In this regard, Batten points out that, "There is no actual proof. It is virtually impossible to test for market efficiency since the 'correct' prices cannot be observed. To get over this hurdle, most tests examine the ability of information-based trading strategies to make above-normal returns. But the results of such tests do not really prove whether markets are efficient. Therein lies the basic dilemma" (p. 210).
In his book, Stock Market Cycles: A Practical Explanation, Bolten (2000) reports that assuming that an economy begins in a trough (a period this author refers to a the first stage of the economic cycle), expectations are for positive economic growth and higher future earnings, which has a positive impact on stock prices. In this regard, Bolten points out that, "Interest rates are typically low at this period in the business cycle, which will positively affect stock prices due to a decrease in firms' cost of capital. Low interest rates also induce investors to transfer wealth from low-yielding bonds into stocks, which pushes up stock prices. The combined effect of these factors causes stock prices to rise relatively quickly at this stage, even though the economy may show only marginal signs of improvement" (p. 121).
During the second phase of the economic cycle, the nation's economy continues to grow and the demand for capital increases, a process that leads to inflationary pressure and interest rates begin to rise gradually (Bolten, 2000). The author adds that, "Expectations of future earnings increase due to the strengthening economy, however. At this stage of the cycle the positive impact of higher earnings expectations dominates the negative impact of higher interest rates. The overall effect on the stock market is positive and prices rise, although not as fast as in the first stage of the economic recovery" (Bolten, 2000, p. 121). The third economic cycle stage is characterized by continued economic expansion: "The supply of loanable funds cannot keep pace with the increased demand for capital, which causes the rise in interest rates to accelerate. As inflationary concerns worsen the Federal Reserve is likely to tighten monetary policy, which puts more upward pressure on interest rates. Furthermore, the rate of earnings growth begins to slow down due to diminishing marginal productivity" (Bolten, 2000, p. 121). These factors result in a decrease in the rate of economic expansion; stock prices increase slowly and eventually peak, even though the economy has not yet reached its peak (Bolten, 2000).
While the economy slows, interest rates may not immediately decrease. Inflationary pressures and the increased costs of financing unanticipated inventory accumulations and lagged accounts receivable collection will cause interest rates to continue rising. The combined effect of investors transferring wealth from stocks to bonds and the slow growth in corporate earnings has a negative effect on stock prices (Bolten, 2000).
During the fourth stage of the economic cycle, worsening economic expectations dim future earnings prospects, which has a negative effect on stock prices. The decreased demand for credit causes interest rates to begin falling. Stock prices will continue to decline until interest rates fall substantially, however. The downtrend in interest rates and improvement in earnings expectations eventually cause a rebound in stock prices (Bolten, 2000). These processes are illustrated in Figure ____ below.
Figure ____. Economic Factors and the Stock Market Cycle.
Source: Bolten, 2000, p. 122.
As noted above, Fama (1970) coined the term "weak-form market efficiency" and suggested three levels of efficiency; the semistrong form of market efficiency implies that markets adjust rapidly and in an unbiased manner to public information. Under the strong form of market efficiency, both public and private information are quickly impounded in the security price. Strong-form market efficiency implies semistrong-form market efficiency, and semistrong-form market efficiency in turn implies weak-form market efficiency (Batten, 2000, p. 282). The growing body of research into weak-form market efficiency that began with Bachelier concluded that stock prices follow a random walk. The random walk hypothesis means that at a given point in time, the size and direction of the next price change is random with respect to the knowledge available at that point in time. This implies that charting and all other forms of technical analysis practiced by various investors, amateur and professional alike, are doomed to fail. Market efficiency can also take a semistrong form or a strong form (Batten, 2000).
Market efficiency also seems to have its roots in the idea of intrinsic value. Although the value of most goods is acknowledged to be a function of consumer beliefs, preferences, and endowments, securities have often been treated as having a value independent of these consumer characteristics. Their value is based on the characteristics of the firm behind the security. This is a supply-side approach. The price of any security, however, depends not only...
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