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TRADER'S NOTEBOOK


Debunking The Random Walk Myth

05/06/03 03:30:05 PM PST
by Matt Blackman

Any technical analyst familiar with the random walk theory can tell you it has flaws. Yet the theory persists.

Recently, Working Money ran an article titled "What Are Those Indicators Really Indicating?" (April 4, 2003) that was indeed interesting, if only to reopen the debate on the random walk theory. But Thomas Maskell's article also touched on a number of other important topics, including trading system design and the expectations for system success.

The random walk theory postulates that price movements are random and unpredictable. A large part of the theory relies on the efficient market hypothesis, which states that prices fluctuate around the intrinsic value of an equity. According to the hypothesis, price changes are "serially independent," and price history cannot help indicate future direction. The theory also supports the buy and hold strategy, as opposed to technical analysis, for securing the best returns. In a nutshell, it attempts to discredit technical analysis (TA) while promoting pure fundamental analysis (FA).

Maskell writes that he has spent the last two years looking for a trading system that works, to no avail. Any experienced trader and technical analyst can understand his frustration. As many traders will attest, the study of TA is a lifelong endeavor. Finding a workable trading system often takes years. However, the time is well spent if the intent is genuine. The trading system must be based on realistic expectations; it should not be a get-rich-quick scheme, but a method that will consistently produce above-market returns over the long term. Anyone who fails to appreciate this will be sorely disappointed.

But contrary to the idea of random movement, stocks and other equities are anything but random, thanks to investor sentiment and the all-too-predictable effects of fear and greed exercised on a tick-by-tick to month-by-month basis. Not surprisingly, the random walk theory does not attempt to examine or explain the all-important aspect of investor psychology and its effects in the form of probable patterns and relationships between price and volume.

PIE IN THE SKY?

Maskell makes a number of statements in his article that demonstrate his inability to find a workable trading system. He begins to outline them:

As a stock trader, I prefer the scientific approach. . . . Without the logic of science, trading is gambling . . . I would be willing to jump through some very complex mathematical hoops for just [a] tiny bit of premonition.

For an indicator to forecast, it must demonstrate three attributes. First, it should give signals before the event to be predicted occurs. Second, it must have some cause-and-effect relationship to the event. Third and finally, it must predict the event with a reasonable degree of accuracy.

His discussion continues:

Probability is used to measure the third attribute — accuracy. Probability is the science of judging outcomes in an environment of uncertainty. It expresses accuracy in percentages, with 100% being the best and 0% being essentially useless. In most business situations, 80% is an acceptable accuracy level.

I recently surveyed moving average convergence/divergence (MACD) buy signals . . . The results showed that MACD predicted a significant price rally less than 50% of the time. Most technical indicators are equally poor forecasting tools. They routinely fail to achieve the 80% accuracy threshold.

Wouldn't we all be prepared to "jump through some very complex hoops" to find a system that predicts the future? But technical analysis is not about predicting a stock's future price. By employing trend analysis and with the help of indicators to confirm trend direction and strength of price momentum, a trader produces a series of target prices at which to consider trades based on realistic assumptions. Is an 80% accuracy threshold a realistic expectation?

Let's think this through for a second. If a trader could achieve a success level of 80%, he or she would become a millionaire in no time at all (even assuming that losses equaled wins). If a trader were assured that every trade she entered had an 80% chance of success, it would be a relatively short period of time before she became quite wealthy. It would be a simple numbers game. The more trades she made, the faster she would make money. That would be without practicing any form of money management at all.

It's not surprising that Maskell's indicators routinely failed tests if an 80% level was his threshold. I too have yet to find a system that routinely generates an 80% success rate across the board.

In Technical Analysis Of The Financial Markets, John Murphy says about risk/reward ratios: "The best futures traders make money on only about 40% of their trades. . . . Most trades end being losers." Hence the importance of good money management, but statement also demonstrates the hard truth about trading.

Traders should never rely on one indicator to make a buying or selling condition. For example, the moving average convergence/divergence (MACD) is a poor indicator for choosing target prices for entering trades. It, and all such indicators, should only be used to confirm a trading decision.

Finally, all equities have individual personalities. Searching for an indicator or group of indicators that work across a vast array of equities is pure folly. For such a system to work, it must be continually customized to work with the equity of choice.

TECHNICALLY CHALLENGED

In his book A Random Walk Down Wall Street, Burton Malkiel concludes that "stock prices are random and, therefore, inherently unpredictable, at least in the short run. Thus, technical indicators are useless, and the search for an effective one is futile."

But Maskell demonstrates his approach to stocks in the following statement, suggesting that he does not buy into the random walk theory completely:

If the stock is random, short-term price movements can be effectively forecasted with well-constructed Bollinger Bands. If the stock is purposeful, long-term price movements can be effectively forecasted using fundamental analysis. However, once a stock turns purposeful, its short-term price movements are unpredictable.

These comments would leave successful scalpers and short-term traders scratching their heads. When Maskell refers to random and purposeful, does he equate "random" with stocks stuck in a trading range, and "purposeful" with trending stocks? If so, it makes more sense, but technical analysis is still far more effective. Momentum indicators (oscillators) work nicely in trading ranges, and trending indicators work as well, if not better, in trending markets. But the trader must understand what type of market he/she is in to know which indicators to use.

