In the world of trading and investing, there are two theories with which the financier will have to contend at one point or another. Two theories that have been created and pushed by academicians for quite some time. Those theories are: The Random Walk Theory and The Efficient Market Theory (Hypothesis). Let’s define both concisely.
Random Walk Theory:
The theory that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement.
Let’s now define the other….
Efficient Market Hypothesis:
An investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.
Time to break it down.
I know some of you are expecting me to completely disregard both theories, but there’s actually some validity in both. The RWT, in my opinion, is correct in that it’s impossible to predict the future movement of any security. However, it is incorrect in stating that it’s impossible to outperform the market. The EMH is also correct in that all relevant information is usually priced into a security. But like the RWT, it is incorrect in suggesting that no one has an edge in the market. One thing to bear in mind is that these theories were formed during a time of price stability thanks to the Bretton Woods agreement.
Since academicians have made themselves look foolish by embracing both of those theories, they now say that the only way to correctly analyze the market is through fundamental analysis or by complex quantitative (mathematical) models. Academia has even convinced many would-be traders that chart reading is BS.
I’ve already stated in a previous article that your average trader or investor isn’t going to know all of the fundamental information that causes a security’s price to move. Therefore, a lot of traders believe that price movement will tell you everything you need to know. In a way, the EMH is in partial agreement with traders. Since traders understand that fundamental a lot of data is out of their reach, a lot of traders rely on the reading of charts, better known as technical analysis to track what the major players may be up to. Stated another way is that, when used correctly, one can anticipate the most probable direction of a market without knowing the reason as to why that move is occurring.
But here’s where things get interesting — could it be that both academicians and traders are correct? Only partially and here’s why: I’d estimate that 85% of the time, markets actually are random and efficient. The remaining 15% of the time, markets will trend. What causes a trending market? It’s simple…an imbalance between supply and demand. If there is strong demand and little supply, prices will rise. And the reverse will occur under the opposite condition. However, 85% of the time, the market is in a state of balance. On a chart, this displays itself as a trading range or sideways trading.
“Play the market only when all factors are in your favor. No person can play the market all the time and win. There are times when you should be completely out of the market, for emotional as well as economic reasons.” – Jesse Livermore
Also, technical trading is not a holy grail! Nor is technical trading a science — it is an art. I’ve known many purely technical traders (myself included) who can call the market correctly around 90% of the time! I’ve also witnessed many technical traders who just can’t figure it out. Speaking anecdotal and from my observation of other traders, technical trading makes the most sense if your goal is to make money in the markets. Believe it or not, there are those (usually those academic types) who feel the need to be right and will try to force the market to agree with their fundamental views. Technical traders, on the other hand, it’s about making money and losing as little as possible when wrong.
With all of that being said, academia needs to stay out of the markets because their approach is purely theoretical. Academicians are not traders. Therefore, to rely on what they say concerning the markets is like getting car repair advice from a guy who flips burgers. The majority of academicians couldn’t place a profitable trade even if you put a gun to their head and forced them to do so. When you deal with traders, guys who actually trade the markets, you’re hearing it straight from the horse’s mouth. Many academicians will tell you that charting doesn’t work and that the only way to trade or invest is to study the fundamental conditions of a stock, commodity, currency, etc. As I stated earlier, there’s only one thing that moves markets and that is an imbalance between supply and demand. Fundamentals may give you a reason as to why prices are likely to rise or fall but charts are great for determining supply/demand imbalances and will tell you when the moment for a rise of fall has arrived…or if it’s gonna happen at all.
Another fallacy with the RWT is that it assumes that traders are trying to PREDICT the market. I don’t doubt that there are some traders who try to act as if they have a crystal ball, but most profitable traders won’t dare attempt to predict the market. What many academicians don’t understand that traders do understand is that trading is a probabilities game. Therefore, traders look for signals that indicate a market’s probable direction. A signal doesn’t guarantee anything, but it increases a trader’s probability of profiting from that trade…along with good risk management.
Conclusion: To put it bluntly, academicians don’t know what they’re talking about. They may be able to impress you with their fancy, well-written studies with tons of complex mathematical models but that stuff is no substitute for actual trading experience. The majority of profitable traders use charts to make their calls, this is a fact. They understand, as I’ve stated, that fundamentals are great for explaining why but the charts will tell you when and if.