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Are Stock Prices Random or Chaotic?

April 01, 2012 | About:
EconMatters

EconMatters

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Price momentum is a key component of chart analysis. Traders commonly look for stocks moving in a certain direction or signs that the direction of a stock’s price is about to change. The idea is that momentum is a trader’s friend, if it can properly be identified and analyzed.

The argument against price momentum is that price movements are random. Share prices, many argue, adjust quickly to reflect new information, and new information cannot be predicted. Thus, trend analysis does not lead to improved long-term performance.

A study recently published by the American Institute for Economic Research (and recommended to me by an AAII member) suggests that price momentum may actually be the result of traders adjusting prices to incorporate trend information. Research fellow Shelly Liang points to the Positive Feedback Trading Hypothesis (PFTH), which says traders may buy a stock simply because the price is going up. Such decisions are therefore rational, as opposed to a reaction to a random event, because traders believe the existence of momentum is a reason for the stock price to rise higher. Hence, stock prices are chaotic, but not random. (I intend to publish the study in a future issue of the AAII Journal.)

How much validity you should assign to PFTH depends on whether you think stock prices move in a chaotic manner or follow a random walk.

The case for PFTH is that price momentum is driven by the actions of market participants. As a stock’s price begins to move in one direction, traders place orders to take advantage of the trend. As more traders buy (or sell) the stock, the upward (or downward) trend is extended. The trend then continues until new information emerges that warrants selling (or buying) the stock. Thus, price direction is chaotic, but not random.

The case for the random walk argument is that trends can appear in patterns that are actually random. Think of a coin toss. A coin can land on heads for several consecutive tosses. Yet, for each toss, the odds of landing on heads remain a very steady 50%, regardless of how often the coin landed on heads for the previous 10 tosses. Put another way, the chance of a roulette wheel ball landing on red or black is in no way tied to any of the previous spins; the odds stay at a steady 47%. Those who adhere to the random walk theory also point out that the timing of new data and news is unpredictable, and that stock prices react quickly to the introduction of new information.

I don’t think the argument that stock prices are random can be dismissed. The introduction of news, such as a merger announcement or revised earnings guidance, is often unpredictable. Economic conditions also change in ways that are not predictable in advance. On the other hand, it is important to note that incorporating price momentum indicators, such as relative strength, do help improve the performance of otherwise fundamentally-based stock screens.

The middle ground may be that while long-term price movements are random, over shorter periods, trends that attract investment dollars emerge. Thus, stock prices can be both chaotic and random over the short term (due to the combination of price trends and the introduction of new information) and random over the long term. The key is to realize that momentum should never be used as a sole strategy for selecting securities and that the mere existence of a trend does not imply that it will continue into the future.

The Week Ahead

[b][/b]If you turned 70 1/2 last year, you have until tomorrow, March 30, to take your first required minimum distribution (RMD). See IRS Publication 590 for more information.

The U.S. financial markets will be closed next Friday, April 6, in observance of Good Friday.

The only S&P 500 member company scheduled to report earnings next week is Constellation Brands (STZ) on Thursday.

The week’s first economic reports will be the March ISM manufacturing survey and February construction spending, published on Monday. Tuesday will feature March factory orders and the minutes from the March Federal Open Market Committee meeting. The March ISM non-manufacturing survey and the March ADP employment report will be published on Wednesday. Friday will feature March jobs data, including the unemployment rate and the change in nonfarm payrolls.

Three Federal Reserve officials will make public appearances next week. Cleveland President Sandra Pianalto will speak on Monday, St. Louis President James Bullard will speak on Monday and Thursday, and San Francisco President John Williams will speak on Tuesday and Wednesday.

H/T to EconMatters

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