Stock Market Extinction Hypothesis

Brandt Cornell research paper : “Is the response of analyst to information consistent with fundamental valuation?” suggests that one week after press release :

Lets go back to December 5th, 1996 when Greenspan said “Irrational exuberance and unduly escalating stock prices.” Those words alone triggered markets around the world to decline. The Japanese stock market took a 3.2% plunge and the German market fell 4%. When the stock market opened in the United States, the New York Stock Exchange went down 145 points in 30 minutes.

1. Why did Irving Fisher believe that stock prices had reached a permanently high plateau?

The strong form claims that asset prices fully reflect all of the public and inside information available, therefore no one can have advantage on the market in predicting prices. The introduction of the efficient market hypothesis marked a turning point in scholarly researches on security prices and many studies have been made since to test market efficiency. Many studies of the weak form of market efficiency have been made on technical analyses and how investors use them to predict about future security prices by looking at past prices. In 1969 Fama, Fisher, Jensen and Roll were the first to test the semi-strong form of market efficiency by using event studies. Their conclusion was that stock prices adjust very rapidly to new information. Many scholars since then have studied how new information affect the market by using event studies. Many articles about the strong form have also been published and most of them study professional investor performances in the stock market (Malkiel, 2003). Many of the studies on technical analyses, event studies and the performance of professional investors in the stock market have reached the conclusion that markets are efficient and therefore that stock prices are right (Malkiel, 2003). Before studies of behavioral finance became popular, evidences began to appear that were inconsistent with the hypothesis of market efficiency.

Efficient capital market “It was generally believed that securities markets were extremely efficient in reflecting information about the stock market as a whole” (Fama 1970). To extent that when there is new information about stock rise, the news was dispersed immediately and it affects the security 's price at that time.

The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to

Behavioral finance – is a relatively new field of modern finance concerned with studying the relationship between human psychology and market efficiency.

The EMH supposes that the capital market should be a level game for all players. Herein, all information consequential to an investor’s decision is incorporated in determination and fixation of share prices. This is irrespective of whether it has been made public or not, as long as any single investor is aware of its existence. As such there is no chance of overpricing or underprizing of shares (Gili, Cheng-few & Basin 2008). With any new information, the change is instantly effected. Prediction, according to the premise, is a mere episode of chance. Today, some of the world’s business moguls have seemingly done the impossible by overtaking the market alteration. This has made them reap great benefits from capital market trading and obviously evoked doubts on the authenticity of this proposition.

Stock market corrections happen more frequently than crashes, and corrections occur when the value of stocks reverse by 10 percent or more, according to Investopedia. Corrections often signal the onset of an economic downturn or recession but do not guarantee a stock market crash. Many investors follow the Dow Jones Industrial Average, the Nasdaq and the S&P 500 to try and gauge when and if corrections occur.

However there are times when irrational investors are dominant. A possible cause of market overreaction is the tendency of some investors (often small investors) to follow the market. Such investors believe that recent stock price movements are indicators of future price movements. In other words they extrapolate price movements. They buy when prices have been rising and thereby tend to push prices to unrealistically high levels. They sell when prices have been falling and thereby drive prices to excessively low levels. There are times when such naive investors outweigh those that invest on the basis of fundamental analysis of the intrinsic value of the shares. Such irrational investors help to generate bubbles and crashes in stock markets.

In a bull stock market, blind and over chase rising lead to generate the bubbles; In a bear market, blind and hasty sell out stocks lead to crashes. The herding behavior results in the great volatility of stock prices and decrease the stability and efficiency of the stock markets.

The phenomena behind equity risk premium discussion for 35 years, was first took place in Robert J. Schiller’s work done on volatility of equity prices. The research conduct by Schiller (1982), highlighted the difficulty of explaining the historical volatility of stock prices. The results of Shiller’s paper stunned the profession at first as most of economists felt discount rates were close to constant over time. The intuition behind the unpredictability of volatility, later named volatility puzzle by scholars who have studied this paradox as well. Just after 3 years from Schiller work on historical volatility, Mehra and Prescott (1985) introduced the equity premium puzzle. It is mainly based on the lack of evidence for a high risk premium in terms of consumption growth. In other words, investors require and have high returns which have low covariance with consumption growth. Using Schiller’s data collected on the volatility puzzle, they have found out that between 1889 and 1978, the consumption growth rate, the indicator for opportunity cost of investors is insufficient to explain 6% risk premium. Moreover, it was so high that the findings suggested only a risk premium of 0.35% on top of the risk-free rate. Behavioural finance approached this puzzle based on preference of investors. The decision making process of investors on investing on equities and why do they require high risk premium and fear equities this much. One of the leading papers on the

With the penetration of the research on the securities market, scholars have found many “abnormal phenomenon”, which is contrary to the Efficient Market Hypothesis(EMH) proposed by Eugene Fama, a professor of Finance at the university of Chicago Booth School of Business. The hypothesis was based on the efficient markets model after the proof of theoretical and empirical literature. Fama argued that stock prices has fully reflected all available information (mainly historical information about price changes, such as the previous stock price) in the efficient market and new information is unpredictable which makes the stock price changes follow a random walk. However, in weak-form efficiency market, investors can not rely on the analysis of the trend of historical changes of stock price to get the so-called law of change in the stock price and consistently obtain excess profits by it. If the weak-form Efficient Market Hypothesis is set up, the technical analysis of the share price become unhelpful anymore, and the basic analysis may also help the investors to gain extra profits. Numerous experimental tests on weak-form efficiency market hypothesis show that the market is basically inefficient after deducting trading costs. For

My motivation to look closer into the relationship between expectations and price movements comes from my trading experience within the forex market. For the past two years, I have been trading live within the forex market, with two years prior to this paper trading. What attracted me to the forex market rather than the many other markets available to trade independently was the high volatility and the opportunity to profit from it. However, as I quickly learned during my period of paper trading this volatility would cause me to incur more losses than profits. Since then I 've adopted a more conservative trading style which is mainly oriented around technical analysis. However, I 'm still quite interested in the immediate and often drastic price movements which happen when news is released. My primary goal of this paper was to understand and possibly adopt new elements into my trading strategy to become a better trader.

Throughout the history of finance mankind has devised various ways to predict future costs, price changes, changes in supply and demand, and changes to bond and stock prices. We’ve created sophisticated models and formulas to help us make financial decisions. Although, we can’t always prepare for the inevitable depression, inflation, stock bubble bursts, long or short term shocks to the economy, and changes in taste, we can try our best to protect ourselves financially from our own irrational behavior and decisions when it comes to finance. With our sophisticated technology shouldn’t everyone generally come to the same conclusion when it comes to changes in the stock or bond market? What causes people to act differently to