Empirical tests of a market trading rule based on the notion of market disequilibrium
Creators: name: Yaworski, Laurie Gerald
Publisher: name: University of British Columbia
Year: 2011

description: The notion of beta in the stock market is a concept of risk that has had wide acceptance in the academic and investment communities as a coefficient of non-diversifiable risk. The definition of beta and its use as a measure of risk depends on the empirical validity of the market model. The market model is a linear equation of the form y = a + bx + c where b (the slope of the line) is the beta coefficient: It relates the proportion by which a stock's price will change to a change in the market index. The measurement of the beta value has been tested and proven to be stationary over time. Therefore the estimated values in one period are biased estimates of the future values. Professional managers can select a level of uncertainty at which to operate and have tended to remain at that level over the years. A model such as this for selecting efficient portfolios is a very relative component in the development of improved normative procedure for investment management. Among the possible uses of an effective measure of risk are: 1) the assessment of risk in specific securities as well as portfolios; 2) measurement of the current risk in any group of stocks represented by the various market averages; 3) comparison of the risk of individual securities with that of other securities and the market as a whole; 4) means of screening in search for undervalued and overvalued stocks; 5) aid to timing in buying and selling; 6) a basis for selecting and adjusting portfolio risk to fit an investor's requirements; 7) means of adjustment to take advantage of market trends and a logical basis for investment decision making. In accordance with the above theory of market equilibrium, stock prices would adjust instantaneously in some proportion to the changes in the market index. Given the assumptions of the theory, the length of the period over which beta is calculated should be irrelevant to the measure. The implication is that beta may be useful in short run investment strategy. It is felt that the adjustment process is not instantaneous but incorporates some stocks that may be overpriced and others that may be underpriced. Furthermore stocks may lead or lag the market index into a bullish or bearish market. Trading rules based on the market sensitivity of stocks in the period June 1959 to June 1969 were used to test the profitability of short run investment strategy in rising and falling market trends. These trading rules developed in the ex post were applied in the ex ante from June 1969 to June 1972 to determine if there were any stable relationships. The empirical evidence does not provide very strong conclusions. The results indicate that the adjustment of a stock price relative to the market is not instantaneous. There are stocks that lead and stocks that lag the market into either an "up" or "down" swing. However these relationships are not stable from one period to the next. Where there is stability, the timing is most uncertain. This indicates that the markets are not truly efficient and thus it becomes a test of the major assumption of the market model. Despite this lack of stability the results of the trading rules indicate that beta may be used effectively on a continuing basis in a declining market. The rules which are based on a long term beta help us to identify those stocks which vary widely from their expected prices allowing us to activate trading which is profitable for the portfolio. The findings indicate that beta may be used in this sense as a "loss" minimizing technique. However the obvious limitation is that the trading rules cannot be applied symmetrically to both markets in order to bring the best results. Furthermore there is the major difficulty of predicting the market. Extreme confidence in the filter rules is required. Another problem is that continuous trading alters the portfolio beta at which the manager has selected to operate. The most useful information obtained from the tests is that through further study and the development of better trading rules the technique may be quite useful.