Evidence that Weak-Form Capital Market Efficiency Does Not Hold

149 Pages·2016·4.9 MB·English

Evidence that Weak-Form Capital Market

Efficiency Does Not Hold

by

DENYS BAILLIE MAASDORP

submitted in accordance with the requirements

for the degree of

DOCTOR OF BUSINESS LEADERSHIP

at the

UNIVERSITY OF SOUTH AFRICA

SUPERVISOR: PROF JW KRUGER

FEBRUARY 2015
Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

ABSTRACT
It is generally accepted in academic circles that the developed country capital markets with their advanced
infra-structure, depth and liquidity are at a minimum Weak-Form efficient.
Since the Weak-Form EMH proposes that current security prices immediately assimilate all historical
information, it therefore also implies that technical analysis (which relies on charts and analysis of past
price patterns to extrapolate future price movements) would be a futile exercise. Ye t technical analysis
has endured over time and is still an intensively and widely used investment analysis technique.
This indicates a clear disconnect between technical analysis as employed by practitioners in the market
and the technical analysis methodologies utilized by academics in prior Weak-Form EMH studies.
The problem is prior technical analysis Weak-Form EMH studies were burdened with methodological
weaknesses which severely handicapped the profit generating potential of technical analysis and suggest
that previous Weak-Form EMH research findings were erroneous in being unable to reject the null Weak-
Form market efficiency hypothesis.
This study addresses the problem by eliminating prior methodological weaknesses and utilizing high
frequency intra-day data, the combination of qualitative and quantitative techniques and volume signals
to develop a portfolio of Intermarket Momentum technical analysis strategies that generate significant
excess profits.
The objective of this study is therefore to provide evidence that contrary to prior research findings, the
developed country capital markets are not Weak-Form efficient.
The results show that the portfolio of Intermarket Momentum trading strategies generated returns in
excess of the market with a significantly positive Alpha of 8.52% that allowed the rejection of the Null
Hypothesis and the acceptance of the Alternative Hypothesis that the developed country capital markets
are not Weak-Form efficient, thereby refuting the widely accepted EMH.

Key Words: Efficient Market Hypothesis; Weak-Form Market Efficiency; Technical Analysis; Charting;
Qualitative Technical Analysis, Quantitative Mechanical Rules; Intermarket Analysis.
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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

ACKNOWLEDGEMENTS

To my supervisor, Professor Jan Kruger, whose invaluable guidance throughout is reflected in the quality
of this thesis.

To my wife, Sandy, for her patience, love and support during this endeavo ur.

I dedicate this thesis to my parents, Dr. Peter and Jean Maasdorp, who were a constant source of love,
inspiration, and support throughout my life.

I only wish I had completed this project in time to celebrate this accomplishment with them.

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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

TABLE OF CONTENTS

1 ORIENTATION ...................................................................................................................................... 11
Introduction ................................................................................................................................ 11
Research Question ...................................................................................................................... 11
Research Problem ....................................................................................................................... 12
Research Objective ..................................................................................................................... 12
Significance of the Study ............................................................................................................. 13
Modern Finance Theory ...................................................................................................... 13
Bank Regulation .................................................................................................................. 13
Allocation of Resources ....................................................................................................... 13
Long-Term Investment Strategy ......................................................................................... 13
Business Leadership ............................................................................................................ 13
Limitations................................................................................................................................... 14
Delimitations ............................................................................................................................... 14
Ethics ........................................................................................................................................... 14
Summary ..................................................................................................................................... 15
Organization of the Study ........................................................................................................... 16
2 LITERATURE REVIEW ........................................................................................................................... 17
Origin ........................................................................................................................................... 17
Classical EMH Taxonomy ............................................................................................................ 18
Weak Form EMH ................................................................................................................. 18
Semi-Strong Form EMH ....................................................................................................... 18
Strong Form EMH ................................................................................................................ 18
The Underlying Theory ................................................................................................................ 18
The “Fair Game” Model ...................................................................................................... 19
The Martingale Model ........................................................................................................ 20
The Random Walk Model .................................................................................................... 20
The Empirical Evidence ............................................................................................................... 21
Weak-Form EMH ................................................................................................................. 21
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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

