Can an investor gain an edge over the markets? It depends on who you ask. There has long been discussion over whether the markets are random or cyclical. Each side claims to have evidence to prove the other wrong. Random walk proponents believe the markets follow an efficient path where no form of analysis can provide a statistical edge. Both fundamental and technical analysts, on the other hand, believe there is a certain rhythm to the markets that careful analysis can help uncover, providing at least a slight advantage.

Efficient Market Theory
The basic facet of random walk proponents is the efficient market hypothesis (EMH). The EMH idea states that all known information is already priced into a security's price structure. Therefore, no known information can help an investor gain an edge over the market. Additionally, this hypothesis includes the idea that all future news events are unpredictable, and therefore investors cannot position themselves in a particular security on an expected outcome to an upcoming event. Read on to find out how fundamental and technical analysts might counter that idea.

Fundamental Analysis
Fundamental analysis is a study of a company's current situation in regard to its potential for both sustainability and future growth. A fundamental analyst may decide to purchase a stock if he or she sees that a company has a strong balance sheet with low debt and above-average earnings per share growth. These analysts would disagree with the efficient market theory belief that one cannot use this known information to make an investment decision regarding potential future price performance.

In his book, "24 Essential Lessons for Investment Success" (2007), William O'Neil states that, "From our study of the most successful stocks in the past, coupled with years of experience, we found that three out of four of the biggest winners were growth stocks, companies with annual earnings per share growth rates up an average of 30% or more - for each of the past three years - before they made their biggest price gains." It goes without saying that the results of this study seem to conflict with the EMH belief that no known information can help one gain an edge over the market.

If one wishes to do his or her own research on the usefulness of fundamental analysis, a good resource for gathering various fundamental information on companies is the EDGAR page of the SEC's web site, from which one can gain access to annual (10K) and quarterly (10Q) reports as well as other financial information for all listed companies.

Technical Analysis
Technical Analysis revolves around the belief that investor behavior repeats over time. If one can recognize these patterns, he or she can benefit by using them to potentially predict future price movement. The most basic of technical analysis is support and resistance. An example of support would be if a stock has been trading sideways in the $20 range for several months and then starts to move higher. The $20 range may act as a support area for any near-term correction. The logic here is that the $20 range represents the collective decision of many investors to have purchased shares in that area. A return to the $20 range will only put them back at even to the point at which they purchased their shares.

Technical analysts believe that investors are not likely to sell unless a significant break below that area occurs. The longer the time period over which a support area develops, the more investors it represents, and hence the stronger it may prove to be. A support area that only developed for a day or so will likely prove insignificant as it does not represent many investors.

Resistance is the opposite of support. A stock that had been trending just below $20 for a period of time may have trouble breaking above this area. Again, technical analysts would argue that the reason is human behavior. If investors have identified that $20 is a good selling area for either booking profits on existing long positions or initiating new short positions, they will continue to do so until the market proves otherwise. It is important to note that once support is broken it may become resistance and vice versa.

Of course, the ideas of support and resistance are only guidelines. Nothing in the market is ever guaranteed. Prudent investors always use a risk-management strategy to determine when to exit a position in the event the market moves against them.

A Random Walk
Random walk proponents do not believe that technical analysis is of any value. In his book, "A Random Walk Down Wall Street" (1973), Burton G. Malkiel compares the charting of stock prices to the charting of a series of coin toss results. He created his chart as follows: If the result of a toss was heads, a half-point uptick was plotted on a chart; if the result was tails, a half-point downtick was plotted. Once a chart of the results of a series of coin tosses was created in this fashion, it was postulated that it looked very much like a stock chart. This led to the implication that a chart of stock prices is as random as a chart depicting the results of a series of coin tosses.

To stock market technicians, this claim is not a true comparison because by using coin flips, he altered the input source. Stock charts are the result of human decisions, which are far from random. Coin flips are truly random as we have no control over the outcome; human beings have control over their own decisions. One well-known example a technician might use to counter this claim is to produce a long-term chart of the Dow Jones Industrial Average (DJIA) demonstrating the 40-month cycle. The 40-month cycle, also known as the four-year cycle, was first discussed by economic professor Wesley C. Mitchell when he noted that the U.S. economy went into recession roughly every 40 months. This cycle can be observed by looking for major financial market lows approximately every 40 months. A market technician might ask what the odds are of replicating that kind of regularity with the results from a series of coin tosses.

The Bottom Line
The debate between those who believe in an efficient market and those who believe that the markets follow a somewhat cyclical path will likely continue for the foreseeable future. Perhaps the answer lies somewhere in between. The markets may indeed be cyclical with elements of randomness along the way.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Convertible Secs

    Read an in-depth analysis of the SPDR Barclays Capital Convertible Bond ETF, which tracks an index of high-growth potential convertible bonds.
  2. Active Trading Fundamentals

    Technical Vs. Fundamental Investing - Friends Or Foes?

    Making money in the stock market has been likened to gambling by some, but experienced investors who do their homework usually profit by doing market analysis. However, even experienced investors ...
  3. Mutual Funds & ETFs

    Introduction To Fundamentally Weighted Index Investing

    If you believe the market smiles on those who focus on value, growth or income, this vehicle may be for you.
  4. Fundamental Analysis

    An Introduction To Coverage Ratios

    Interest coverage ratios help determine a company's ability to pay down its debt.
  5. Fundamental Analysis

    Equity Valuation: The Comparables Approach

    The main purpose of equity valuation is to estimate a value for a firm or security. There are three primary equity valuation models: the discounted cash flow (DCF), cost and comparable approaches. ...
  6. Fundamental Analysis

    Understanding Profit Metrics: Gross, Operating and Net Profits

    Rather than relying solely on net profit figures to evaluate a company's performance, seasoned investors will often look at gross profit and operating profit as well.
  7. Fundamental Analysis

    Fundamentals And Technicals: Together At Last

    It's a big mistake for a fundamental investor to ignore technical analysis. Find out how to become chart smart.
  8. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  9. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  10. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  1. What types of securities perform best in a bull market?

    Technically speaking, the types of securities that perform best in a stock market are those that have volatile correlations ... Read Full Answer >>
  2. How do technical analysts predict bull markets?

    Technical analysis studies past data and trends to predict future market movements. The underlying concept inherent in technical ... Read Full Answer >>
  3. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  4. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  5. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  6. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!