Stock Market Theories
There have been numerous market theories developed over the years which attempt to explain the pricing behavior of stocks.
These theories provide valuable insight into the seemingly irrational movements observed in the stock market. The task of analyzing the stock market is simplified when the investor has a solid understanding of the mechanisms which drive the markets.
Some theories such as Elliott Wave Theory and Wyckoff Market Analysis give the stock investor a better understanding of how stock prices move. Many new stock investors are under the illusion that markets continuously move upwards in a straight line. The Elliott and Wyckoff theories will dispel those illusions.
The Efficient Market Hypothesis is based on the notion that stock prices quickly reflect any new information. Indeed any new information which will affect the views market participants have over a stock or the market overall are rapidly absorbed into the prices. This information will often drive market prices in the opposite direction and the Efficient Market Hypothesis rationalizes that speculation and market participants with inside knowledge drive market prices before the information is publicly known and once the information is publicly known there is nothing left to speculate on.
Other aspects of the Efficient Market Hypothesis are more controversial, such as the stock price accurately reflecting the fundamental valuation of the company, which business economics dispels as being incorrect.
The Principle of Supply and Demand is the basis which moves stock prices. Simply put, when there are more buyers wanting to purchase stocks than there are sellers who are willing to sell their stocks, this puts upward pressure on prices and prices rise.
A useful concept in market analysis is that inflation and the price paid for a company's earnings are inversely related. High inflation tends to produce lower average PE ratios and low inflation tends to produce higher average PE ratios.
The inflation PE ratio relationship comes about from the rotation of capital between stocks and bonds. Basically when inflation is high, the coupon payments from bonds are also high and the investor receives a good return on a relatively low risk investment. This leads investors to allocate more money to bonds at the expense of stocks which leads to lower PE ratios on average. When inflation is low the coupon payments from bonds is also low and investors naturally seek better returns and allocate more money to stocks thus driving up stock prices and their PE ratios.
Another useful theory is Dow Theory which is based on the notion that the level of business activity of industrial companies and transport companies are directly related. When the sales of goods provided by industrial companies is increasing it is reasonable to expect that the demand on transport companies which transport these goods will also increase. Dow Theory goes one step further than the other theories and provides a simple to use means of determining whether the current stock market cycle is bullish or bearish by using these two Dow Averages.
Elliott Wave Theory
Elliott highlighted the concept of trends
The Elliott Wave Theory was developed by Ralph Nelson Elliott during the 1930s and was largely based on the movements of the Dow Industrial Averages. The principle behind the theory is that the mass psychology of market participants alternates between optimism and pessimism.
Elliott observed that the markets moved in short waves which alternate up and down and repeated over and over. Elliott also noted that external news events had no consistent effect on market prices as the same news would drive prices up one day and down the next.
Elliott identified a structure to the price movements and theorized that markets move in an orderly sequence of market swings which he called impulse waves and corrective waves.
An impulse wave moves in the direction of the main trend and a corrective wave moves against the main trend. So in an uptrend the impulse wave trends up (a rally) and the corrective wave trends down (a pullback).
The Elliott Wave principle is illustrated below in Figure 1.
Figure 1. Elliott Waves - impulse and corrective waves
From Figure 1. above, the broad rally is an impulse wave and consists of sub-waves 1 to 5. The broad pullback is a corrective wave and consists of sub-waves A to C.
The basis of Elliot Wave Theory is that main impulse wave is split into five sub-waves and the main corrective wave is split into three sub-waves. The sub-waves that move in the direction of the main wave are also referred to as impulse waves and sub-waves that move counter to the main wave are referred to as correction waves.
Thus for the main impulse wave, Waves 1, 3 and 5 are also called impulse waves. With the main corrective wave, Waves A and C are also called impulse waves since these two sub-waves are in the direction of the main corrective wave (note that wave B runs counter to the main corrective wave).
For the main impulse wave, Waves 2 and 4 are corrective waves since they run counter to the main impulse wave. With the main corrective wave, only wave B runs counter and is therefore the corrective wave.
All the blue waves shown in Figure 1. are impulse waves and all the red waves are corrective waves.