The statement that "[u]sing fundamental or economic analysis is our best chance of forecasting a purposeful stock" places Maskell in the random walk camp, and brings up another question. Would he have us believe that fundamental analysis has successfully targeted eventual prices in the last two years on stocks such as Intel, Sun Microsystems, or Cisco? If so, who and where were the "super-analysts" who pulled it off?

How many "sell" recommendations occurred between 1999 and 2001? I can count the ones I read or heard about on the fingers of one hand. The reason is simple. Using traditional independent fundamental logic, these stocks would have become even more attractive as their valuations plummeted, causing those who followed this pretzel logic to buy more as the stocks went into freefall. This is why more than 99% of fundamental analysts continued to recommend them. I agree that fundamental analysis has its place, but it is most effective when combined with technical analysis.

The cruel truth? The parade of fundamental analysts who have appeared on various stock market programs since May 2000 who have tried to pick a bottom using fundamental analysis have had a hand in helping to obliterate the portfolios of those foolish enough to listen!

The reality is that by the time the fundamentals are known, the stock has already reacted. As the old saying goes, "Buy on rumor, sell on news." Put another way, the stock market is a leading indicator. It has so far proven to be the most reliable signal of an improving or deteriorating economy, or of changes of fortune in a company. (Case in point? By the time Enron was on the verge of bankruptcy, the stock had plunged from $80 to $0.80.)

As any technical analyst worth his salt will tell you, any trader trying to predict the bottom of a chart pattern that looks like a ski slope into oblivion is begging to have his money taken from him. Unfortunately, there is no discussion on how the author employs fundamental analysis in "forecasting a purposeful stock."

BUT WHAT ABOUT TRENDS?

I would ask Burton Malkiel what I ask Thomas Maskell: If stock movements are random, how does he explain trends? And therein lies one of the major rubs of the random walk theory. Equities move in trends, and it is these trends that make technical trading possible. This means that traders can buy and sell equities when the trend is in play and increase the probability of winning.

By its very essence, the concept of trend makes the movement of equities anything but random. We cannot infer where prices are going by looking at trends; all we can infer is that there is a greater probability the prices will reach the trader's target. If new evidence comes to light in the meantime in the form of unfavorable fundamentals, the trader exits his position (hence the term stop-loss).

All we have to do to see if trends exist is examine the stock charts of any of the major indexes (or, for that matter, most stocks) over the last 100 years. Whether over the long term or short, we can make money trading them, as successful traders have amply proven (see Figure 1).

Figure 1: Monthly chart of the DJIA, 1978­2003. Note the two distinct major trends. This hardly appears to be a collection of random price movements.

Further, what about chart patterns, candlestick formations, moving averages, and intermarket analysis? These, too, are important parts of technical analysis that work quite well for those who learn how to apply them. How does the random walk theory explain these principles?

But perhaps the most convincing evidence against the validity of the random walk myth is that hundreds, if not thousands, of traders and investors make money every day in markets around the world employing systems based on technical principles, as the records of people like Dan Zanger resoundingly attest (see the next section).

DON'T GIVE UP ON A GOOD THING

For those who have been disheartened by their inability to find a system that works, don't give up! I know a number of traders who take a very nice living out of the markets daily and who have spent much time and no small amount of energy honing their tools over the years. By definition, however, they are the exception.

As anyone with sales experience will tell you, the 80/20 rule is alive and well (20% of salespeople make 80% of the money). It is similar in engineering and business. In trading, I estimate the ratio to be an even more lopsided 90/10. The top 1% does very well indeed! The random walk theory proponents would have us believe that these people are pure gamblers and simply enjoy incredible luck.

The Fortune article listed in the "Suggested reading" section shows what is possible (granted, markets were somewhat different in 1999­2000), thanks to technical analysis. The article explains how Dan Zanger, who spent 10 years working at his craft, turned $10,000 into $18 million in less than two years, complete with commensurate tax receipts. He is also a rarity in the trading community; the majority of traders prefer to keep their strategies and successes to themselves. (In addition, check out the other article, in which he was quoted. Royal Gold hit a high of $28.80 in February 2003!)

CONCLUSION

The random walk theory misses the boat in its attempts to discount the intrinsic values of technical analysis in favor of the fundamental approach. Not only does the theory fail to address trends, it also ignores many other important technical principles that have proven their value time and again in the analysis and trading of equities.

Last but certainly not least, if the assertions of the random walk theory were correct, the market returns produced by top-echelon short- and long-term traders and technically based investors, some of whom are extremely successful, would simply not be possible.

Matt Blackman is a trader, technical analyst, software and book reviewer, freelance writer, and content provider for financial publications and websites. He can be reached at trader@goldhaven.com.

SUGGESTED READING

Berentson, Ben [2002]. "Breakout for Royal Gold?" Forbes: September 11.

http://www.forbes.com/2002/09/11/0911chartroom.html

Lee, Clifford [2000]. "My stocks are up 10,000%!" Fortune: December 18.

http://www.chartpattern.com/news/fortune.html

Malkiel, Burton [2003]. A Random Walk Down Wall Street, W.W. Norton & Co., 8th ed.

Maskell, Thomas [2003]. "What Are Those Indicators Really Indicating?" Working Money: April 4.

Murphy, John J. [1999]. Technical Analysis Of The Financial Markets, New York Institute of Finance.

Charts courtesy of TradeStation

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He tweets about stocks he is watching at www.twitter.com/RatioTrade Matt has earned the Chartered Market Technician (CMT) designation.

E-mail address: indextradermb@gmail.com


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