Semi-Strong Form EMH ....................................................................................................... 22
Strong-Form EMH ............................................................................................................... 26
EMH Synopsis .............................................................................................................................. 27
Weak-Form EMH Focus ............................................................................................................... 27
Technical Analysis ....................................................................................................................... 28
Background ......................................................................................................................... 28
Principles ............................................................................................................................. 29
Methods ...................................................................................................................................... 29
Qualitative Charting ............................................................................................................ 29
Quantitative Mechanical Rules & Indicators ...................................................................... 31
Summary ..................................................................................................................................... 40
3 RESEARCH QUESTION ......................................................................................................................... 41
Problem Statement ..................................................................................................................... 41
Focus on Absolute Efficiency of Individual Capital Markets ............................................... 41
Qualitative or Quantitative Studies .................................................................................... 42
Daily Closing Price Data Series ............................................................................................ 42
Volume Confirmation .......................................................................................................... 43
Summary ..................................................................................................................................... 43
4 METHODOLOGY .................................................................................................................................. 44
Hypothesis ................................................................................................................................... 44
The Null Hypothesis ............................................................................................................ 45
The Alternative Hypothesis ................................................................................................. 45
Measurement Instruments ......................................................................................................... 46
TradeStation Trading Platform ............................................................................................ 46
EasyLanguage ...................................................................................................................... 46
CSI Correlation Lab .............................................................................................................. 46
IBM SPSS Statistics Software ............................................................................................... 46
Measurement Techniques .......................................................................................................... 46
Intermarket Analysis ........................................................................................................... 46
Momentum Indicator (MOM) ............................................................................................. 47
High Frequency Data ........................................................................................................... 47
Volume ................................................................................................................................ 47
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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

Qualitative Charting ............................................................................................................ 48
Ex Ante Study .............................................................................................................................. 48
Strategy Automation ................................................................................................................... 48
Strategy Performance Testing ............................................................................................. 49
Portfolio Construction ................................................................................................................. 50
Summary ..................................................................................................................................... 50
5 DATA ................................................................................................................................................... 51
Data Collection ............................................................................................................................ 51
Data Analysis ............................................................................................................................... 52
Trading the Commodity Currencies .................................................................................... 52
The Australian Dollar Strategy ............................................................................................ 53
The Canadian Dollar Strategy .............................................................................................. 60
The South African Rand Strategy ........................................................................................ 65
The Norwegian Krone Strategy ........................................................................................... 70
The Commodity Index Trading Strategy ............................................................................. 75
Trading the Precious Metals ............................................................................................... 81
The Gold Strategy ................................................................................................................ 83
The Silver Strategy .............................................................................................................. 88
The Platinum Strategy ......................................................................................................... 93
The Crude Oil Trading Strategy ........................................................................................... 98
The 30 Year US Treasury Bond Trading Strategy .............................................................. 104
Summary ................................................................................................................................... 111
6 RESULTS............................................................................................................................................. 112
Trade List ................................................................................................................................... 112
Performance Summary ............................................................................................................. 119
Number of Trades ............................................................................................................. 120
Profitability ........................................................................................................................ 120
Risk Management ............................................................................................................. 120
Kurtosis ............................................................................................................................. 121
Skewness ........................................................................................................................... 122
Return ............................................................................................................................... 122
Comparative Total Return Analysis ........................................................................................... 122
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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

Jensen’s Alpha ........................................................................................................................... 124
𝑅𝐼𝑃 .................................................................................................................................... 124
𝑅𝑀𝐾𝑇 ............................................................................................................................... 124
𝑅𝐹 ..................................................................................................................................... 124
𝛽 ........................................................................................................................................ 126
ε ......................................................................................................................................... 126
Alpha (α) ............................................................................................................................ 126
Calculating Alpha............................................................................................................... 127
Test of Significance ................................................................................................................... 127
Time Series Price Data ...................................................................................................... 127
Actual Daily Return Time Series ........................................................................................ 127
Initial Estimated Returns ................................................................................................... 127
Sum of Squared Differences.............................................................................................. 128
Alpha Estimated Using the Least Squares Method (LSM) ................................................. 128
Statistical Significance Test of Alpha ................................................................................. 129
Hypothesis Testing .................................................................................................................... 130
The Null Hypothesis .......................................................................................................... 130
The Alternative Hypothesis ............................................................................................... 130
Summary ................................................................................................................................... 130
7 CONCLUSIONS AND RECOMMENDATIONS ....................................................................................... 131
Significance of the Results ........................................................................................................ 131
Modern Finance Theory .................................................................................................... 131
Bank Regulation ................................................................................................................ 132
Allocation of Resources ..................................................................................................... 133
Long-Term Investment Strategy ....................................................................................... 133
Business Leadership .......................................................................................................... 134
Recommendations for Future Research ................................................................................... 134
8 BIBLIOGRAPHY .................................................................................................................................. 136
9 GLOSSARY OF TERMS ........................................................................................................................ 143

