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A Few Notes on Probability Theory, The Logic of Science

Because economics and financial markets lack mature theoretical (deductive) foundations, these fields involve largely empirical (inductive) work. The principal mathematical tools in this pursuit derive from probability and statistics. In his 2003 book Probability Theory, The Logic of Science, E.T. Jaynes presents in textbook form his own evolutionary growth in the understanding of probability theory. His approach is Bayesian, in that he views probabilities as conceptually distinct from frequencies of occurrence and probability theory as synonymous with the process of inductive inquiry. He emphasizes iterative “plausible reasoning” as the kernel of probability theory. He offers a few summarizing points relevant to equity investors/traders, as follows: Keep Reading

A Few Notes on Reinventing The Bazaar, A Natural History of Markets

In his 2002 book, Reinventing The Bazaar, A Natural History of Markets, John McMillan offers an overview of recent research on the workings of markets. His perspective is empirical rather than ideological as he examines economies worldwide to infer when markets work and when they do not. Some summarizing points on critical factors for economic growth are relevant to equity investors considering international diversification, as follows: Keep Reading

Abnormal Returns from Small Stocks with Good Prospects

In their December 2005 paper entitled “Information and Prospects: Investment Opportunities and Market Efficiency in the Small-Cap Segment”, German Espinosa and Robert Veszteg examine the value of analysts as guides for selecting stocks that amplify the small firm effect. Is it better to search independently for “hidden gems” or to focus instead on small stocks followed by analysts? Are those analysts one step ahead in the relatively slow diffusion process for new information about small firms? The authors test the hypothesis that small firms with unusually large analyst followings tend to be those with the best prospects. Using monthly data on financial analyst coverage and returns for the stocks of U.S. and Canadian markets between June 1996 and June 2004, they find that: Keep Reading

Challenging the Value Premium

Current research on the value premium, the outperformance of value stocks in comparison with other (growth) stocks, mostly involves explaining it through either behavioral or efficient-market mechanisms. However, in their November 2005 paper entitled “Does the Value Premium Really Exist in the UK Equity Market?”, Panagiotis Andrikopoulos, Arief Daynes, David Latimer and Paraskevas Pagas challenge its existence. Their study focuses on eliminating any possible effects of survivorship bias, look-ahead bias and the method of calculating returns in comparing the performance of value and growth stocks of United Kingdom firms. They classify value versus growth via four selection factors (low for value, high for growth): book-to-market value, earnings-to-price ratio, dividend yield and weighted average sales growth. Using a new database of 2006 UK equity issues fully listed at any time during 1987-1996, they find that: Keep Reading

Trading Signals from Retail Investor Behavior

What can small-trade volume tell us about the behavior and success of retail investors? Two December 2005 papers tackle this question. In a paper entitled “Small Trades and the Cross-section of Stock Returns”, Soeren Hvidkjaer investigates the effect of retail investor trading behavior on stock returns by studying intermediate-term and long-term returns for stocks with small-trade buying or selling pressures. In a paper entitled “Do Noise Traders Move Markets?”, Brad Barber, Terrance Odean and Ning Zhu offer a similar study, adding an analysis of the short-term returns for stocks with small-trade buying or selling pressures. Their joint findings are: Keep Reading

Jason Kelly on Market Timing

Guru Grades ranks a group of 29 stock market experts according to our assessments of the accuracy of their stock market forecasts. Since Jason Kelly has been at or near the top of the list, we asked him to encapsulate his thinking on stock market timing in a short piece for this blog. What makes him get in, and what makes him get out? Jason graciously agreed. Here is Jason Kelly on market timing: Keep Reading

The After-January Effect?

In case you are sick of hearing about the January effect… Keep Reading

Give Me Your Money Because…

Financial services firms must persuade investors to hand over their money. How do they do that? Do these companies rationally present their track records of excess risk-adjusted returns, or do they appeal for funds using less rational messages? In the October 2005 draft of their paper entitled “Persuasion in Finance”, Sendhil Mullainathan and Andrei Shleifer review and interpret trends in financial advertising over the past decade. Their investigative framework assumes that investors shift relative emphasis between two broad investment motivations, growth (getting rich, or greed) and protection (securing the future, or fear), depending on the state of the market. High past returns activate greed, and low past returns activate fear. They use this framework to test the rationality of financial firm advertising. Using 1469 ads from Business Week during January 1994 through December 2003 and 4971 ads from Money during January 1995 through December 2003 aimed at investors, they find that: Keep Reading

Are Some Shorts Smarter Than Others?

The prevailing wisdom is that, in general, short sellers know what they are doing. But there are different kinds of short sellers, likely in a range from highly informed to noise. Can we find the ones who are best informed? In the November 2005 version of their paper entitled “Which Shorts Are Informed?”, Ekkehart Boehmer, Charles Jones and Xiaoyan Zhang examine a large proprietary dataset to segregate short-sellers according to the informativeness of their trading. Using data on short sales for an average of over 1,200 NYSE stocks daily during the period January 2000 through April 2004, they find that: Keep Reading

The Decline of Stock Picking?

How much buying and selling comes from picking stocks rather than assuring diversification by use of stock indices? Is stock picking a dying practice? In their November 2005 paper entitled “Is Stock Picking Declining Around the World”, Utpal Bhattacharya and Neal Galpin model and measure the relative proportions of stock picking and index use in the United States and elsewhere. Their model measures the level of stock picking via the relationship between stock trading volume and firm market capitalization. Using data for stocks in 43 countries (21 developed and 22 emerging) beginning with 1962 in the United States and focusing on 1995-2004 for cross-country analysis, they find that: Keep Reading

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