Can an investor gain an edge over the financial markets? It depends on whom 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 analysis, 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.
- The debate over whether the financial markets behave in a random or cyclical manner comes down to two camps: random walk advocates vs. fundamental and technical analysts.
- The basic tenet of random walk proponents is the efficient market hypothesis or theory, which states that all known information is already priced into a security's price.
- Fundamental analysis is a study of a company's current situation in regard to its potential for both sustainability and future growth.
- Technical analysis revolves around the belief that investor behavior repeats over time in alternating patterns of support and resistance.
- The markets may indeed be cyclical with elements of randomness along the way.
Efficient Market Theory
The basic tenet of random walk proponents is the efficient market hypothesis (EMH). The EMH 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 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 they see 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 hypothesis 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 (2000), 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 their own research on the utility of fundamental analysis, a good resource for corporate fundamentals and financials is the EDGAR page of the SEC website, from which one can gain access to annual (10-K) and quarterly (10-Q) reports as well as other financial information for all listed companies.
Technical analysis revolves around the belief that investor behavior repeats over time. If one can recognize these patterns, they can benefit by using them to potentially predict future price movement.
The most basic tenets of technical analysis are 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.
Random Walk Theory
Random walk proponents do not believe that technical analysis is of any value. In his book A Random Walk Down Wall Street (1973)—the source of the term—Burton G. Malkiel compared 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.
Cute. But to stock market technicians, this comparison isn't a valid one–because, by using coin flips, Malkiel altered the input source. Stock charts are the result of human actions, which are far from random. Coin flips are truly random as we have no control over the outcome, but human beings have control over their own decisions.
One well-known example a technician might use to counter Malkiel's 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 economics 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.