Elliott Wave Theory includes some general rules. For the main impulse wave in an uptrend these general rules are as follows:
Elliott Wave Theory:
- With an uptrend the low of Wave 2 must be above the low of Wave 1.
- Wave 3 is usually the longest wave
- The low of Wave 4 is above the high of Wave 1.
At first Elliott's notations may seem a little confusing, but the main thing to remember is that impulse waves move in the direction of the trend and corrective waves are simply corrections to the trend.
Investors should keep in mind that Elliott Wave Theory is just that - a theory. While in reality stocks do follow a sequence of waves, they do not necessarily follow the ordered approach as depicted by Elliott Wave Theory.
The Elliott waves are shown below on an actual stock chart.
Chart 1. Elliott Waves - AOS chart
As Chart 1. above shows, the stock does move with a sequence of waves, but the Main Impulse Wave shows more waves than the theory suggests should have occurred.
Some stocks show numerous waves within the Main Impulse Wave while others show only one wave. Similarly for the Main Corrective Wave where some stocks show many waves during the decline while others showed only one.
Elliott Wave Theory further sub-splits each wave within the Main Impulse Wave and the Main Corrective Wave. This is nothing more than locating trends within trends. A long-term trend typically consists of several intermediate-term trends and an intermediate-term trend typically consists of several short-term trends. Elliott simply refers to trends as waves.
Elliott Wave Theory further splits the sub-waves shown in Figure 1. into more sub-waves. This is illustrated below in Figure 2.
Figure 2. Sub-waves split into further sub-waves
From Figure 2. above, all the impulse waves shown in blue in Figure 1. are split into five sub-waves and all the corrective waves shown in red are split into three sub-waves. By now the wave chart is starting to resemble a typical line chart. These sub-waves are trends and not closing prices.
The basic principle with Elliott Wave Theory is sound as the theory recognizes and highlights that markets do not move in straight lines but constantly advance and retrace their movements in a zigzag like manner. An issue with this theory is that it over simplifies. While markets form a zigzag pattern, the notion that an advance in an uptrend (impulse wave) consists of five sub-waves and a pullback consists of three sub-waves makes the theory difficult to implement. Basically the trend-lines would have to be manipulated until the correct number of waves is displayed on the chart.
In summary, Elliott Wave Theory is useful in understanding the zigzag movements that markets readily display, but more often than not the number of waves on actual market line charts does not align with the requirements of the theory.
Wyckoff Market Analysis
Accumulation and distribution
Richard Wyckoff was a speculative stock trader and market analyst from the late 1800s and early 1900s who studied, analyzed and traded the stock market. He based his theories on observing the markets and their reaction to fundamental information and the seemingly disconnection between market prices and stock fundamentals. He concluded that any new information was readily factored into stock prices and viewed the market in terms of supply and demand.
Richard Wyckoff also noticed that the markets did not behave exactly the same with each rally and decline and that the market developed its own patterns which only generally resembled any previous patterns formed. Richard Wyckoff broadly classified the market into four phases.
Wyckoff market phases:
- Accumulation: During this phase market prices bottom out and form a broad basing pattern. This is basically a bear market bottom.
- Markup: This phase is where market prices rise. This is the bull market stage which is characterized by market rallies and market corrections.
- Ditribution: During this phase market prices top out and form a broad pattern. This is basically a bull market top.
- Markdown: This phase is where market prices decline. This is the bear market stage which is characterized by market declines and bear market rallies.
Richard Wyckoff noted that markets tended to spend more time in the Accumulation phase than they did during the Distribution phase.
The general market phases identified by Richard Wyckoff are illustrated below in Figure 1.
Figure 1. Wyckoff market phases
From Figure 1. above, Wyckoff observed that when markets bottomed out they would often trade is a broad trading range which could last 6 months or more. Once the market broke out of this Accumulation phase the next bull market could begin which Wyckoff referred to as the Markup Phase. It was during this phase that Wyckoff would trade and primarily made his purchases during market pullbacks.
Wyckoff generally avoided trading during the Accumulation phase and also tended to avoid the Distribution phase. He would wait for a breakdown out of the Distribution phase and Wyckoff was an active short seller in bear markets which he referred to as the Markdown phase.
