An Assessment of Theories Underlying the Operations of the Nigerian Stock Market

13

Theories Underlying the Operations of the Nigerian Stock Market

The Fundamental Theory

The fundamental theory argues that, at any point in time, an individual security has an intrinsic or true value, which is the present value of the future receipts, accruing to the security-holder. This view is essentially the same as the basic valuation model. It is based on the assumption that the analyst needs to consider the major factors affecting the economy, the industry and the company.

To make an appropriate investment decision, the environment within the company and its reaction to that environment in terms of investment and financing policies determine the future net receipts. It is also affected by the state of the national economy, government economic policies such as the control of inflation, the balance of payments, government budgetary and interest rate policies. The effect of each of these factors is largely dependent on the nature of the company’s activities.

The fundamentalists forecast stock prices on the basis of market information about the economy, industry and the company. As it is usually the case, when the market anticipates an event, such as the national budgets, fiscal policies or exchange rate policies; the share prices are affected. It may be argued that market price approaches ‘intrinsic’ or ‘true’ value ‘asymptotically’, that is, it gets nearer and nearer but never quite gets there. During this time, new information may alter the intrinsic value so that market prices will have to start chasing a new intrinsic value such that to calculate the intrinsic value is to predict the market price. If fundamental analysis is used as a guide to investment decision, the buy and sell decision will be based on the discrepancy between intrinsic and market prices; if the intrinsic is greater than the market, the investor should buy, and sell if the market price is greater than intrinsic price. The amount of discrepancy and speed with which the market approaches an intrinsic value may be regarded as indications of the degree of perfection in the market (Nalado & Mohammed, 2000).

     Technical/Chartist Theory

Technical/Chartist theory is based on the view that future patterns of share prices are repetitions of the same patterns of price movement which had occurred in the past; that is, historical price patterns are repeated in the future (Akinsulire, 2006). According to Corrado et al (2002), technical analyst makes attempt to predict the direction of future stock price movement based on historical price and volume behaviour; and investment sentiment. Bodie, Kane and Marcus (1999), have supported this view that chartists is essentially the search for recurrent and predictable patterns in stock prices. Although technicians recognize the value of information regarding future economic prospects of the firm, they believe that such information is not necessary for a successful trading strategy.

This is because whatever the fundamental reason for a change in stock prices, if the price responds slowly enough; the analyst will be able to identify a trend that can be exploited during the adjustment period. It should be remembered that technical analysis is a sluggish response of stock prices to fundamental supply and demand factors.

Technical analysts, also called chartists study records or charts of past stock prices to find patterns to exploit to make profit using Dow Theory, which is a method of analyzing and interpreting stock market movement which dates back to the turn of the century. Share prices/values can be measured using primary, secondary and tertiary trends. Though, there is no real theoretical justification for this approach, it can at times be spectacularly successful. Studies outside Nigeria have suggested that the degree of success is greater than could be expected merely from chance (Udoka and Anyingang, 2013). Nevertheless, not even the most extreme chartist would claim that every major price movement can be predicted accurately and sufficiently enough to make the correct investment decision. Many critics of charting, have suggested that it is unscientific as to be of any practical value, because there is no theoretical justification of this theory except its pointing to empirical evidence of its correctness (Akinsulire, 2006).

The Random Walk Theory

Comparing stock and commodity prices, researchers found that there was no regular price cycle, but that each series was “a wandering one, almost as if once a week the demon of chance drew a random number and added it to the current price to determine the next week’s price” (Mbat, 2001). That is, prices appeared to follow a random walk, implying that successive price changes are independent of one another (Chandra,

2005). The walk is the time series of prices, while its random aspect is the nature by which the numbers are generated (Emekekwue, 2005). Therefore, yesterday’s prices do not tell us as much about tomorrow’s or at least not enough to consistently earn abnormal profits based merely on price data. As a result, tomorrow’s prices cannot be predicted simply because one has a series of historical prices. So, as far as the Random Walk theory goes, the best prediction you can have about tomorrow’s value is today’s value. The key arguments seem to be that: information is freely and instantaneously available to all the market participants; keen competition among market participants, more or less, ensures that market prices will reflect intrinsic values. This means that they (market participants) will fully impound all available information. Accordingly, prices change only in response to new information that, by definition, is unrelated to previous information (otherwise it will not be new information) and since new information cannot be predicted in advance, price changes too cannot be forecast. Hence, prices behave like random walk and yesterday’s prices by themselves apparently do not tell us anything of value for forecasting tomorrow’s prices (Ashanu, 2012). The random walk theory is based on the assertion that the stock prices or the market as a whole reacts instantaneously to new information whether actual or anticipated. This is because any technical information which is considered to influence a stock must influence the price of the stock. This is the foundation for the efficient market hypothesis (EMH), which discussion follows below.

 Efficiency Market Hypothesis

Future cash flow expectation of Stock Market investors are reflected in the prices of the underlying stock. The accuracy and quickness with which the market translates this expectation into the prices is termed market efficiency. There are two types of market efficiencies, namely: operational efficiency  and Information efficiency (Udoka and Anyingang, 2014). The former measures the time taken to execute orders and the number of defective deliveries, while the later measures the swiftness of market reaction to new information, such as economic reports, company analysis, political statements and announcements of new industrial policy. While efficient market hypothesis does not deal with the operational efficiency, it is concerned with information efficiency. Accordingly, Efficient Market Hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information and that the knowledge of that information would not allow anyone to profit from it because stock prices already incorporate the information. According to Omolehinwa (2006), an efficient stock market is one in which: the price of securities traded reflect all the information, which is available to the buyers and sellers such that prices change quickly to reflect all new information about future prospects, no individual dominates the market, transaction costs of buying and selling are not so high as to discourage trading significantly. There are many examples of markets which may or may not be efficient, namely: the foreign exchange market, the interest rate market, commodity markets, the money market and the capital market. Market efficiency means that the market is merely in equilibrium through the supply and demand pressures of participants/investors’ actions based on their revised expectations of the worth of a given share. Under the hypothesis, an efficient market will cause the attention of investment advisors to be directed towards utility, portfolio risk and diversification to maximize risk reduction, minimize transaction costs and minimize taxation payments. The hypothesis, therefore, takes three forms depending on the extent of information deemed available to market participants or investors: weak, semi-strong and strong forms (Brealey and Myers, 1996).

 Weak Form Market Efficiency

This form of the hypothesis asserts that security prices already reflect all information that can be derived by examining market trading data such as the history of past pieces and trading volumes. This is because information available is restricted to details of past share prices, returns and trading volumes. Hence, future prices cannot be predicted (or charted) from historical price data alone and trading rules based only on such price and volume data. According to the weak form market efficiency, no investor can earn excess returns by developing trading (buying and holding) policy based on historical price and return information That is, the chartists’ methodology, a form of technical analysis, cannot consistently produce excess returns if the hypothesis holds true. This is the theoretical basis of fundamental (technical) analysis, which is the study of a company’s earnings, dividends and other financial information to predict future share prices. The most important form of technical analysis is chartism, which involves the study of historic share price and volume information to see if any patterns or relationships exist (Omolehinwa, 2006). Fundamental analysis is the physical study of a company in terms of its product sales, manpower, quality, infrastructure etc. to understand it standing in the market and thereby its profitability as an investment. The technical analysis foretells the fitting time to buy or sell a share. Test results suggest that technical trading rules do not

______________________________________