Infrequently discussed on this site are topics regarding broad market theory.

If at any given moment, the market is right (and as traders we are taught the market is always right) then how can it simultaneously be wrong?  If it wasn’t, there’d never be an opportunity to buy low / sell high or any iteration of that.

Here’s an example.

HOV in 8/2005 was at $72, and HOV at 3/2009 was at .58¢

Both prices were “right” for their respective days, but clearly not right in a longer term sense.  As the company is still currently in existence and priced at  $4.50, it was undervalued by some 775% at the low in March of last year.  And yet people sold there.  Similarly, it was “modestly” overpriced in 2005 to the tune of 99% compared to it’s ensuing low, but there were buyers at $72.

At any given moment of time for a trading day, there is a bid price, an ask price, and a last price.  The last price is the equilibrium price — there is (at that time) a known buying and selling demand, and thus the resultant price.

Then some new information comes out, changes the buying and selling demand, and thus a new price.

As more info comes out, new prices emerge.

This is known as Efficient Market Hypothesis.

EMH asserts that ALL price movement, absent NEW fundamental info, is noise and more specifically totally random.  This is because the only thing that can affect price is new info and new info is unknown until it becomes public and the price moves.  In the long run, you cannot game this.

“Share prices exhibit no serial dependencies, meaning that there are no “patterns” to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk”

This was the prevailing theory for many years, and many still believe it.

Then, you may ask, how does this account for outperformance by any one Manager or Fund?

EMH proponents use this example.

There are, say, 36 million investors in the USA.  This includes do it yourself retail traders, Elliot Wave clowns (excuse my redundancy), Newsletter writers, stock twitterers, all the way up to seasoned vets such as your David Einhorns and George Soros’.

They all flip a coin, heads keeps you in the game, tails, you’re done.

18 million land heads, and they bet again.

9 million get heads twice in a row.

And again.

4.5m get heads a third time in a row.

And again.

2.25m

–> 1.125

–> 560k

–>280k

–>140k

–> 70k

–> 35k

–> 17.5k

–> 8.75k

Ok enough.  So we have ~8700 investors who have flipped heads 12 times in a row, and surely feel emboldened by their demonstrable genius.

So they flip again.

You get to the point where 250 or so people have flipped heads 17 times in a row, thus making them the best market timers ever.

EMH proponents suggest (correctly) that 26m monkeys could just as well do the same and in the end you’d have 250 talented super monkeys.  This neatly explains how EMH can be true, while some investors show outsized returns.

Warren Buffett took this theory and killed it in a probably awesome meeting at Columbia Business School in 1984.

He said, rather than focus on 250 monkeys, what about the instance where 50 monkeys came from the same zoo?  Then what? Similarly, if 500 people get a very rare cancer, it’s chance, but if 500 people in a small town of 1,000 got that cancer, it wouldn’t be the result of chance.  You’d check the water supply.

The conclusion is that clustering means the results aren’t random anymore. They cannot be the result of mere chance.

What Buffett so deftly observed is that these clusters are tantamount to investing styles, because, indeed, the richest money managers then (and now!) follow either one of two things:

Growth strategies

Value strategies

Ultimately, only a few succeed because of computer arbitrage or HFT and for the significant majority of traders, you cannot compete there.  Thankfully, we don’t have to colocate our servers at the NYSE to earn a buck trading.

The ONLY way to outperform is by a time tested growth strategy (think GARP, CANSLIM, etc) or value trade (Graham, Buffett, et al).

I’m sorry to tell you, but there are no billionaire, oxygen breathing fund managers who premise their decisions on simple TA, or retracements, or fibs, or elliot wave or whatever.  There are plenty of managers who do, yet none of the billionaires or even hundred millionaires.  Hmm.  If you disagree with that last assertion, please provide evidence otherwise.  GS making a market and taking spreads is not beating the market.

However,

Buffett beating the S&P 40/45 times since 1965 is.

Steve Cohen turning 25m into 12b is.

Soros / Druckenmiller

Peter Lynch and his seminal classic, One up on Wall St.

Jesse Livermore.

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How does this relate to us?  I realize this post is kinda jumpy from EMH, to Warren, to, umm billionaires?  But the point that really struck home with me is that certain styles outperform NOT due to chance.  And it means that EMH is incorrect, in that prices can move in a non-random fashion.

Critically, it shows how more than TA skills, or the ability to read an 10-k / draw a trendline are needed to beat the market.

Once you get a style down, you have to determine which of the ~5,000 tradable stocks you will focus on, and when you will focus on them.  Then you have to apply proper risk management.

So no, it’s not easy, and that’s why those guys get paid the big bucks.

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Most / this entire post was paraphrased from a great book I’m reading, More Money Than God, by Sebastion Mallaby.   Definitely worth reading.

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