Financial markets: random, cyclical, or both?

Can investors gain an advantage in the financial market? It depends on who you ask. For a long time, people have been discussing whether the market is random or cyclical. Each party claims to have evidence that the other party is wrong. Proponents of random walk believe that the market follows an effective path, and no form of analysis can provide statistical advantages. On the other hand, both fundamental analysis and technical analysis believe that the market has a certain rhythm, and careful analysis can help to find out and provide at least a little advantage.

Key points

  • The debate about whether financial markets run randomly or cyclically comes down to two camps: random walk advocates and fundamental and technical analysts.
  • The basic principle of random walk proponents is the efficient market hypothesis or theory, that is, all known information has been included in the price of securities.
  • Fundamental analysis is the study of the company’s current status in terms of sustainability and future growth potential.
  • Technical analysis revolves around the belief that investor behavior will repeat itself in alternating patterns of support and resistance over time.
  • The market may indeed be cyclical, and there are random factors in the process.

Efficient market theory

The basic principle of random walk proponents is the efficient market hypothesis (EMH). EMH points out that all known information has been priced into the price structure of the security. Therefore, there is no known information that can help investors gain an advantage in the market. In addition, the assumption includes that all future news events are unpredictable, so investors cannot position themselves in specific securities based on the expected outcome of upcoming events. Read on to learn how fundamentals and technical analysts refute this idea.

Fundamental analysis

Fundamental analysis is the study of the company’s current status in terms of sustainability and future growth potential. If fundamental analysts see a company with a healthy balance sheet, low debt, and above-average earnings per share growth, they may decide to buy stocks. These analysts disagree with the efficient market hypothesis that people cannot use this known information to make investment decisions about potential future price performance.

In his book 24 basic lessons for successful investment (2000), William O’Neil (William O’Neil) said: “Based on our research on the most successful stocks in the past and years of experience, we found that three-quarters of the biggest winners are growth stocks. Earnings per share means that the growth rate has averaged 30% or more per year for the past three years before the largest price increase.” Needless to say, the results of this study seem to conflict with EMH’s belief that there is no known information that can help a person gain an advantage in the market.

If you want to conduct your own research on the utility of fundamental analysis, the EDGAR page on the SEC website is a great resource for corporate fundamentals and finances, from which you can access all annual (10-K) and quarterly (10-Q) listings Company reports and other financial information.

technical analysis

Technical analysis revolves around the belief that investor behavior will repeat over time. If people can recognize these patterns, they can benefit by using them to predict future price changes.

The most basic principle of technical analysis is support and resistance. An example of support is if a stock has been trading sideways in the $20 range for several months and then starts to move higher. The $20 range can be used as a support area for any recent corrections. The logic here is that the $20 range represents the collective decision of many investors to buy stocks in the field. Returning to the $20 range will only bring them back to when they bought the stock.

Technical analysts believe that unless there is a sharp drop below the area, investors are unlikely to sell. The longer it supports the development of a region, the more investors it represents, and therefore the stronger it may prove to be. A support area that is only developed for a day or so may prove to be insignificant because it does not represent many investors.

Resistance is the opposite of support. Stocks that have trended slightly below $20 for a period of time may struggle to break out of this area. Similarly, technical analysts will argue that the cause is human behavior. If investors have determined that $20 is a good selling area to book profits on existing long positions or start 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 guaranteed. Prudent investors always use risk management strategies to determine when to exit positions when market trends are not favorable to them.

Random Walk Theory

Proponents of random walk believe that technical analysis has no value.In his book Random walks on Wall Street (1973)-The source of the term-Burton G. Malkiel compares graphs of stock prices with a series of graphs of coin flips. He created his chart as follows: if the result of the toss is positive, draw a half-point increase on the chart; if the result is a tail, draw a half-point decrease. Once a series of graphs of coin toss results are created in this way, people assume that it looks very much like a stock chart. This leads to the suggestion that the stock price chart is as random as the chart describing the results of a series of coin toss.

Lovely. But for stock market technicians, this comparison is invalid—because Malkiel changes the input source by using coin flips. Stock charts are the result of human behavior and are far from random. Coin tossing is really random, because we cannot control the outcome, but humans can control their own decisions.

A well-known example that technicians can use to refute Malkiel’s claims is the creation of a long-term chart of the Dow Jones Industrial Average (DJIA) showing a 40-month period. The 40-month cycle, also known as the four-year cycle, was first discussed by economics professor Wesley C. Mitchell when he pointed out that the U.S. economy would fall into recession approximately every 40 months. This cycle can be observed by looking for major financial market lows approximately every 40 months. Market technicians may ask how likely it is to replicate this regularity with the results of a series of coin toss.

Bottom line

In the foreseeable future, the debate between those who believe in efficient markets and those who believe that markets follow a certain cyclical path may continue. Perhaps the answer is somewhere in between. The market may indeed be cyclical, and there are random factors in the process.

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