Random Walk and Outperforming Fund Managers

I’ve been debating several gentlemen on the 9/11 option grantee issue. The mainstream media (WSJ excepted) has been surprisingly silent on this, so I am gratified that Prof Bainbridge, Larry Ribstein and Eddy Elfenbein have indulged me in a debate on the subject. I went so far as to challenge these gentlement to invest with the corporate management that issues these options.

One of the interesting tangents that came up (via Prof Bainbridge) was the issue of technical analysis and the efficient market thesis. The good prof believes in the latter but not the former.

A few words on the subject are in order:

First, I am not a pure technician. I do use charts, but in combination with sentiment, valuation,  monetary analysis, trend, quantitative data and macro-economics. I am much less interested in the classic pattern recognition TA than I am in Trend and Market Internals. You don’t build a house with just a hammer, and there’s no reason not to use tools that have proven historically useful.   

Many of the charts I use are not what is commonly thought of as pure "Technical Analysis;"  Rather, they are often market internals: Up/down volume, Advance/Decline line, 52 week high/lows, % of stocks below 200 day moving average, etc.  — a true technician would call these quantitative and not technical.

However, I cannot imagine ever buying a stock without first pulling up a chart.  So I guess that makes me reliant on technical analysis in some way.

Second, we should note for the record that the Efficient Market Hypothesis has become an outdated — and disproven — cliche. The Random Walk theory and EMH posits that consistent and regular outperformance of the market is impossible. Even the father of the EMH, Burton Malkiel, the Princeton professor who wrote A Random Walk Down Wall Street, has admitted that the many talented managers have consistently outperformed the indices — something not possible under a truly random walk thesis.

These outperformers include many technical and quantitative driven strategies. Hence, why Malkiel abandoned his so called strong random walk thesis — it was simply wrong. The original concept had too many flaws, and too numerous holes poked in it. So he introduced the weak version, who’s primary attribute is that it is less wrong than the strong verison. Give Malkiel credit for recognizing the theories flaw and attempting to compensate for it.

Why are Markets inefficienct? The aggregation of irrational primates — Human investors. This is a burgeoning field called Behavioral Economics, and has produced several recent Nobel prize winners in Economics. It is also one of the reasons why the efficient market hypothesis frequently fails. See this for WSJ article for more details (if no WSJ, go here).

A perfect example of the failure of EMH can be seen in comments like this one"all information concerning historical prices is fully reflected in the current price."

That’s old school, and it is quite frequently a money-losing falsehood. Pray tell, what was embodied in the price of the market in March 2000, when the Nasdaq was at 5100, profitless stocks were trading at 50 times sales — and the marginally profitable ones were trading at 100 times earnings? Hmmm?

It turns out the market and the information embedded in the stock prices was simply wrong. Stocks were priced too high, markets were at unsustainable levels, and they subsequently crashed. The Nasdaq plummeted 78% over the next 2 1/2 years.

So much for the information contained in that pricing.

Fast forward to October 2002: the Nasdaq was at 1100, and many profitable, debt free companies were trading for below cash on hand. The market, in its pricing wisdom, had determined that a dollar was worth only 75 cents, and that profitable business operations were worth essentially nothing.

So much for the Wisdom of Crowds.

As I’ve written in the past, we have kinda sorta mostly eventually efficient markets — but that is not the same as actually being efficient as described in the random walk theory.

Markets have been shown to exhibit certain attributes – one of which is "persistency" — which makes outperformance possible. Look to these hedge funds with 10 year or better track records for more evidence of trend spotting and trading — what the EMH claims to be impossible.

Theoretically, these people — who have put together terrific long term performance records — cannot exist:

Bernard Baruch?
Bill Dunn (Dunn Capital)
John W. Henry
Tweedy Browne
Warren Buffett
Ed Seykota
Chris Davis
Richard Donchian
Richard Dennis
David Dreman
Louis Bacon
Tom Baldwin
Tom Basso (Trendstat Capital Management)
Peter Borish (Twinfields Capital Management)
Leon Cooperman (Omega Advisors)
Richard Driehaus (Driehaus Capital Management)
Stanley Druckenmiller
Jeremy Grantham
Kenneth C. Griffin (Citadel Investment Group)
Mason Hawkins and Staley Cates
Blair Hull (the Hull Group)
Paul Tudor Jones
Mark Kingdon (Kingdon Capital Management)
Seth Klarman
Bruce Kovner (Caxton Corporation)
Bill Lipschutz
Peter Lynch
Michael Marcus
Bill Miller
William O’Neil
Randy McKay
Roy Neuberger
Mark Ritchie (Citadel Investment Group)
Marty Schwartz
Jim Simons (Renaissance Technologies)
James B. Rogers, Jr (Quantum Fund)
George Soros (SorosTrading)
Victor Sperandeo
David Swensen
Michael Steinhardt
Julian H. Robertson Jr., (Tiger Management)
Monroe Trout
Jesse Livermore
Stan Weinstein
Marty Whitman

And yet they do.

If technicals are voodoo, and quantitative data irrelelvant, than kudos to Bloomberg for building a multi-billion dollar data analysis business on a scam.

Investors who rely on old, cliched and discredited theories do so at their own peril . . .

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UPDATE:  July 22, 2006 11:16pm

Incidentally, how efficient is the market if we are just now learning about  the 9/11 option grants, as well as the more than 2,000 companies that appear to have used backdated stock options in the  1990s?

Your answers should range from "Not very" to "Kinda/sorta" to "Eventually"

If the market ain’t all that efficient, then we should expect to see outperforming managers in numbers beyond mere chance . . .

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