Question

If a stock costs $55 one month and drops to $45 the next month, what is the expected stock price the next month if we assume the stock follows a random walk?

Explain both technical and fundamental analysis and what form of the efficient market hypothesis corresponds to each.

Answer 1

If a stock follows a random walk, the stock prices are independent of each other. The past prices have no relation with the future prices. In short, the stock takes a random or unpredictable path.

So, we cannot predict the stock prices for the next month. We cannot tell what will be the stock price the next month as the stock is following a random walk.

Technical analysis: This analysis is based on the past prices and historical trends . So, technical analysis uses the past data of price and volume to predict the future prices.

Fundamental analysis : This analysis uses financial statements to determine the stock prices . Fundamental analysis of stocks is about the analysis of real data of stock to find stock's value. Fundamental analysis uses earnings, growth rate, revenues, profit margins to determine the stocks value and the potential for growth.

The weak form of market efficiency states that, no past prices can predict the future prices of stocks. All the price and volume data is already reflected in the stock prices. No fundamental nor technical analysis can be useful in earning extra returns. Hence, investors cannot earn any profits in an efficient markets. We can use fundamental analysis to identify undervalued stocks, but it also has has very limited use.

• Advocates of weak form efficiency see limited benefit in using technical analysis or financial advisors.

The semi-strong form efficiency theory follows the belief that because all information that is public is used in the calculation of a stock's current price, investors cannot utilize either technical or fundamental analysis to gain higher returns in the market.

The strong form states all public information as well as all private/insider information is reflected in the stock prices, no fundamental or technical analysis is useful.

Hence, no form of market efficiency corresponds to either fundamental or technical analysis.In the weak form, there is very limited use of fundamental analysis.