How market information affects stock performance

Munyao always admired the prospects of trading public equities. From the Bombay Stock Exchange to the Johannesburg Stock Exchange to the Brazilian Securities, Commodities and Futures Exchange, he followed trends around the world. He read all about the DAX, CAC 40, Hang Seng, Nikkei 225, Dow Jones, S&P 500, Russell 2000 and FTSE 100.

When Munyao sold his clothing retail business, he decided to plough the proceeds into the Nairobi Securities Exchange. He kept his wife up late at night at times reading through newspapers and analysing information on the different companies he traded.

However, slowly Munyao started to lose excitement. He noticed that if the Nairobi Securities Exchange (NSE) went up by 25 per cent, his stock choices only went up by 18 per cent.

One year he earned 15 per cent more than the market, but all other times he performed worse than the market when he chose individual stocks himself or listened to brokers.

Following last week’s Business Talk, Munyao understood why his attempts to use arbitrage to sell clothing at temporary higher prices and later in stocks failed. We highlighted efficient market theory research on how fundamental analysis cannot predict future equity prices.

The vast complex network of information comprising markets and human behaviour means that mutual funds, investment brokers, investment banks and seasoned investors cannot beat the market consistently.

A logical investor begins to ask whether an active or a passive investment approach makes sense.

Since one cannot use analysis or expert advice to garnish consistently higher returns than the NSE generates anyway, then many researchers advise not to actively trade stocks on a regular basis.

Do not choose a stock one week, sell it the next, buy more next month and sell this two months after that. The brokerage fees to perform all the transactions significantly diminishes investor returns to below the average returns for all stocks on an exchange.

However, the inability to beat the market should not discourage but rather liberate the investor – buy the market and make the same return or loss as the market.

Research shows that holding a long term buy-and-hold philosophy pays off more consistently over the years. If you want to buy equities worth Sh1 million, then buy each and every stock in equal proportion. Alternatively, buy Sh50,000-worth of each of the NSE 20 Share Index stocks.

The diversification evens out your risk if one of the firms suffers a catastrophic failure. This way you ride the ups and downs of the bourse as a whole rather than the risks and fees of trading just a few stocks.

The debate around Professor Eugene Fama’s efficient market theory that advocates for the above approaches hinges on four forms of efficiency: strong, semi-strong, weak and none.

In a “none-form” efficient market, historical prices and company financial statement returns are not available to the general public or are difficult to obtain. Inasmuch, making intelligible investment decisions becomes incredibly difficult.

Some analysts claim that Kenya originated from a none-form efficient system. The new Companies Act aims to rectify the last vestiges of any none-form efficiency through greater transparency, along with the most recent enforcement of the executive pay disclosure requirements.

Weak form efficiency means that the general public and every investor may access all historical prices and company financial statement returns.

Numerous research studies support weak form efficiency in global securities markets. In an attempted challenge to the reality of weak form efficiency, many Kenyans, along with millions of investors around the world, employ charting techniques to determine whether they predict if an equity will go up in price or down in value.

Charting a stock involves placing the history on a graph. When an investor notices multiple downward price trends, then he or she assumes the stock would reverse and move in a positive upward trend soon and therefore buys the equity.

However, multiple studies investigating unlagged versus lagged one-month returns show that past stock performance holds no bearing on whether the price goes up or down in the future.

The next stage of possible efficiency equals semi-strong form, which states that the price of a stock fully reflects all publicly available information and expectations about the future.

One way to test semi-strong form efficiency is to check how rapidly an equity on the NSE changes in response to new positive or negative information about a firm.

When prices change quickly, previous old data cannot be used in order to gain returns superior to those of everyone else in the market.

Semi-strong form efficiency repudiates fundamental investment analysis as a way to uncover incorrect values and profit from arbitrage. Research shows that semi-strong form efficiency holds true, except for the following four behavioural finance instances.

First, globally, stocks of smaller companies tend to perform better over time than those of the largest firms. Second, equities with lower price-to-earnings ratios consistently perform better on average than higher P/E ratios.

Third, stocks tend to perform the worst on Mondays and the best on Fridays because most firms release negative data over weekends so investors have time to digest the news before reacting on Mondays. Positive company news often gets released later in the week.

Fourth, in countries with material capital gains and corporate income tax, stocks perform worse year after year in December than they do in January as investors offload stocks for tax loss carryover purposes in December and buy back stocks in January, causing a dip and then a bounce.

In all the above four anomalies, even though the entire market knows about the anomaly, investors may achieve abnormal above general market returns by investing using the techniques.

The final possible stage, strong form efficiency, means that all information, whether public or private, exists as available to the general public.

Clearly not all information is held by all investors because when someone knows an internal secret about an upcoming event or company announcement, they can make gains by trading on that insider information. So, no market in the world is all the way strong form efficient.

Professor Scott serves as the director of the New Economy Venture Accelerator and chair of the Faculty Senate at USIU, www.ScottProfessor.com, and may be reached on: [email protected] or @ScottProfessor