An Empirical Analysis of the Adaptive Market Hypothesis and Investor Sentiment in Extreme Circumstances Andrew Urquhart Submitted in fulfilment of the requirements for the degree of Doctor of Philosophy Department of Economics Newcastle University Business School Newcastle University June 2013 Abstract The Efficient Market Hypothesis (EMH) has been widely studied in the literature, however there remains no consensus among academics whether markets are efficient or not. Although it was initially thought to hold, the recent explosion of studies that find that markets are not efficient has cast serious doubt on the validity of the EMH. Furthermore, the vast majority of the literature examines the EMH over some predetermined sample period, disregarding the fact that the level of efficiency may change over time and a large sample period may not be efficient or not for the whole period. A new theory that tries to accommodate both these facets is the Adaptive Market Hypothesis (AMH), proposed by Andrew Lo (2004). This theory enables market efficiency and market inefficiencies to co-exist together and market efficiency to evolve over time. The main objective of this thesis is to examine the AMH and stock return behaviour in major stock markets using very long data and determine whether it is a more appropriate model for describing stock market behaviour than the EMH. A five-type classification is proposed to distinguish the differing behaviour of stock returns over time. Daily data is spilt into five- yearly subsamples and investigated in respect of linear and nonlinear time-series tests, three calendar anomalies and the moving average technical rule. The results suggest that the AMH provides a better description of the behaviour of stock returns than the classic EMH. Linked to the AMH is the fact that investors are not rational and investor psychology plays a real role in investor’s decision making. With that in mind, this thesis also examines the level of investor sentiment in stock returns during World War Two in Britain. This is a time period that has not been studied in great detail and provides an opportunity to examine investor sentiment in extreme circumstances. The empirical results show that there was strong negative investor sentiment from major negative events and a strong level of local bias during the period known as the Blitz. ii Acknowledgements I would like to thank my supervisors Professor Robert Hudson and Dr Fabrizio Casalin for their support through my research. Their advice on the direction of the work and helpful comments, together with encouragement, has proved invaluable. A special thanks to Robert for his countless hours of reflecting, reading and most of all patience throughout the entire process. I am also indebted to Peter Lomas for the scholarship that enabled this research to be conducted and also to members of Newcastle University Business School Economics department for their informal and extremely helpful comments and support. My parents deserve sincere thanks for their encouragement and support throughout my studies and also to Lizzi for her support and patience throughout. iii Table of Contents Chapter 1: Introduction .......................................................................................................... 1 1.1. Motivation for Study ................................................................................................... 1 1.2. Objective of Study ....................................................................................................... 3 1.3. Contributions of Study ................................................................................................ 4 1.4. Chapter Outline ........................................................................................................... 4 Chapter 2: Literature Review ................................................................................................. 7 2.1. Introduction ..................................................................................................................... 7 2.2. The Efficient Market Hypothesis .................................................................................... 8 2.2.1. Assumptions of Market Efficiency ......................................................................... 10 2.2.2. Forms of Market Efficiency ................................................................................... 11 2.3. Development of the Martingale and Random Walk...................................................... 12 2.3.1. Martingales ............................................................................................................. 12 2.3.2. Random Walk ......................................................................................................... 13 2.4. Tests for Market Efficiency........................................................................................... 15 2.4.1. Linear Tests ............................................................................................................ 16 2.4.2. Non-Linear.............................................................................................................. 16 2.5. Anomalies...................................................................................................................... 17 2.6. Technical Analysis ........................................................................................................ 19 2.7. Problems with Conventional Tests ................................................................................ 20 2.8. The Adaptive Markets Hypothesis ................................................................................ 23 2.9. Classification of the Behaviour of Stock Returns ......................................................... 26 2.10. Markets Examined in this Study ................................................................................. 28 2.10.1. Dow Jones Industrial Average .............................................................................. 29 2.10.2. Financial Times 30 ............................................................................................... 29 2.10.3. Tokyo Stock Price Index ...................................................................................... 30 2.11. Summary ..................................................................................................................... 31 Chapter 3: An Examination of the Independent Behaviour of Stock Returns ................ 33 3.1. Introduction ................................................................................................................... 33 3.2. Literature Review .......................................................................................................... 34 3.3. Data ............................................................................................................................... 40 3.4. Linear Methodology ...................................................................................................... 44 3.4.1. Autocorrelation ....................................................................................................... 44 3.3.2. Runs Test ................................................................................................................ 45 3.4.2. Variance-Ratio Test ................................................................................................ 46 3.4.4. Unit Roots ............................................................................................................... 49 3.5. Nonlinear Methodology ................................................................................................ 55 3.5.1. McLeod Li Test ...................................................................................................... 56 3.5.2. Engle LM Test ........................................................................................................ 57 3.5.3. BDS Test................................................................................................................. 57 3.6. Empirical Results .......................................................................................................... 61 3.6.1. Linear Empirical Results ........................................................................................ 61 3.6.2. Nonlinear Empirical Results ................................................................................... 74 3.7. Conclusion ..................................................................................................................... 80 Chapter 4 – The Behaviour of Calendar Anomalies .......................................................... 83 4.1. Introduction ................................................................................................................... 83 4.2. Literature Review .......................................................................................................... 84 4.2.1. Monday effect ......................................................................................................... 84 4.2.2. January Effect ......................................................................................................... 86 iv 4.2.3. Turn-of-the-month Effect ....................................................................................... 88 4.3. Methodology ................................................................................................................. 90 4.4. Data ..............................................................................................................................