There are many interesting theories in the financial and investing worlds but few are as fervently defended, and disputed, yet as stubbornly enduring as the Efficient Market Hypothesis (EMH) and its predecessor the Random Walk Theory.

In summary, EMH is an investment doctrine that postulates that any attempts at beating the market are doomed because stock prices already reflect all relevant information. EMH states that there is no link between past prices and future prices, and no relationship between the price of one stock and that of another stock. Past movements or trends cannot be used to predict future behavior. The chance of a stock's price going up in the future is the same as it going down. About the only concession made by EMH proponents is that they recognize that over the long-term stocks exhibit an upward trend.

There cannot be any skills involved in buying or selling stocks because it is a pure game of chance. There is no such thing as an undervalued stock because that information is widely known and instantly rectified. No investor can have an edge in spotting a stock with a better gain potential or in identifying a trend because no one has access to information that is not already available to everyone else.

Not surprisingly, this purely theoretical concept was conceived in academia and is backed by mountains of research, books and thesis galore. The efficient market idea originated in the 1950s with Maurice Kendall and got developed further in the 1960s by Eugene Fama. The theory gained a lot of popularity in 1973 when Burton Malkiel published "A Random Walk Down Wall Street" which to this day is high on the list of top-selling finance book. Most of the evidence in favor of the hypothesis is circumstantial statistics showing that most investors and most mutual funds fail to beat the markets. Since Wall Street is founded on analysis and stock picking it is quite surprising to see how popular EMH has been. Maybe it has to do with the fact that the biggest beneficiary of EMH thinking is the Buy and Hold strategy. If you have no chance at beating or timing the market you might as well stop wasting your time trying!

Well, as Trend Timers you can imagine that we are not exactly fervent supporters of the EMH philosophy. And since EMH declares both fundamental and technical analysis futile and obsolete, we have a lot of prestigious company in opposing it.

Empirical evidence against EMH can be found in the fact that there are well known investors (e.g. Warren Buffett) that have beaten the market with techniques that are not supposed to work, consistently and over long periods of time. There are portfolio managers and mutual funds that year after year have better performance than others. How can this be when the efficient market is purely random? Anyone looking at charts comparing various stocks and markets (see for example our charts in the June 11, 2004 Trend Timing School editorial) can see that there are very strong relationships between stocks, and that price movements are very far from random.

An EMH paradox is that the profit-seekers and strategies that believe in and want to exploit market inefficiencies and temporary anomalies (which supposedly cannot be done) are in fact the stated forces that cause the markets to become efficient.

In the advanced information technology age we live in, more information is readily available in quasi real-time to more people than ever before. It is not just news or stock quotes, but just about anything about companies, politics, or the economy is available at our fingertips. With such superior communications the markets should be more efficient than ever.

The primary argument against EMH from technical analysts is that many investors base their expectations on information about the past and study the same technical indicators. It is then logical to suggest that past prices do have an influence on future prices. Some even suggest that technical indicators act as self-fulfilling prophecies because they are followed and trusted by so many.

Probably the major flaw in EMH, in our opinion, is that stock prices are not set by a fixed computation of all the data available but by how investors perceive this information. Human psychology is not easily reduced to models and constants. Perceptions change a lot from one individual to another and they can change rapidly. The great tech bubble of the late 1990s is a perfect example of how market valuations can get totally out of whack, with the "efficient market" failing to correct monstrous anomalies for prolonged periods of time. Despite the fact that all the information about the outrageous market over-valuation was available to everyone, the market was not efficient, and investors that bet that it would all come crashing down were handsomely rewarded.

Investors are very different from one another. They do not all look at information the same way, or at the same information. Some have access to or can afford better research and smarter analysts than others. Not everyone's risk tolerance is the same. Some bail out at the first sign of trouble, others can take the rollercoaster ride all the way down.

In conclusion we firmly believe that past market behavior has an impact on the future because of investor psychology. This is why our Model relentlessly looks for what the market is telling us, and once the trend is clear, we simply follow.

There has been a lot of press lately, and confusion, about Standard & Poor's announced intent to move their U.S. indices, including the S&P 500, to float adjustment over the next 12 months. As many of the companies contained in the S&P indices can be found in many other indices and the countless mutual funds and ETFs that follow them, nearly every fund investor will be affected in some fashion.

Float is defined as the amount of a company's stock which is available to investors, and excludes the shares closely held by insiders or other companies. Ownership of closely held shares really depends on strategic and control reasons rather than the true economic value of a company. It is generally thought that float adjusted indices better reflect the true publicly traded value of their component companies, are more liquid, have lower costs, and show better performance over time, albeit all differences are in small measures. Most popular indices like the Nasdaq Composite are float adjusted.

So why does the S&P conversion affect us? Instead of counting all outstanding shares as they have in the past, the S&P indices will begin weighting each company according to their "investable weight factor", which is simply the available float shares divided by the total shares outstanding. The net effect is that on the days the changes take place any fund that tracks the index will need to sell shares of low-float companies and buy shares of high-float companies to maintain the same weighting as the index. This shares-shuffling is estimated to amount to a turnover of about 3.3% of the S&P 500, comparable to the annual turnover. It is hard to anticipate what the price impact will be on various indices and funds, but most expect it to be small. What is likely to be big is the volume surge on the days the changes take place. Seeking guidance from the Russell reconstitution that took place in June 2004 (see the June 25, 2004 Market Update) and caused the daily Nasdaq volume to almost double during the last hour of trading, one can expect volumes to soar by at least as much when the S&P actions take place.

Any investment system or technical analysis relying in part on trading volume has the potential of being tricked by such artificially induced stimulus. Rest assured we will be on guard and will ensure our Model does not detect a trend change where there is none.

Here is the official schedule of events:

• On October 15, 2004 (today) S&P starts publishing three versions of every index (the existing index, a half float adjusted index, and a full float adjusted index). TimingCube continues using and reporting the existing index - no change
• On March 18, 2005 the S&P officially shifts to half float adjusted indices, and TimingCube switches all reporting to the half float adjusted S&P 500
• On September 16, 2005 the S&P officially shifts to full float adjusted indices, and TimingCube switches all reporting to the full float adjusted S&P 500

Warm wishes and until next week.

The TimingCube Staff