Far From Random

Stock market is not random but is the function of aggregate psychology and behaviour of the participants

March 10, 2014 11:27 IST | India Infoline News Service
Title: Far From Random
Author: Richard Lehman
Pages: 235, Hardcover
Price: US $39.90
Publication Date: November 2009
Published by Bloomberg Press

In Far From Random, Richard Lehman, an instructor of finance and derivatives, tries to break the widely accepted belief that stock market movement is unpredictable. According to him, market moves in well-defined and often predictable ways. Market trends exist and can be comprehended before they are completely formed. One needs to understand investor behaviour and trend analysis to forecast market. Human behaviour drives the market. As long as human beings are the market participants, human factors in financial markets will be present. Technical analysis is one of the best ways to interpret the impact of the behaviour on stock prices.

Fundamental analysis is important but it cannot explain certain changes in the price movement in the market. It serves as a rough guide for what price the stock is trading and when one wants to sell it. Fundamental analysis is a comprehensive process however there are other factors also which affects the stock prices in the open market.

The author also highlights timing of investments made in stock market should be an integral part of investment strategy. To be a successful investor, one must anticipate correct timing most times.

The price of a stock has two components—fundamental value and subjective value. The subjective value is the majority of the price one pays for stocks. Subjective value is based on participant behaviour and psychology. The fundamentals of a company change very slowly over time. So the day-to-day movements in stock prices are mostly based on behavioural factors. The impact of behavioural factors on the stock market gives it non-random characteristics, making it possible to interpret and to a certain extent predict movements within certain parameters.

The book begins by describing the situation in 1970s, when Securities and Exchange Commission had abolished fixed commissions, which was initially, imposed by the New York Stock Exchange on all brokerage firms. It also mentions that initially charts were drawn and later were made available online. Thus, with the introduction of the Internet what was called “straight lines” became “trend channels”.

California-based Lehman criticises brokerage firms by saying they make money through transaction fees, sales commissions, mark-ups, margin spreads or investment management fees. Brokerage firms would certainly prefer that clients/customers to gain so that the clients would remain attach to brokerage firms. However, increasing customers’ wealth is not the firms’ priority. He compares brokerage firms will “airplanes”. Like airplanes, brokerage firms are built to go in only one direction. They only have a “forward gear” as they only have a method of collecting stocks without saying whether it’s a good time to buy the stock or not.

Even if they have a method of telling when to get in and out of stocks, it is difficult for these firms to tell thousands of investors the right time of buying or selling stocks as these investors would have bought stocks at different prices. Thus, this is a major reason why issuing “sell” recommendations are problematic. Many stocks are “buy”, because many of them are companies with which brokerage firms have an investment banking relationship.

The author makes reference to the classic finance book, A Random Walk Down Wall Street written by Burton Malkiel, an American economist and writer. Lehman says Malkiel describes the random nature of individual stocks but makes no distinction between individual stocks and the overall market. Till the 1990s, the random walk hypothesis was widely accepted by academics and investors. But later, the behavioural finance approach was involved. It views the market as generally efficient and for the most part random but with identifiable imperfections that are caused by imperfect structure of the market or the imperfect behaviour of the participants.

Lehman points out that there are ambiguities in random walk theory. While the movement of individual stocks supports random hypothesis in short term. The market exhibits decidedly non-random characteristics in both short and long term. It may be possible for the action of individual stocks to be primarily random, while predictable patterns exist at the market level. This led to the conclusion that stock market is far from random.

Lehman, thus, parts significantly with Malkiel and the random walk theory. He points out that both efficient market hypothesis (EMH) and random walk theory are generalised theories that describe the stock market at a very high level. But if studied in detail, one is sure to find faults, exceptions and anomalies. It is unlikely that random walk hypothesis provides an exact description of the behaviour of the stock market prices.

Lehman says that the stock market is not random. It is the function of aggregate psychology and behaviour of the participants. The market can be understood through an analysis of price charts, using techniques such as trend channel analysis (TCA). The stock market’s price action is characterised by discrete directional movements called trend channels. The market always moves back and forth in a channel, even during extreme market movements. Channels are always bounded by parallel lines. TCA is a powerful technique for reading the market behaviour and forecasting not just the direction but also potential lows, highs and turning points.

To make the book comprehensive for a reader, who lacks technical skills, Lehman supports his views through a series of charts. He starts explaining from the very basic of technical analysis such as bar graphs and then moves on to the concept of TCA. The book is an interesting read.

About Author

Richard Lehman is the co-author of New Insights on Covered Call Writing, with Lawrence McMillan (Bloomberg Press, 2003). Lehman is an instructor of both finance and derivatives at UC Berkeley Extension and a vice president in the wealth management group at Mechanics Bank in Richmond, California. His financial career spans more than thirty years in product management, marketing, and investment management, beginning with an eleven-year stint on Wall Street with EF Hutton, Thomson McKinnon, and the New York Stock Exchange. He lives in Richmond, CA.

About Bloomberg:

Bloomberg LP, founded in 1981, is a global information services and media company. Serving customers on six continents, Bloomberg, through its wholly-owned subsidiary Bloomberg Finance L.P., holds a unique position within the financial services industry by providing an unparalleled range of features in a single package known as the Bloomberg Professional® service. Bloomberg News, founded in 1990, provides stories and columns on business, general news, politics, and sports to leading news papers and magazines throughout the world. In addition to the Bloomberg Press line of books, Bloomberg publishes Bloomberg Markets magazine. The company’s website can be accessed at http://www.bloomberg.com

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