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Why Analyze Securities?

Strong-form: Technicians

The strong-form of market efficiency theorizes that the current price reflects all information available. It does not matter if this information is available to the public or privy to top management; if it exists at all, it is reflected in the current price. Because all possible information is already reflected in the price, investors and traders will not be able to find or exploit inefficiencies based on fundamental information. Generally, pure technical analysts believe that the markets are strong-form efficient and all information is reflected in the price.

Semi-Strong Form: Random Walkers

The semi-strong form of market efficiency theorizes that the current price reflects all readily available information. This information will likely include annual reports, SEC filings, earnings reports, announcements and other relevant information that can be readily gathered. However, there is other information not readily available to the public that is not fully reflected in the price. This could be information held by insiders, competitors, contractors, suppliers or regulators, among others. Anomalies exist when information is withheld from the public and the only way to profit is by using information not yet known to the public. This is sometimes called insider trading. Once this information becomes public knowledge, prices adjust instantaneously, so it is virtually impossible to profit from such news. The Random Walk theory is an example of the semi-strong form of market efficiency.

Weak-form: Fundamentalists

The weak-form of market efficiency theorizes that the current price does not reflect fair value and is only a reflection of past prices. Furthermore, the future price cannot be determined using past or current prices (sorry technical analysts). Fundamental analysts are champions of weak-form market efficiency and believe that the true value of a security can be ascertained through financial models using information readily available. The current price will not always reflect fair value, and these models will help identify anomalies.

Which Form Exists in the Market Today?

Many in academia, including Gordon Gemmill of the University of Warwick and Aswath Damara of NYU, believe that security prices are semi-strong efficient. Recall that semi-strong efficient implies that all public knowledge is reflected in the price and it is virtually impossible to exploit deviations from the true value based on public information. Only new information will affect the price. Judging from the reaction of many stocks to news events, there seems to be evidence to support this case. The flow of information has become faster with the Internet, and surprises are factored in instantly. Few will argue that a surprise, both positive and negative, can violently move the price of a security. A few examples include:

  • After Pre-announcing that earnings would come in below expectations on 6-Jan-00, Lucent fell from 59 to 43 in one day.
  • After positive comments from an influential analyst on 23-Feb-00, Time Warner shot up 49 to 59 in 2 days.
  • After reporting earnings that were below expectations on 15-Feb, Abercrombie & Fitch fell from 24 to 15.

Even though these are but a few examples, it is obvious that new information can move the price of a security in non-random ways. (stockcharts.com)

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