Question

(a) Why are there surprise market crashes? The market should signal this or at least communicate in a timely fashion. It could be said that insufficient attention has been paid to psychological factors when explaining stock efficiency anomalies. Outline the efficient stock market hypothesis (EMH) and describe some of the evidence which casts doubts on the semi-strong level of the efficient market hypothesis for which psychological explanations might be useful.

(b) The following statements are extracts from the detailed minutes taken at a board meeting of Advance plc. This company is discussing the possibility of a new flotation of shares on the Nairobi Securities Exchange.

CFO: 'I have been following the stock market for many years as a private investor. I put great value on patterns of past share prices for predicting future movements. At the moment my charts are telling me that the market is about to rise significantly and therefore we will get a higher price for our shares if we wait a few months. This will benefit our existing shareholders as the new shareholders will not get their shares artificially cheap. Furthermore, I know of other investors who have consistently beat this market based on the such techniques. It is like darts board. Where the darts land, is as good as another, just that group of assets’

Deputy Finance Manager: 'I too have been investing in shares for years and quite frankly have concluded that following charts is akin to voodoo magic, and what is more, working hard analyzing companies is a waste of effort. The market cannot be predicted. I now put all my money into tracker funds and forget analysis. Delaying our flotation is pointless; the market might just as easily go down. Prices are just but random variables'

Required

Consider the efficient stock markets theory and the rational expectations theory and relate it the position of CFO and Deputy Finance Manager.

Answer 1

(a) The four major reasons for a surprise market crash could be outlined as follows:

The panic sentiment: more of these factors all by themselves. It's typically a combination of a negative catalyst and investor panic that causes a sharp dive in the stock market.

Political instability: Markets like stability, and wars and political risk represent the exact opposite.

Interest rate spikes: Rising interest rates are generally perceived negatively by investors since it degrades the value of income-focused stocks. Investors invest in stocks for good dividend yields, and any instances of high interest rates diminishes the value of the stock.

Leverage: Leverage works either way. When markets are positive and stocks are rising, one can earn more money. If one invests in $500 worth of stock when markets are rising, and it rises 10%, then one is in for a profit. If one borrows an additional $2000 and invests in the same stock. one can make higher profits of the same stock.

On the other hand, if markets are falling, leverage can magnify losses as well.

The efficient market hypothesis states that stocks are reflective of fair market values and all available information, thereby making it difficult for an investor to outperform the market through careful stock selection or technical analysis. One cannot purchase undervalued stocks or sell stocks for inflated prices.

EMH may be useful for research but lacks practical application.

The semi-strong level of EMH assumes that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, and no excess or abnormal returns can be generated on the basis of the information.

For example, the  2008 financial crisis should not have occurred if the EMH had held. The housing bubble that had occured was an anomaly that the theory failed to explain.A bubble occurs when the actual price is significantly different from the market price, and is subject to massive and irrational speculation.

The housing bubbles made investors act irrationally and invest in subprime mortgages to take advantage of arbitrage opportunities. In the semi-strong form of efficiency, the market would have reflected the true worth of these asset prices by taking into account all publicly available information and MNPI(material non public information) such as dividends, book value, etc.

Traditiionally, the efficient market hypothesis operates under the assumption that all investors are rational and markets are 'informationally efficient' . However, in the practical scenario,people may be more speculative and irrational in their investing approaches and have certain psychological and emotional biases that lead to such behaviors. Behavioral finance as an alternative model best explains this.

b) The rational expectations theory is an economic theory which states that the decision making process of individuals is largely based on how they perceive the future, and such future expectations are a function of their observations and past experiences.”

For example, many of us will hold off on a purchase if we find that the price of a particular good or service will fall in the upcoming month.

As we can observe, the CFO of Advance, Plc is in favor of the rational expectations theory, when he says that he values fundamental and technical analysis when it comes to predicting share prices. He is of the belief that the company will stand to profit if they issue the shares in a few months' time as the markets will be on an upward trend.

On the other hand, the Deputy Manager follows the Efficient Market Hypothesis and believes that no amount of financial or technical analysis will get them to predict share prices correctly since the markets are always reflective of true and fair values of stocks at a given point of time.

It is impossible to maximize returns through any form of forecasting. Any delays in floatation may possible cause a fall in share prices as well.