stocks. However, timing changes in the relative performance between the two groups could lead to still-better performance. In the Fall 2007 Journal of Portfolio Management, L’Her, Mouakhar and Roberge test three nonparametric techniques derived from artificial intelligence and using 20 macroeconomic and financial variables as inputs.

The three approaches are recursive partitioning, a neural network and a genetic algorithm.

Each of the three techniques outperforms a naive small-minus-big strategy, but the best results are derived from taking the consensus of the three techniques.

Behavioral finance theory has pointed to research that shows short-term momentum and long-term reversals in pricing as signs that markets are not fully efficient. In the December 2007 Journal of Finance George and Hwang show that the trends may be at least partially attributable to the differential tax rates applied to short-term and long-term capital gains.

The authors first note an asymmetry between the reversals of stocks with capital gains and stocks with capital losses. In the latter case, there is no tax incentive for holding over longer periods. They then test the capital gains hypothesis by comparing U.S. results to Hong Kong, where there are no capital gains taxes. They find no evidence of reversals in Hong Kong, supporting the thesis that short term momentum may be a means of compensating holders for additional taxes, while long-term reversals result as the tax effects subside.

The study is reminiscent of Harti’s study showing underperformance around the anniversary dates of large price swings, which would also appear to be tax-driven.