Are Daily Asset Prices Predictable in Some Degree?

Abstract

This paper addresses the long-standing question of whether asset prices are predictable. The common view holds that daily prices fully incorporate all available information, and therefore price changes are unforecastable. This conclusion does not necessarily hold when the vast bulk of market trades are made by investors, who choose naïve price extrapolation rules over above fundamental-based rules. For that to happen, markets must suffer from two key problems. First, limits to arbitrage prevent informed speculators from setting prices right. Second, some rational speculators choose to bet not on fundamentals, but on future crowd behavior. And more important, their actions spread by contagion and become a norm. Under this norm, daily prices follow a random walk. But time series of price changes are co- integrated with time series of net demands generated by price extrapolation rules. As a result, prices are predictable in some degree.

Keywords: adaptive learning, extrapolative expectation, trend chasing, price predictability

JEL Classification: C22, C73, G14, G17