Forecasting Markets
Let’s start with some common false beliefs about any financial markets; it does not matter whether it concerns bonds, equities, earnings or any other financial product. Do we have to believe experts, as fund managers or financial institutes, when they provide forecasts with a great level of confidence? The conclusion of M.R. Geer (1999) is quite clear: “On the first business day of each year, the Wall Street Journal surveys the top macroeconomic forecasters in the in order to ascertain their predictions for the economy in the forthcoming year… The findings in this study thus indicate that the forecasts issued by the nation’s premier economic forecasters are no better than random walk or flipping a coin forecasts.” In fact, an enormous amount of evidence suggests that we simply can not forecast any financial market trend. For example, it is quite funny to know that around 75% of fund managers think that they are above the average at their jobs! It is an ancient lesson from Lao Tzu (6th century BC): “Those who have the knowledge don’t predict. Those who predict don’t have the knowledge”. Of course, on the very long run, as the economy is growing, it must reflect in earnings and then on main financial indices, but you have to keep in mind that it only holds for the very long run. In a report from the Federal reserve bank of Kansas City, Shen (2005) has concluded that “over the years, for investors who have held their portfolios for shorter periods (than 25 years), both stocks and bonds were exposed to substantial risks, and stocks does not necessarily outperform governments bonds.” Then, long term means at least 25 years. On shorter time scale, since a stock represents a ‘small piece’ of a company, the stock price should somehow reflect the overall value (net worth) of this company. However, the present value of a firm depends not only on the firm’s current situation but also on its future performance. Thus, one sees already the basic problem in pricing risky financial assets: we are trying to predict the future on the basis of present information. Thus, if any new information is revealed that might in one way or another affect the company’s future performance, then the stock price will vary accordingly. It should therefore be clear from this simple discussion that the future price of a stock will always be subjected to a large degree of uncertainty. We can not forecast but can we provide anything quantitative on a financial market? Financial markets are systems in which a large number of traders interact with one another and react to external information in order to determine the price for a given item, equity, currency, bond or any other products.
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The Efficient Market Hypothesis (EMH)
“I’d be bum in the street with a tin cup if the markets were efficient” (W. Buffet). In practice, all traders and external news result collectively into large fluctuations of any price of a financial product. It follows that any predictability pattern is neither detectable nor exploitable. This is basically what is called the “Efficient Market Hypothesis” (EMH) that Buffet contests: for him markets are not efficient, arbitrage opportunities exist and it’s possible to make money out of them! Of course, we have to consider any proposition by Buffet with the highest level of attention. Markets are complex systems that incorporate information about a given asset in the time series of its price. The EMH was originally formulated in 1965 by Samuelson. A market is said to be efficient if all the available information is instantly processed when it reaches the market and it is immediately reflected in a new value of prices of the assets traded. The conclusion of this ‘weak form’ of the efficient market hypothesis is then that price changes are unpredictable from the historical time series of those changes.
In 1970, E.Fama developed the first ideas on Efficient Market Hypothesis (EMH) and made a distinction between three forms of EMH: (a) the weak form (of Samuelson), (b) the semi-strong form and (c) the strong form. The strong form suggests that securities prices reflect all available information, even private information. Seyhun (1986, 1998) provides sufficient evidence that insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. The semi-strong form of EMH asserts that security prices reflect all publicly available information. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. Again, no arbitrage opportunity exists. What next? Certainly, the weak and semi-strong forms of the EMH are not fully correct and Buffet is right. Then, one can start from EMH and incorporate deviations from rational expectations in the behaviour of agents in an attempt to explain anomalies of financial markets. It raises the question of finding arbitrage opportunities! In addition, it is not so obvious that even if an arbitrage is present, we could exploit it. Since the 1960s, a great number of empirical investigations have been devoted to testing the limits of the EMH, which has been put on trial and subjected to a constant critical re-examination.