Chapter 9 • The secondary capital market and its efficiency
gain plus dividend received over a period, expressed as a percentage of a security’s
price at the start of that period.
Tests of this type pose several methodological problems. Such is the number of fac-
tors acting simultaneously on the price of a particular security that it is difficult to
know to what extent prices are affected by the specific factor in which the researcher
is interested and to what extent other factors are involved. For our present purposes,
let us accept what most qualified observers believe, that the major researchers in this
area, some of whose work we shall consider, have sufficiently well overcome the prac-
tical problems for their results to be regarded as providing significant insights. Where
this seems not to be the case, we shall discuss it. Readers who are interested in look-
ing at the methodological problems in detail should take up some of the references
given during and at the end of this chapter.Tests of weak-form efficiency
Technical analysis
It has long been popularly believed that security prices move in cycles or patterns that
are predictable by those who study the matter closely enough. Many feel that past pat-
terns of security price behaviour repeat themselves, so that spotting a repeat starting
to occur can put the investor in a position to make abnormally large investment
returns. Not surprisingly, adherents to this philosophy use graphs and charts of past
security prices to facilitate recognition of the pattern early enough to benefit from it.
These people are often referred to as chartists.
Others seek to develop trading rules that are perhaps easier to apply than those of
the chartists. For example, it is believed by some that the price of a particular security
tends to hover around a particular value, rarely deviating from it by more than a small
percentage. If the price starts to break outfrom the ±xper cent band, they believe that
this implies a large movement about to occur. This they feel can be taken advantage of
by buying or selling according to the direction of the breakout. Such dealing rules are
usually called filter rules. More generally, the use of techniques such as filter rules and
charts is known as technical analysis.
If the market is efficient this should mean that no gains could be made from tech-
nical analysis because there are so many observers at work that if any information
were contained in past price movements it would be impounded in the current price
as a result of buying and selling. Only new information would affect share prices. As
new information is random, security prices would be expected to follow a random
path or random walk. New information must be random or it would not be new infor-
mation. That the sales of a Christmas card manufacturer were greater towards the end
of the year than at other times during that year is not new information because this
pattern tends to occur every year and is predictable.Spotting repeating patterns
Let us suppose that the price of a particular security has followed the cyclical pattern
shown in Figure 9.1 over a number of years. There is obviously a regular pattern here.
What should we do if we spotted this pattern at time t? Surely we should buy some of
the securities and hold them until the next peak, sell them and buy some more at the
following trough and so on until we became bored with making money! It seems too
good to be true and, of course, it is. In real life we should not be the only ones to spot‘