Are markets random?

The question above should be more specific and say: Are markets totally random? Obviously, there is a lot of randomness in financial markets but is it all random?
If the answer to that very big question were a resounding yes, that would mean anybody trying to use charts (or more generally past data) to trade is doomed to failure. That's what proponents of the efficient market theory and its relative, the random walk theory believe.
So I think that, far from merely being a rhetorical question, it is of existential importance to any practitioner of technical analysis.
A lot of evidence has turned up in the past 20 years that seemed to disprove or at least seriously damage the random walk and the efficient market theories, none more potent than the crash of October 1987. As any self-respecting statistician will tell you, if the markets actually followed a random walk, that crash would have never happened.
For more background information about this most interesting of subjects, I found this on that most hated (but most useful) of sources, Wikipedia:

"The mathematical characterisation of stock market movements has been a subject of intense interest. The conventional assumption that stock markets behave according to a random Gaussian or normal distribution is incorrect. Large movements in prices (i.e. crashes) are much more common than would be predicted in a normal distribution. Research at the Massachusetts Institute of Technology shows that there is evidence that the frequency of stock market crashes follow an inverse cubic power law.[6] This and other studies suggest that stock market crashes are a sign of self-organized criticality in financial markets. In 1963, Benoît Mandelbrot proposed that instead of following a strict random walk, stock price variations executed a Lévy flight.[7] A Lévy flight is a random walk which is occasionally disrupted by large movements. In 1995, Rosario Mantegna and Gene Stanley analyzed a million records of the S&P 500 market index, calculating the returns over a five year period.[8] Their conclusion was that stock market returns are more volatile than a Gaussian distribution but less volatile than a Lévy flight.
Researchers continue to study this theory, particularly using computer simulation of crowd behaviour, and the applicability of models to reproduce crash-like phenomena...."

I actually found the article they're mentioning about markets and power-laws.

For what appears (to my untrained eyes) to be an impressively conclusive proof of the non-randomness of markets, you can check out this paper titled, oddly enough:
Stock Market Prices Do Not Follow Random Walks: Evidence from a Simple Specification Test. Be warned: it is math-heavy.

Despite all the new recent research, followers of the Random Walk Theory have been, so far, impervious to self-doubt. Their argument goes something like this: outliers, nothing but outliers!

My wish for 2008

Boy am I glad I waited until after the first trading day of the year to blog about my wishes for 2008 as pertains to trading. Now my task is easy:

May the year 2008 be as exciting trading wise as January 2, 2008, official first trading day of the year, was. May we have monster sell-offs (SPY, SMH, QQQQ, FNM, JCP) and monster rallies (USO, GLD, GDX, FXY) all on the same day, every day.

Poker vs Trading

The best article about trading I've come across in a while is actually not about trading. It's about Poker. I am not a Poker player but some of the things mentioned in the latest Economist's article could very well be said about trading. To wit:
"The object is to control the swings of luck with skill, figuring out how to win the maximum with your luckiest hands and lose the minimum with your unluckiest one".
"Over the long run, a player with a head for calculating odds and a feel for the psychology of the game, such as bluffing, will always overcome an untalented opponent."
"The skill is in the betting. And it is apparent in the fact that you can win without the best hand. More than half of all hands end without the cards being shown, not because one player got lucky but because he managed to persuade the others, given their analysis of the available information and the size of the pot, that it was sensible to fold."

It seems Poker also has its share of skill vs luck controversies:

"Online poker sites have reams of game-by-game data. These could, in theory, be used to show what makes some players better than others, and what defines their skill (bluffing? Shrewd betting based on the rapid calculation of odds? Or both?). Through research in this area has been thin on the ground to date, number-crunchers are starting to rise to the challenge......These efforts may produce fascinating results. Or they might reveal nothing much. Even if the data highlight strong trends, it may still not be clear which are caused by skill and which by luck..."

One thought I've had while reading this is that, if we're ready to accept that good Poker players are more than just lucky and that, whatever the nature of their set of skills, they are more skillful than the other players, why is it so controversial (among a certain set of people) to say that good traders (or investors) are skillful and not lucky only.

