Efficient Market Hypothesis and trends investing

2015-02-12 10:25:58

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According to the Efficient Market Hypothesis (EMH), every stock price incorporates all relevant information. Stock market efficiency makes it impossible to beat the market by purchasing undervalued or selling overvalued stocks. Expected returns are always proportional to the risk. Stock price volatility should reflect the volatility of fundamental factors expected in the future. That means the price should always be equal to the time-discounted value of expected future dividends.


In fact, EMH did not ever explain all the stock prices moves. Moreover, during the second half of the 20th century the connection between prices and expected dividends seemed to diminish. One of the reasons was shorter and shorter period of holding stocks. According to Allfred Rappaport, the American economist, in the middle of 1960s the average holding period was 7 years. 40 years later it was less than a year for professional funds, whose annual portfolio turnover exceeded 100 percent.

EMH was already severely challenged in 1981 with the article written by Robert J. Shiller, the American economist, who received the Nobel Prize in Economics in 2013 for "empirical analysis of asset prices". The article's title was "Do stock prices move too much to be justified by subsequent changes in dividends?". According to the analysis, no more than 7% of the variance of annual stock market returns can be explained by new pieces of information connected to future dividends.

Paul Samuelson claimed that stock markets can be "micro efficient" but they are still "macro inefficient". It means a particular stock's price tends to be more related to the firm's future prospects than an aggregate's moves to the prospects of the companies from the aggregate. However, if financial data have an influence on stock prices, it is mainly quarterly data of short-term earnings, and more specifically, the difference between the actual and expected figures.

That is the reason why following fundamental analyses alone, ignoring current moods and trends, may result in a huge failure. Arbitrages, especially against aggregates, are highly risky. According to Andrei Shleifer, Professor of Economics at Harvard University: "Because the S&P 500 Index does not have good substitutes and relative prices of imperfect substitutes can move even further out of line, arbitrage of the Index is extremely risky (...) Not surprisingly, very few arbitrageurs or even speculators have put on such trades." (Inefficient Markets: An Introduction to Behavioral Finance)

Analyzing trends is the core of technical analysis. However, there is a shortage of popular instruments used to analyze trends, compared with the enormous demand for technical analyses. One of the new tools is the concept of Cumulative Abnormal Returns Trends (CARTs). CART Investment Strategy uses algorithmic techniques of analyzing trends but is not based purely on computation, because human intelligence is not computable.

CART Strategy is very useful for short-term analysis as well as for early detection of medium to long-term events. Furthermore, it can be used anytime, even in case of a market turmoil or panic. During such periods it is hardly possible to observe normal trends. Most financial instruments move in the same direction and the volatility reaches high level. However, CART is still able to detect systematic relative changes.

CARTs' usefulness has already been verified in practice. Real portfolio results for 2014 of Long-Term CART Strategy were compared to S&P 500, iShares MSCI EAFE ETF and Vanguard Total World Stock ETF. CART Strategy achieved the best Ending VAMI (Value-Added Monthly Index) the best mean return and the smallest standard (and downside) deviation. Hence it attained the best Sharpe and Sortino Ratios. It also experienced the most positive periods (months) and the shortest (together with S&P 500) recovery time.

Anyone interested in CARTs and generally in trends investing can visit TrendsInvesting.com website, which was developed by a company using advanced market screeners and innovative trends analyses. The website presents a lot of data containing various types of trends, based on ETFs and stocks, together with market screeners, market overview and blog comments. There is also more information about CART Strategy.

Link to the website: http://www.trendsinvesting.com/

CART Investment Strategy: http://www.trendsinvesting.com/whitepapers/CART_Investment_Strategy.pdf


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