Efficient-Markets Hypothesis

Gibson makes a compelling case against market timing in his book, Asset Allocation: Balancing Financial Risk, which presents a thoughtful and well-researched argument against timing. An asset’s market price, he explains (with the support of a great deal of research in modern portfolio theory since Fama), follows a random walk—at any given time, it is as likely to increase in value as to decrease, for example. Only in hindsight does this random series of price movements form what appears to be (to the market timer) a trend.

Now a believer in trends, the timer seeks to identify the next trend and, following the adage, to buy near the low end of its range and sell near its high. The mechanism by which markets are said to follow a random walk—making fools out of market timers—is, in Gibson as everywhere, its efficiency.

The financial literature often seeks to explain that a market timer’s approach is problematic for the reason that an asset’s price is (supposedly) no more predictable from one period to the next than, say, the outcome of a coin toss is predictable from one flip to the next. So a market timer is like a coin-tosser who, having noted that the coin has come up “heads” five or six (or however many) times in a row, believes the coin must be in a “heads trend”—or maybe at the turning point in a heads trend, destined for a “tails cycle,” or some such—and accordingly, uses such reasoning to place his money on a certain outcome in the next toss. Gibson expands on the analogy (italics in original):

“The run of heads in our coin flipping experiment can represent a prolonged period of rising stock market prices, known as a bull market. The run of tails corresponds to a period of declining stock prices, known as a bear market. With a prolonged bear market, such as occurred in 1973–74, we tend to berate ourselves after the fact by concluding that we should have known that the bear market would have continued once prices started falling.”

—-Gibson, Roger C. Asset Allocation: Balancing Financial Risk. 2nd ed. Chicago: Irwin, 1996.

But are the events that contribute to a market’s performance, including the bear market that characterized the early 1970s in the United States, wholly random—no more predictable than the outcome of a coin toss?

If the answer is yes, then the investor who seeks to benefit from an understanding of the relationships between macroeconomic and intermarket fundamentals (an understanding that Stracia seeks to enhance) is being “fooled by randomness,” to borrow a phrase from the author whose book appears at left [Taleb, Nassim Nicholas: Fooled by Randomness]. Such an investor is essentially chasing imaginary “heads trends” or “tails trends.”

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