During the Markup phase the markets frequently pause in broad trading ranges which Wyckoff referred to as Re-Accumulation. While this stage is similar to the Distribution phase Wyckoff noted that if the market breaks out to the upside then the Market would likely continue with the Markup phase. A pause also occurs with the Markdown phase which Wyckoff referred to as Re-Distribution. Should the market breakdown through the trading range, then the Markdown phase would likely continue.
These market phases are shown on Chart 1. below for the Dow Industrials index covering the current bull market and the previous 2008 bear market.
Chart 1. Dow Industrials Wyckoff Market Phases
Chart 1. above shows the top of the 2008 bear market as a Distribution Phase. The 2008 bear market did not show a Re-Distribution Phase. The Bottom of the 2008 bear market is shown as a Accumulation Phase. A significant Re-Accumulation Phase occurred during 2015 (which we called a Market Consolidation in the eMagazine Stock Market Update section). The 2015 Phase is labeled as a Re-Accumulation Phase because the market broke out to the upside. Note that if the market had broken down instead of up then this Phase would have been labeled a Distribution Phase signifying a market top.
Wyckoff also studied the volume relationship and rationalized that volume should decline during the accumulation and distribution phases. Also when the market broke out of these basing patterns the volume should increase. He used an indicator which he called the Optimism Pessimism index which is known nowadays as the On Balance Volume indicator.
Wyckoff also studied the markets sectors and identified sectors which were strong and which were weak. He based this analysis on relative strength and traded stocks from the strong sectors during the Markup phase and shorted stocks from the weak sectors during the Markdown phase.
The general principles developed by Wyckoff some 100 years ago are essentially incorporated into most modern day speculative trading strategies. In particular, trading on the long side in bull markets and trading on the short side in bear markets.
In summary Wyckoff's market analysis was based on a long-term view rather than the short-term and he was interested in identifying when the market was in a general bull market phase or in a general bear market phase. His basic concepts are as valid today as they were 100 years ago.
Efficient Market Hypothesis
The Efficient Market Hypothesis is a theory which was formally developed in the 1960s however the basic concepts were first put forward a hundred years before that during the 1860s.
There are several basic principles of the theory. These are as follows:
Efficient Market Hypothesis:
- Market prices are random over time and cannot be predicted.
- All information is readily absorbed into market prices and there is no net gain in excess of the market gain.
- The market price accurately reflects the fundamentally value of an asset.
- No investor or trader can receive returns greater than what the market provides.
- Fund managers cannot outperform the market.
Needless to say this theory certainly has more than its fair share of critics and the theory is certainly not popular with stock market participants. It should be pointed out that the theory is a general theory for financial markets such as the currency market, bond market and the commodities markets. The theory is not specifically for the stock market even though it is most often cited with reference to the stock market.
The five basic principles of the Efficient Market Hypothesis are examined in detail as follows:
1. Market prices random
In the short-term there is no denying that stock prices do fluctuate about considerably. The theory states that these fluctuations cannot be predicted as they are random. While this is partially true it is not completely true.
When the stock market is rallying there is an increased probability that the stock price fluctuations will head in the direction of the market rally. Conversely when the stock market declines there is an increased probability that the stock price fluctuations will on average also decline. For stock prices to be totally random implies that the stock price fluctuations must head in a horizontal direction.
While market prices are random in a sense, a more accurate statement for the stock market would be that market prices fluctuate considerably about their intermediate-term trends (which can be up or down or even sideways).
In the long-term the random theory makes little sense. Over the last century the stock market has shown a never ending sequence of bull markets and bear markets with each subsequent bull market ending higher than the previous one.
Over the decades the stock market continues higher with a
never ending sequence of bull markets and bear markets
While both bull and bear markets exhibit rallies and declines, which are quite random in their occurrence, they do however constantly appear and they are a characteristic of the stock market. If the stock market were random then these rally and decline sequences should not occur.
