Financial Education

Major movements in interest rates, equities and commodity prices are related to changes in the business cycle.

Typically, the bond market is the first to signal business cycle turning points. Bonds will begin a bull phase after economic growth has slowed considerably, and often during the early stages of a recession. Bond prices are inversely related to interest rates, so falling interest rates result in higher bond prices.

As the recession deepens, equity investors begin to “look past” the trough in corporate profits. As a general rule, the longer bonds have been rallying prior to the bottom in the stock market, the better the chances of a rally in stocks.

Once the recovery begins, resource utilization begins to tighten and commodity prices bottom.

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.

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.

The semistrong form of the efficient market hypothesis assumes that security prices adjust rapidly to all publicly available information. Such information includes market based information and thus the semistrong EMH encompasses the weak form EMH (if markets are semistrong efficient, they are also weak form efficient.)

In addition to market information, other public information includes earnings and dividend announcements, financial ratios, accounting practices, stock splits, and economic and political news. If markets are semistrong efficient, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

If the weak form of the efficient market hypothesis holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Researchers testing weak form market efficiency generally use one of two groups of tests when studying weak-form market efficiency.

1. Statistical tests of independence measure either the significance of positive or negative correlation over time (autocorrelation) or by comparing the number of runs (consecutive moves in the same direction) with that expected in a normal sample. In general, statistical tests of independence have shown no relationship between current and future price movements.
2. Tests of trading rules seek to mechanically simulate various trading strategies. For example, testing whether a strategy of buying when the stock price closes above the 50 day moving average and selling when the price closes below the moving average. In general, these tests have supported the weak-form efficient market hypothesis by showing no excess returns (after trading costs, compared to a buy-and-hold strategy) from following such rules. However, the results are not unanimous - some rules have been shown to offer superior returns.

Technical analysts criticize the existing tests as being too naive or simplistic to capture the

The weak form of the efficient market hypothesis assumes that current stock prices fully reflect all security market information. Security market information includes historical price and volume data, as well as other market-generated information such as odd-lot trades and short interest.

If the weak-form EMH holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Internet message boards offer a forum for professionals and amateurs to discuss the relative merits of various stocks. In the Journal of Technical Analysis, Issue 64, Manuel Amunategui creates a technical indicator based on the total traffic and moving average of traffic to the Yahoo! Finance message boards for 550 NASDAQ stocks.

In one test, the author finds that modifying a moving-average crossover strategy to enter the market only on days when the number of message board posts is declining results in fewer trades, lower transaction costs, and higher profit per trade. The premise behind the added condition is that declining message board traffic indicates the stable conditions under which trend-following systems flourish.

In another test, a strategy of trading for a bounce after four consecutive down days is modified to enter the market only when the message board posts have increased from the prior day. The logic in this case is that the increased attention may signal the opportunity for a reversal.

Standardized unexpected earnings is a means of comparing earnings surprise to the company’s track record of earnings surprise. For example, Cisco was once said to consistently beat earnings estimates by a penny. Thus, if the company did beat by a penny it was hardly unexpected. A method frequently used in academic research to adjust for this factor is the standardized unexpected earnings, or SUE.

SUE = the earnings surprise at a given time divided by the standard deviation of earnings surprises measured over some historic period such as the previous 20 quarters.

Consider a stock that had a $0.03 earnings surprise, and that the standard deviation of past earnings surprises is $0.05. The surprise is smaller than normal, and the standardized earnings surprise would be $0.03/$0.05 = 0.6.

I was sent a pre-publication copy of Timothy Sykes’ book An American Hedge Fund and found it to be a quick and fairly enjoyable read.

The book recounts the improbable tale of how Sykes turned his Bar Mitzvah money into a multi-million dollar hedge fund, and reads as much like a trading diary as it does either a novel or a personal finance book. As to what it actually is, if you were one of those people offended by the “truthiness” of A Million Little Pieces you may want to steer clear. The book is billed as a memoir, categorized under Business/Personal Finance and described in the cover letter I received as a novel. Not to mention it was published under Sykes’ own “Bullship Press” label, so consider yourself warned if not every fact in the book is verified.

Personally, though, I could care less about whether a story is truth or fiction as long as it reads well. And here the book turns out to be quick and, assuming you are into the stock market, enjoyable. The biggest turnoff was that hardly a page goes by without a clinical description of the gain/loss on some trade that was made. I would have preferred a more general discussion of how Sykes learned from his successes and mistakes, with the trades serving as illustrations rather than the other way around.

Sykes is able to tell the story with the right mix of chutzpah and humility, fessing up to his mistakes - some of which he continued to make even after professing to learn from them. I find it particularly ironic that late in the book Sykes says:

Looking back, I had foolishly gotten into this industry thinking I could easily grow my operation to the $20 to $50 million asset range based on my performance alone. I would’ve saved a great deal of time, energy and money if somebody had written a book like this to warn me about the true nature of the industry.

Four pages later, he says:

I’d read up on the self-publishing industry and thought I’d found another niche market ripe with opportunity. If I went this route, I’d have total control over my book, quadruple profit margins, and I could distribute the truth to the general public within a few months.

Something tells me his next book will be an expose of the publishing industry.

Once an appropriate allocation between different investment types (for example, stocks, bonds and real estate) has been determined, individual securities (or mutual funds) must be selected within each investment type.
There are two basic approches to individual security selection: top-down and bottom-up.
In a top-down approach the analyst examines the overall economy and market and selects sectors (for example, healthcare or financial) that are expected to perform well in the current environment. Individual companies are then selected within each sector based upon desired characteristics.
In a bottom-up approach the analyst first idenifies individual companies with desired characteristics and then examines the prospects for those companies given current economic and market conditions.
Regardless of which approach is taken it is important that the economy, market and industry conditions are considered when making the desicion to invest in individual securites of any type.
In evaluating individual securities there are also two main approaches: fundamental and technical. Fundamental analysis deals with examining a host of data such as a company’s financial statements, ratios and management in selecting securites for investment. Technical anlaysis involves looking at past trends in market price and volume information to discern the underlying trend in a security. These trends reflect underlying supply and demand and investor behavior.Often these two techniques are viewed as mutually exclusive (some people follow one but not the other). Another view is that the approaches are complimentary, a company may look great fundamentally but technical analysis may indicate it is not the best time to buy.