Can stock market prices be predicted? Can they be predicted with enough strength to make profits?
The current wisdom may be that market predictability is like craps. That is, you might win (correctly predict) for a while, maybe walking away with nice winnings, if you are lucky. But over the long haul, the casino is the winner.
This seems close to the view in Andrew P. Lo and Craig MacKinlay’s A NonRandom Walk Down Wall Street (NRW), a foil to Burton Malkiel’s A Random Walk Down Wall Street, perhaps.
Lo and MacKinlay (L&M) collect articles from the 1980’s and 1990’s – originally published in the “very best journals” – in a 2014 compilation with interesting intoductions and discussions.
Their work more or less conclusively demonstrates that US stock market prices are not, for identified historic periods, random walks.
The opposite idea – that stock prices are basically random walks – has a long history, “recently” traceable to the likes of Paul Samuelson, as well as Burton Malkiel. Supposedly, any profit opportunity in a deeply traded market will be quickly exploited, leaving price movements largely random.
The ringer for me in this whole argument is the autocorrelation (AC) coefficient.
The first order autocorrelation coefficient of a random walk is 1, but metrics derived from stock price series have positive first order autocorrelations less than 1 over daily or weekly data. In fact, L&M were amazed to discover the first order autocorrelation coefficient of weekly stock returns, based on CRSP data, was 30 percent and statistically highly significant. In terms of technical approach, a key part of their analysis involves derivation of asymptotic limits for distributions and confidence intervals, based on assumptions which encompass nonconstant (heteroskedastic) error processes.
Finding this strong autocorrelation was somewhat incidental to their initial attack on the issue of the randomness, which is based on variance ratios.
L&M were really surprised to discover significant AC in stock market returns, and, indeed, several of their articles explore ways they could be wrong, or things could be different than what they appear to be.
All this is more than purely theoretical, as Morgan Stanley and D.P. Shaw’s development of “high frequency equity trading strategies” shows. These strategies exploit this autocorrelation or time dependency through “statistical arbitrage.” By now, though, according to the authors, this is a thin-margin business, because of the “proliferation of hedge funds engaged in these activities.”
Well, there are some great, geeky lines for cocktail party banter, such as “rational expectations equilibrium prices need not even form a martingale sequence, of which the random walk is special case.”
By itself, the “efficient market hypothesis” (EFM) is rather nebulous, and additional contextualization is necessary to “test” the concept. This means testing several joint hypotheses. Accordingly, negative results can simply be attributed to failure of one or more collateral assumptions. This builds a protective barrier around the EFM, allowing it to retain its character as an article of faith among many economists.
Andrew W. Lo is a Professor of Finance at MIT and Director of the Laboratory for Financial Engineering. His site through MIT lists other recent publications, and I would like to draw readers’ attention to two:
Can Financial Engineering Cure Cancer?
Reading About the Financial Crisis: A Twenty-One-Book Review