A more accurate statement for the stock market would be that market prices broadly fluctuate about in an up-trending direction during bull markets and also broadly fluctuate about in a down-trending direction during bear markets. It can also be added that the duration of bull and bear markets is quite random but there are general time frame ranges. The randomness implies that the duration is never known in advance but history does provide a guide to the range of expected duration.
2. All information readily absorbed into market prices
The theory states that any new information is readily factored into market prices. This is certainly true and anyone following the stock market constantly observes this. Look at what happens when a company announces an earnings warning? The stock price tanks.
There is no arguing that the stock market is extremely efficient at incorporating any new information into stock prices. Generally all the technical analysis based theories recognize and acknowledge this, such as Dow Theory, Elliott Wave Theory and Wyckoff Market Analysis.
An issue with this part of the theory is that it also states that there should be no trends following the information release. The theory seems to overlook the fact that the information can propel the stock price, especially if the information suggests that there would be more information to come. The stock market is fueled by the anticipation of future information.
3. Market price reflects the fundamental value
This would have to be the most ridiculous part of the theory and totally ignores the fact that stocks are companies with operating businesses.
The problem here is that businesses have a valuation. If they are a private company this is the price they sell for.
The stock market is obsessed with the stock price increasing, which is a result of the general public who view a good investment as one where the price is currently increasing. Thus their only concern is that the stock price increases and will pay ridiculously high prices for a stock for no other reason than that the price is increasing. On the other hand, when businessmen buy a business their primary concern is with the profit that it will generate over the future years and are not really concerned with the future resale value.
The general public only buys a minuet portion of a company with the primary concern being that the resale price of a share increases. This has absolutely nothing to do with the business valuation which is what a businessman will pay to purchase the entire company for its future profitability.
The last thing the market price does is reflect the fundamental value of a company. Stock prices fluctuate above and below their fundamental valuation as they go on their roller coaster ride.
4. No returns greater than the market
The implication is that any portfolio of stocks constructed must follow the market, as according to the theory there cannot be any excess returns. The problem here is that any portfolio constructed of financially distressed companies must then also follow the market returns. Don't be surprised if such a portfolio significantly underperforms the market.
For this part of the theory to be valid it must work both ways, if a portfolio of quality companies cannot outperform the market then a portfolio of financially distressed companies cannot under perform the market.
The implication here is that if an investor deliberately constructs a portfolio of financially distressed companies heading into bankruptcy then they will simply achieve the same capital gains as the market.
Some will argue that the theory is only applicable in the short-term rather than the long-term even though the theory does imply that it also applicable over the long-term.
In the short-term stock prices are certainly random and any short-term trading is certainly heavily correlated to the market. This part of the theory is more applicable to short-term trading even though a lot of beginner stock traders do manage to lose money, which they shouldn't. According to the theory they should breakeven when brokerage and slippage are excluded.
5. Fund managers cannot outperform market
This part of the theory states that an actively managed fund can only achieve the same returns (before expenses) as a passively managed fund (before expenses). This is an interesting part of the theory as it has implications for funds investors.
Numerous research has been conducted on the performances of funds with the results indicating that most funds do not outperform the market on average. This in particular seems to be the case with funds that are very active and have a high portfolio turnover. There is also some evidence that in the long-term value funds perform better than growth funds.
Actively managed funds do have the problem of having to accumulate large holdings in a stock and then liquidate these large holdings. As such they exert considerable pressure on stock prices and end up with less than favorable prices. High portfolio turnover further compounds the problem. This in part explains their relatively unimpressive performance compared to a passively managed fund which only needs to acquire the initial holding.
To a certain extent this part of the theory is basically correct but there are some actively managed funds which do outperform the market, however the costs of owing these funds needs to be taken into account as some of these do have high fees.
There are some aspects of the theory that reflect the stock market, such as information being efficiently incorporated into market prices and that market prices do fluctuate about considerably. Also fairly accurate with the theory is that actively managed funds tend to struggle with outperforming the market.
Other aspects of the theory such as market prices reflect the fundamental value of a company and that any portfolio will match the market returns are completely useless and inaccurate.
Some parts of the theory have merits for the stock market but it seems that the theory in general may be more applicable to other financial markets. The reason it was discussed here is that Efficient Market Hypothesis is a common theory which gets a lot of exposure from the financial press.
