Evidence on a New Stock Trading Rule that Produces Higher Returns with Lower Risk

Abstract

This new stock market trading rule uses three steps to remove random unsystemic risk from stock price data to smooth volatility. Proving empirically that a technical analysis relative maxima and minima trading rule for an S&P 500 Index portfolio substantially beats a naïve buy-and-hold policy, at significantly lower risk. Calling key theories in economics and finance into question. The new trading rule succeeds because of market participants' emotions. Investor fear and panic selling plunges stock prices downward below equity intrinsic values at market bottoms. Investor greed brings prices above equity intrinsic values at market tops. Keywords: Stock market, Rational expectations theory, Efficient market theory, Technical analysis 1. Introduction This research empirically tests the Rational Expectations Theory (RET) and the Efficient Market Theory (EMT), key theories in economics and finance. The important question is, are markets efficient? If markets are inefficient, a key premise becomes questionable. Existing research on the efficiency of the United States (US) stock market-using either statistical inference or trading rules-is inconclusive. This empirical research on a new technical analysis relative maxima and minima trading rule tests the RET and EMT-and is the first to report in the literature, clear evidence of substantially beating the US stock market at significantly lower risk-over 81 years of data. Calling the RET and EMT into question. The rest of the paper's organization is as follows: Section 2 discusses the relevant literature. Section 3 explains the new stock trading rule. Section 4 presents the data selection and research method. Section 5 analyses the empirical results while Section 6 offers final remarks. 2. Literature Review Is the US stock market efficient? The Rational Expectations Theory (RET) (Muth, 1961), and (Lucas, 1972) and the Efficient Market Theory (EMT) (Samuelson, 1965) and (Fama, 1965, 1970) define efficient markets and are the dominant theories in economics and finance (Fama, 1991, 1998), (Malkiel, 2005), and (Peress, 2010). A major RET tenet-supporting the EMT-assumes organizations and individuals who engage in an institutional marketplace, even when their decisions and actions are irrational, produces systemically correct markets. The marketplace produces rational results through the regulating influence of other rational participants. A critique of this RET assumption points out that it does not maximize utility for rational investors who understand irrational market forces and decide the current price trend advance does not match market fundamentals. And-based on correct timing-want to make more money during the market run-up and get out of the stock market or go short-at the correct time-before the market plummets downward (Graham, Harvey, and Huang, 2009). The EMT defines markets as: 1) being in equilibrium and if unexpected events cause disequilibrium, it is only temporary, markets are self-equilibrating; 2) asset prices "fully reflect" all available information, properly represent each asset's intrinsic value, and as a result, prices are always accurate signals for capital allocation; and 3) stock prices move randomly or are uncorrelated with, if not independent of the prior period's price change. So, beating the stock market is impossible to achieve using either technical analysis or stock charts. Therefore, says the EMT, if investors want to earn more money than the stock market, they have to take on more risk. This research empirically tests this third EMT tenet. Grossman and Stiglitz (1980) challenge tenet number one. A stock market always in equilibrium and efficient is impossible because traders have different endowments, beliefs and preferences. Arbitrage costs throw markets out of equilibrium, making markets necessary which calls the EMT into question. The current credit crisis and the US government's use of anywhere from $3-to-$24 trillion taxpayer dollars and Federal debt guarantees to stabilize the financial system is a recent real-life example that markets are not self-equilibrating. In tenet number two, of the EMT's definition of markets-that stock prices "fully reflect" all information-has long been challenged in the literature (Ball and Brown, 1968). Post-earnings-announcement drift survives robustness checks, including extensions to more recent data. Bernard and Thomas (1990) study earnings announcements and find evidence of three-day abnormal return predictability, based on one-to-four prior quarterly earnings announcements. Gift, Gift and Yang (2010) report the stock market responds only gradually to new information. Electronic copy available at: https://ssrn.com/abstract=3949604