Is There Momentum in the Stock Market?
Past stock prices cannot be used reliably to foretell future movements. Furthermore, transactions costs and taxes make it hard to exploit any short-term momentum.
Flip a fair coin many times. Sequences of heads (or tails) and jumbled up sequences occur with equal probability.
Just What Exactly is a Random Walk?
In a random walk, knowing all prior moves is no help in predicting the next move.
The pronounced “cycles” that we seem to observe in coin tossings or in the stock market don’t occur at regular intervals. This lack of regularity is crucial.
The weak form of the random-walk hypothesis: the history of stock price movements contains no useful information that will enable an investor consistently to outperform a buy-and-hold strategy in managing a portfolio.
Some More Elaborate Technical Systems
More elaborate technical systems, e.g. The Filter System, The Dow Theory, The Relative-Strength System, Price-Volume Systems, Reading Chart Patterns, achieve returns similar to buy-and-hold after transaction costs.
Other technical theories that aren’t any better: The Hemline Indicator, The Super Bowl Indicator, The Odd-Lot Theory, Dogs of the Dow, January Effect, Technical Market Gurus.
Randomness Is Hard to Accept
The “hot hand” in basketball is a myth. The streaks are not unusual for a random set of data. Psychologists conjecture that long sequences of misses or hits are more memorable - making observers likely to overestimate the correlation between successive shots.
Appraising the Counter-Attack
But in the long run, future earnings must influence present value, and in the short run, the crowd’s temper dominates. Thus, the market isn’t random…
- The crowd’s irrationality doesn’t imply predictability.
- New fundamental information about a company, e.g. mineral discovery, is unpredictable.
No one can prove conclusively that technical methods can never work…
- People will act in a way that prevents regularities from happening in the future. Any successful TA scheme must ultimately be self-defeating.
Implications for Investors
With the best 5 days in each year from 1900 to 2013, $1 in the Dow Jones Industrial Average grows to $290. Without those 5 days per year, the $1 investment would be less than a penny in 2013.
Market timers risk missing the infrequent large sprints that are the big contributors to performance.
The foundational paper that discredited the hot hand by Gilovich, Vallone and Tversky (1985) for defined evidence for the hot hand as the probability of a hit being higher after a streak of hits than the probability of a hit after a streak of misses. Miller and Sanjurjo (2018) contend that the expected rate of hits after a streak of hits should be lower than the rate of hits after a streak of misses. An equal rate of hits to misses after a streak is thus a sign of a hot hand. MS contend that GVT incurred a sampling bias for they started counting after a series of hits/misses, which introduces a negative bias given that the sample size is small. Hot Hand (en.wikipedia.org) .