Weak Form 

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Weak Form



The weak form of the efficient market hypothesis contends that successive changes in stock price movements are independent of one another. Consequently, no relationship exists between past and future stock price movements. The weak form of the efficient market hypothesis holds that historical information about stock prices has no bearing on future stock prices. In other words, the stock prices of today and tomorrow are unrelated to past stock prices. Thus a comparison of two stocks, as illustrated in Figure 12–1, would be meaningless in predicting future price behavior. Both stocks have a current price of $20 per share, but the stock of Company X rose from a low of $2 per share to $20, whereas the stock of Company Y fell from a high of $40 to $20. The weak form of the efficient market hypothesis maintains that past stock prices are independent of future stock prices. In other words, no relationship exists between past and future stock prices. This hypothesis would make futile the use of past prices, as shown in Figure 12–1, to determine which stock to buy. Technical analysts would argue that you would not want to buy a stock that has declined from $40 to $20 per share because of its downward trend. Technical analysts would advocate buying Company X over Company Y because of its upward trend going from $2 to $20 per share. In other words, the weak form suggests that the use of charts and past prices in technical analysis in the selection of stocks is inconsequential and does not produce superior returns.

According to the weak form of market efficiency, stock prices reflect all historical market data. The stock price already includes the price history of the stock, the trading volume, and all other information that forms the basis for technical analysis.

Figure 12-1
Evaluation of Past Stock Price Information in the Weak Form of the Efficient Market Hypothesis

Evaluation of Past Stock Price Information in the Weak Form
of the Efficient Market Hypothesis

Studies testing the weak form of the efficient market hypothesis show that stock prices appear to move independently or in a random fashion because of the dissemination of information (Fama, 1965, pp. 34–105). This statement refutes the view of technical analysts, who assert that stocks move up or down in runs (trends). By spotting the trend early, you can profit by sticking with the stock during its uptrend or selling at the top of a downtrend.

For a number of years, the Wall Street Journal published results that compared stocks picked by dart throwers with those chosen by financial analysts. The stock picks of the analysts more often outperformed those of the dart throwers. Does this experiment mean that the weak form of the efficient market hypothesis has no validity? No, argue academicians. According to Burton Malkiel and Gilbert Metcalf, analysts picked stocks that were riskier than the market (40 percent more volatile) as opposed to the dart picks, which were only 6 percent more volatile. The second reason that the results are slated toward the analysts is the favorable publicity from the competition, which ran up the prices of the stocks picked by analysts (Dorfman, 1993, p. C1). If the advantages of the analysts had been taken away, then the competition would have been on an even footing.

Technical analysts and many others on Wall Street dispute the findings of the studies that support the weak form of the efficient market hypothesis. After all, if the weak form is not valid, technical analysts would be able to consistently earn superior returns by charting and analyzing past stock price information to predict future stock prices. The weak form, however, does not directly refute the use of fundamental analysis in selecting stocks that may produce superior returns.




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