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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

LIST OF TABLES

Table 5-1: TradeStation Historical Market Data ......................................................................... 51
Table 5-2: Correlation Coefficients - Commodity Currencies Intermarket Relationships .......... 53
Table 5-3: Traded Market and Intermarket Data - Australian Dollar Strategy ........................... 54
Table 5-4: Intermarket Correlation Coefficients – Australian Dollar (AD) .................................. 55
Table 5-5: Traded Market and Intermarket Data - Canadian Dollar Strategy ............................ 60
Table 5-6: Intermarket Correlation Coefficients – Canadian Dollar (CD) ................................... 61
Table 5-7: Traded Market and Intermarket Data - South African Rand Strategy ....................... 65
Table 5-8: Intermarket Correlation Coefficients – South African Rand (RA) .............................. 66
Table 5-9: Traded Market and Intermarket Data - Norwegian Krone Strategy .......................... 70
Table 5-10: Intermarket Correlation Coefficients – Norwegian Krone (NOK) ............................ 71
Table 5-11: Correlation Coefficients - Commodity Index Intermarket Relationships ................ 76
Table 5-12: Traded Market and Intermarket Data - Commodity Index Strategy ....................... 76
Table 5-13: Intermarket Correlation Coefficients – Commodity Index (GI) ............................... 77
Table 5-14: Correlation Coefficients - Precious Metals Intermarket Relationships ................... 82
Table 5-15: Traded Market and Intermarket Data - Gold Strategy ............................................ 83
Table 5-16: Intermarket Correlation Coefficients – Gold (GC) ................................................... 84
Table 5-17: Traded Market and Intermarket Data - Silver Strategy ........................................... 88
Table 5-18: Intermarket Correlation Coefficients – Silver (SI) .................................................... 89
Table 5-19: Traded Market and Intermarket Data - Platinum Strategy ..................................... 93
Table 5-20: Intermarket Correlation Coefficients – Platinum (PL) ............................................. 94
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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

Table 5-21: Correlation Coefficients - Crude Oil Intermarket Relationships .............................. 98
Table 5-22: Traded Market and Intermarket Data - Crude Oil Strategy ..................................... 99
Table 5-23: Inter-market Correlation Coefficients – Crude Oil (CL) .......................................... 100
Table 5-24: Correlation Coefficients - 30 Yr. US Treasury Bond Intermarket Relationships .... 105
Table 5-25: Traded Market and Intermarket Data - 30 Year US Treasury Bond Strategy ........ 106
Table 5-26: Intermarket Correlation Coefficients – 30 year US Treasury Bond (US)................ 107
Table 6-1: Trade List for the Year 2008 ..................................................................................... 112
Table 6-2: Trade List for the Year 2009 ..................................................................................... 113
Table 6-3: Trade List for the Year 2010 ..................................................................................... 113
Table 6-4: Trade List for the Year 2011 ..................................................................................... 114
Table 6-5: Trade List for the Year 2012 ..................................................................................... 115
Table 6-6: Trade List for the Year 2013 ..................................................................................... 116
Table 6-7: Summary Performance Statistics ............................................................................. 119

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Evidence that Weak-Form Capital Market Efficiency Does Not Hold 2015

LIST OF FIGURES

Figure 5-1: Australian Dollar Strategy - TradeStation Workspace .............................................. 59
Figure 5-2: Canadian Dollar Strategy - TradeStation Workspace ............................................... 64
Figure 5-3: South African Rand Strategy - TradeStation Workspace .......................................... 69
Figure 5-4: Norwegian Krone Strategy - TradeStation Workspace ............................................. 74
Figure 5-5: Commodity Index Strategy - TradeStation Workspace ............................................ 80
Figure 5-6: Gold Strategy - TradeStation Workspace ................................................................. 87
Figure 5-7: Silver Strategy - TradeStation Workspace ................................................................ 92
Figure 5-8: Platinum Strategy - TradeStation Workspace .......................................................... 97
Figure 5-9: Crude Oil Strategy - TradeStation Workspace ........................................................ 103
Figure 5-10: 30 Year US Treasury Bond Strategy - TradeStation Workspace ........................... 110
Figure 6-1: Comparative Total Return Analysis ........................................................................ 123
Figure 6-2: Comparative Quarterly Return Analysis ................................................................. 125

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