The Principle of Supply and Demand
The principle of supply and demand is derived from economics which models the pricing behavior of an item.
The economic model states that the price of an item will vary until it reaches a price where the supply for that item is matched by the demand for that item.
The economic model has four basic laws as follows:
The principle of supply and demand:
- When supply increases this results in a surplus and prices drop until supply equals demand once again.
- When supply decreases this results in a shortage and prices rise until supply equals demand once again.
- When demand increases this results in a shortage and prices rise until demand equals supply once again.
- When demand decreases this results in a surplus and prices drop until demand equals supply once again.
When the demand for an item equals the supply of an item the market is in equilibrium. Changes in either the demand or the supply create an imbalance and the price for the item moves until equilibrium is restored.
This is the basic economic model for supply and demand. A sound understanding of the basic model is extremely beneficial for stock investors and traders as this is what drives stock prices.
Stock prices do not rise and fall for no reason. At any given point in time there are buyers wanting to buy stock and there are sellers wanting to sell stock. Prices move around until equilibrium is achieved. This happens in a matter of seconds (not days or weeks) for actively traded stocks. Thus the demand from buyers and the supply from sellers are constantly adjusting the equilibrium price for that stock throughout the trading day.
Buyers and Sellers:
- Whenever more buyers place orders to buy stock than sellers place orders to sell stock, the demand exceeds supply and prices rise until a new equilibrium price is reached.
- Whenever more sellers place orders to sell stock than buyers place orders to buy stock, the supply exceeds demand and prices fall until a new equilibrium price is reached.
The stock market is a place where the general public buys stocks they want and sells stocks they no longer want. They do this either directly through a stock broker or they do this indirectly through a fund. So even if the general public buys a fund, the fund must still buy the stocks from the stock market.
What moves the stock price around during the trading day is the never ending change in supply and demand from the general public. This never ending change in supply and demand continues for every single day the stock market is open for trading. Thus the stock price is forever changing.
The reasons why buyers want to buy stock and sellers want to sell stock are many and varied but they do tend to have certain common characteristics.
The general public typically has no real understanding of what it is they are buying. For the most part they are simply attracted to any investment in which the recent returns are impressive. So when stock prices are rising, the general public views this as a good investment and they are keen and eager to participate. In order to do this they must buy stock either directly or through a fund. This in turn places additional demand for the stock which pushes the equilibrium price higher.
The general public are the new market participants who buy stock, but who is selling stock to them?
Market participants who entered the market some time ago are by now more experienced and have realized that stock prices do not go up for ever and in fact also decline. These old market participants are more cautious and skeptical. It is these old market participants who sell their stock when they are concerned that stock prices will fall rather than rise. It is these old market participants who provide the stock that's for sale.
So now we have a supply and demand model. New market participants provide the demand and the old market participants provide the supply. Stock prices will keep rising for as long as the demand from new market participants exceeds the supply from the old market participants. This is what forms a bull market.
A bull market top is reached when the supply from old market participants exceeds the supply from new market participants. Once stock prices are pushed down, any new demand from potential new market participants is now reduced, since the only reason that any new market participants would enter the stock market was that stock prices were rising. When stock prices are falling, the interest from new participants drops.
Whenever stock is exchanged there are also two different opinions. The buyers of stock think that prices will rise and sellers of stock think that prices will not rise.
So what happens in a bear market?
As the old market participants are fueling the supply from the bull market top, prices are falling. Those new market participants who entered the stock market are by now wondering what's gone wrong. After all, stock prices were just supposed to go up. They become stressed at the thought of having made the wrong decision by entering the stock market. After all nobody likes making mistakes and the solution as far as they are concerned is to exit this bad investment. So they sell their stocks and funds which further adds supply and drives prices down even further.
As prices drop this attracts the attention of the old market participants who start to buy stock again with the money they received from the stocks previously sold. They made a nice profit from the previous bull market and being experienced investors realize that bear markets are relatively short lived and are keen to repeat their previous success. Unfortunately for the recent new market participants this is at their expense as they sold without acquiring a sound understanding of how the markets work.