Abelson bashing continued

It appears I have some competition in the game of Abelson bashing. A letter to the editor from an inspired Barron's reader starts like this:
"In Alan Abelson's soul, it is always 6 a.m. in a one-room apartment with a view of nothing. I can taste the ashes and bitter coffee." and ends like this:
"Abelson isn't a value investor. He is a perma-bear, who will rarely help investors. Unlike stopped clocks, he is never right, but as his calls for recession and apocalypse whine more vociferously, we must remember what he never understands: The market gets less risky as it corrects, and our equity markets and capitalist system though flawed, tend to make us real money over time - especially when Abelson's fear and loathing are in abundance."
I wouldn't be surprised if Abelson himself selected this particular letter out of his weekly stash of hate mail for its poetic qualities.

The following comment might be viewed as simplistic but sometimes simplistic is what is needed to drill down the actual meaning behind an overly complex reality:
"We really need to be plain about this: Companies such as Washington Mutual, which announced a $1.6 billion write-down of home-lending-unit losses Monday, essentially took money placed in passbook savings accounts by hard-working, conservative customers -- many of them retirees -- and shoveled it to low-income, Fantasy Island condo flippers. Bankers paid 2% or less to customers they obviously considered suckers and lent it out at 6%-plus to customers they courted. " More not so simplistic but very illuminating comments are to be found in this article by the always bold Jon Markman.

Interesting article on Jim Simons and his Renaissance Technologies LLC group of hedge funds.
Mr. Simons is otherwise known as "God" among the quant crowd.
The laws of the financial markets present a special challenge, Simons says. Unlike the laws governing physics or chemistry, they tend to change over time. ``One can predict the course of a comet more easily than one can predict the course of Citigroup's stock,'' he says. ``The attractiveness, of course, is that you can make more money successfully predicting a stock than you can a comet.''

Return of the technical

I have noticed in myself a tendency to write about peripheral matters or avoid writing (or thinking) about the market altogether when one of the following three things happen:

1) The market is extremely volatile

2) The market is extremely unpredictable and I feel I have no special insight into what it's going to do next

3) The market is doing the opposite of what I thought it was going to do.

As it happens, all three did occur at one point or another over the last few weeks. I must admit the latest bout of weakness and its vigor took me by surprise and that the eventual rebound (the one that's taking place now) came much later (and at a much lower level) than I expected.

Add to that the fact that I seem to have run out of exciting charts (and my natural laziness) and you have a ready made explanation for my avoidance of technical market analysis. But all things must come to an end and that thankfully includes lack of inspiration so here we go.

The chart above (it is strongly suggested the reader click on the chart to enlarge so as to have the faintest idea what I am talking about) is the most recent daily chart for Microsoft. After its breakout move on 10/26/07, the day after shockingly above-expectations earnings were announced, the stock looked like it was off to the races but it actually came down pretty hard with the rest of the market. However, starting 3 days ago, it did stage a rally that could be the real thing for two reasons:

1) it took place right at the 50-day Simple Moving Average around 32.6

2) and as the 10/26 gap was almost filled (or the window closed in candle-speak).

I could also add the fact that the RSI has formed what looks like a double bottom at around 45, a level that frequently marks the end of a corrective move within a larger bull move.

Granted, volume has been unexceptional at best and that's a cause for concern. Therefore, we would need a decisive close on decent volume above the previous intermediate high (reached on 11/20) above 35 to call with some authority for a resumption of the uptrend.

The end of the world as we know it

You know the market is due for a serious bull move when perma-bears like Barron's Alan Abelson, high from the fumes off the recent selloff, think Armageddon is upon us.
He announces in his most recent weekly oeuvre nothing less than the end of the financial world as we know it. Judge for yourself (emphasis mine):
"Pure and simple, we've had three decades of mostly bull markets fed by cheap and abundantly available credit and an insatiable lust for leverage. That's fast coming to what we suspect will be a crashing end."
"Part and parcel of this epochal change will be a purge of the hedge funds, the private-equity operators, the investment banks driven by a casino mentality, who have served as the hallmarks of this gilded age now teetering toward its close. Their numbers and, more importantly, their profits will be drastically reduced."
Quite a terrifying depiction of a financial end-of-days day of reckoning or Abelson's special wet dream.