Is the Stock Market Random or Predictable? The Final Debate on Efficient Markets

One of the foundational elements of my personal trading style with options is the belief that the stock market is random. Random meaning that we can't gain an edge picking a direction. And for years, this assumption has been more or less accepted by the public and academia.

In the last couple months, the theory or hypothesis around random financial markets has repeatedly been challenged, which is a good thing. A countless number of people have tackled the issue and published their findings on random market behavior. I wish I could link them all up here, but it's just not possible nor realistic.

Admittedly, I scheduled this show as a follow-up to Show 49 where we backtested 15 different option buying strategies during the last market crash. And the reason is that I wanted you to recognize how much "perfect timing" had an impact on the results of that case study. In Show 49, we only backtested the put buying strategies for two years assuming you were 100% right in calling the impending market crash.

If you expanded the timeline out to 3 years on either end - i.e. you're not a market wizard and can't time the crash precisely, then each and every scenario lost money. In fact, each backtested put buying strategy only made money during Sep & Oct of 2008 at the height of the collapse. During all of 2007, you would have lost on average 56% of your capital waiting for the crash to happen.

Be honest with me now; how likely is it that you would have actually held through a 56% drop in your account balance before you called it quits? And that was assuming you had near perfect market timing! Still, the traders who sold options didn't try to time the market, eventually won. Sure, they may have experienced a draw down in 2008 if there were not positioned correctly, but even still they would have made money trading through the crash.

As you listen to the show, I want to challenge you to ask yourself the following pressing questions about investing: Is the stock market random? If it is, why should we care so much about picking a random direction? If it isn't, and indicators are present to predict future moves, can I even uncover the non-random patterns? How much time or money would it take to profit under the assumption of randomness vs. non-randomness? What trading strategies fit my personal style the best?

Key Points from Today's Show:

Background Hypotheses and Theories

• Time Series Hypothesis — everyone in the market has more or less a different timeline that they are trading on; day traders, minute chart traders, weekly traders, monthly traders, yearly traders, etc.
• Random Walk Theory — the stock price changes have the same distribution and are independent of each other, so yesterday's move cannot be used to predict it's future movement tomorrow.
• Efficient Market Hypothesis — the main facet of Random Walk that supports the idea that all information is already priced into the security or the stock price. There is no edge that can be gained when you get news; as soon as news is released to the market it is disseminated and the news re-prices the value of the stock.

Research and Findings

• Mean reversion study by Lo and MacKinlay (1999): suggests that short run stock correlations are not zero — not a high correlation, but not zero.
• Concludes that the short-run price movement of a stock is not completely independent of each individual day, showing that Random Walk is not completely true.
• Also, prove that short run stock prices can gain momentum, due to investors "jumping on the bandwagon", leading to several consecutive periods of the same direction of price movement.
• However, in the long run, they do see correlations that are much closer to zero, if not at zero, for major markets, suggesting that the patterns normalize in the long term.

Conclusions:

• In the short-term, you can see price movements start to trend or “gain momentum” in either direction. In the longer term, these trends are more or less averaged out.
• Any patterns or anomalies are more reliable than random during the short term and become less and less reliable in the long term as they do normalize.
• Be aware that with data mining, if you churn data enough, you are eventually going to find predictive patterns somewhere.
• If you had to pick, the markets are random — 95% of the market is random in nature. However, in the shorter term periods the momentum or "bandwagon indicators" do actually have some predictive power.
• Does technical analysis work? Yes. In a short term and a small contained set of parameters. Is the market 100% efficient and random? No. It is definitely more random than not, but there are inefficiencies and non-random aspects to the market that you have to be aware of.