As prices continue to fall in a bear market the demand is largely provided by the old market participants and the supply is largely provided by the new market participants.
Market Rallies and Market Declines
The above discusses the broad bull and bear markets but each market cycle consists of sub-cycles of market rallies and market declines.
When a market index such as the DOW or the S&P 500 runs up on the day, this is because the demand for stocks was greater than the supply. Conversely, if the index drops on the day, then supply exceeded demand.
With a market rally within a bull market, the demand broadly exceeded the supply. The market rally ends when the old participants feel that this may be as far as the market will rise for now and they sell some of their stocks to lock in a profit, just in case this is the top of the current bull market. This is usually referred to as profit taking and it is the actions of the old market participants which increases the supply and thus causes the market correction. It is during the market correction where new market participants are more reluctant to enter as they see market prices dropping.
When the old market participants are finished with their profit taking, the supply is then reduced and these old market participants will typically now repurchase their stocks at lower prices thus increasing demand again. Now that market prices are rising again, any new market participants see the rising prices which provides the confidence they need to enter the market which in turn further increases demand and thus fuels the next market rally.
This process of shifting supply and demand produces the market rallies and market declines. This continues until ultimately the top of a market rally produces such an excess of supply from the old market participants that the next market rally falls short and the broad bear market forms.
Supply and demand for stocks is what drives the prices of stocks. When the collective total demand from all stocks exceeds the supply of all stocks provided, this causes market indices to rally. Conversely, when the collective total supply from all stocks exceeds the demand from all stocks, this causes a market correction. These market rallies and market corrections produce the bull and bear markets.
High interest rates make bonds more attractive to investors
There is a distinct relationship between company earnings and stock prices. Over the decades, as company earnings increase in line with economic growth in the U.S. economy, the stock prices also generally increase in line with the increase in earnings. However the stock price paid for those earnings tends to fluctuate. There are periods where investors are willing to pay high prices for these company earnings and there are periods where investors will only pay relatively low prices for these company earnings.
The basic theory of supply and demand is at work here. The stock market is only one market in which investors can invest. While the stock market provides the highest long-term returns, it is also the most volatile market to invest in.
When investors are able to receive decent returns from a lower volatility market, they will naturally transfer their capital from the stock market across to the lower risk market. This affects the supply and demand for stocks which impacts on stock
The inflation rate is monitored and controlled to a large extent by the Federal Reserve Bank (the Fed). As inflation increases, the Fed typically increases interest rates to control the rising inflation rate.
As the Fed keeps raising interest rates, the coupon payments from newly issued bonds increases and reaches a level where the returns from bonds are approaching and even exceeding the returns available from stocks. Since bonds are relatively low risk compared to stocks, this makes bonds an attractive alternative to stocks and investors tend to increase their bond holdings and reduce their stock holdings. This increases the supply of stocks and thus puts downward pressure on stock prices.
Stocks prices may well still continue to rise in a bull market but the rate of price increase is hindered by the selling from investors rotating their capital from stocks to bonds.
The net effect is an increase in the supply of stock from investors selling their stocks to buy bonds. The remaining stock investors now do not have to pay as high a price for company earnings. This means the price earnings ratio known as the PE ratio is now not as high.
When inflation drops, the Fed typically lowers interest rates and so the returns from bonds decline. As the Fed continues to reduce interest rates, the returns from bonds continues to diminish. This motivates investors to seek better returns and they naturally look to the stock market to achieve better returns. The low yields from bonds basically force investors to take on more risk or else they must remain content with their low returns.
Due to the increased demand for stocks from investors selling their bonds, stock investors have to pay higher prices for company earnings. This means the PE ratio is driven higher.
Stocks prices may well still continue to decline in a bear market but the rate of price decline is hindered by the buying pressure from investors rotating their capital from bonds to stocks.
The PE ratios of stocks are not constant but actually vary with inflation or more specifically with interest rates. How much stock investors will pay for company earnings is dependant on supply and demand. The bond market plays an important role in the demand and supply for stocks.
The general relationship between inflation and the PE ratio is that in a high inflationary environment the PE ratios are generally lower and in a low inflationary environment the PE ratios are generally higher.