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Far from Random
Using Investor Behavior and Trend Analysis to Forecast Market Movement
Richard Lehman
Behavior-based trend analysis debunks the random walk theory
Format: hardcover
ISBN: 9781576603239
Publisher: Bloomberg Press
Pub. Date: 11/2009
256 pages, 6" x 9"
Retail Price: $39.95
Your Price: $33.96
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Since Burton Malkiel’s seminal work A Random Walk Down Wall Street was published, the financial world has swallowed whole the idea that market movement is chaotic and random.
In Far from Random, Richard Lehman uses behavior-based trend analysis to debunk Malkiel’s random walk theory. Lehman demonstrates that the market has discernible trends that are foreseeable. By learning to spot these trends, investors and traders can predict market movement to boost returns in anything from equities to 401(k) accounts.
Richard Lehman has been a financial professional for more than thirty years. He studied the first iterations of behavioral finance back in the 1970s as a financial marketer and has since worked in various facets of the financial industry. His early introduction to behavioral finance and the more recent introduction to trend analysis led him to this important discovery.
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Richard Lehman is the coauthor of New Insights on Covered Call Writing, with Lawrence McMillan (Bloomberg Press, 2003). Lehman is an instructor of both finance and derivatives at UC Berkeley Extension and a vice president in the wealth management group at Mechanics Bank in Richmond, California. His financial career spans more than thirty years in product management, marketing, and investment management, beginning with an eleven-year stint on Wall Street with E. F. Hutton, Thomson McKinnon, and the New York Stock Exchange. He lives in Richmond, CA.
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Foreword by Lawrence G. McMillan
Acknowledgments
Preface
Introduction
PART I A Market of What?
1 The Time Has Come
2 Fundamentally Flawed
3 Subjective Value
4 Random and Efficient Markets
5 Market Timing
PART II Behavior, Behavior, Behavior
6 New Thinking in Finance Isn’t Financial
7 The Behavioral Phenomenon
8 Anomalies
PART III Charting a Golden Path
9 A New Market Paradigm
10 Introduction to Trend Channel Analysis
11 Reading Between the Lines
12 Putting It All Together
Index
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From Introduction
The Trend Channel Epiphanies
As we all know, epiphanies are those “aha” moments when a swarm of previously unconnected nodes in your neural network suddenly link up to expose some kind of significant revelation. The cartoon depiction of an epiphany is the illumination of a giant lightbulb hovering over one’s head. Two operative characteristics of epiphanies are that they are by nature instantaneous and they tend to turn previously intuitive notions upside-down. Mine held true to the latter but occurred in a more choppy fashion, with smaller epiphanies occurring over many years. I didn’t even notice the lightbulb was lit until it had burned off most of my hair.
When ETFs arrived, I began tracking them by drawing simple trend lines connecting peaks and troughs on the price charts of major indexes like the Dow Jones Industrial Averages, Standard & Poor’s 500 Index, and Nasdaq-100. The first epiphany was that parallel straight lines contain much of the market’s zigs and zags in both short- and long-term time horizons. The second was that with a few intuitive modifications, they contained virtually all of the market’s moves. The third was that trend lines worked extremely well on five-minute price charts, allowing for almost instantaneous recognition that the trend was changing or modifying itself. These were significant epiphanies, but the most important was yet to come.
There was inherent conflict between explaining the market’s price behavior through technical analysis during the trading day and explaining it in terms of classic financial principles in the courses I taught at night. The two didn’t mix. I began to read more and more about traditional finance in an effort to reconcile these opposing ideas. I read Malkiel’s A Random Walk Down Wall Street. That led me to the books debunking the random walk and the related efficient markets hypothesis, which began my descent into the maelstrom of what is now called behavioral finance. Ironically, the notion that investor psychology could affect the market’s action connected me all the way back to the original revelations in investor psychology from the NYSE study in 1978 and to Prechter’s wave analysis. It all came together—the studies, the weaknesses in classic finance, the charting, the behavioral work, and the realization that the charts were eloquently telling me what classic financial analysis could not: The stock market is not random after all; it is a function of the aggregate psychology and behavior of the participants and can be interpreted through an analysis of price charts, using techniques such as trend channel analysis. Furthermore, if not random, then the market is also, at least to some degree, predictable!
The Behavioral Perspective
This book examines the stock market from a behavioral perspective, building on a growing body of content that views the action of the stock market not simply as a compilation of the actions of individual stocks but as the compilation of the actions of the participants. This perspective will add a new context to investment decision making that can make all of us better at tailoring our investment strategies. Such a perspective has been sorely missing in the industry and the media. The trend channel technique described in this book is a new way to interpret the behavior of the market and can be utilized to enhance existing investment strategies or formulate entirely new ones. I offer this theory empirically, as a result of years of observation and technical analysis of the equity markets coupled with my knowledge as a thirty-year financial professional and as an instructor of both corporate finance and options. Skeptics may claim that my technique is unproven as a means of managing investments. You can decide for yourself whether my hypothesis has merit or whether you want to wait twenty years for the theory to be fully accepted by the investment community.
For all intents and purposes, virtually all of the research in behavioral finance has thus far been conducted by the academic community. While a valuable body of work has been amassed, much of it suffers from a lack of practical trading and investing knowledge. Richard Thaler, a Cornell professor who compiled a number of behavioral finance papers into Advances in Behavioral Science (The Russell Sage Foundation, 1993) and Advances in Behavioral Finance Volume II (The Russell Sage Foundation, 2005), admits that a great many papers on behavioral finance have been written by recent doctoral graduates and that their lack of industry experience tends to show up in their assumptions as well as conclusions. Most important, while the fact that behavior affects stock prices has been convincingly demonstrated, little has been drawn from these findings to alter investment strategy. We may know more, but we have yet to meaningfully incorporate that knowledge into the practice of investment management.
While my trend channel observations occasionally yield moments of astonishing accuracy in predicting market movement, there are occasions that fall short of expectations and others that prove later to be false signals. Frequently, the observations require interpretive judgment. As such, this analysis is not in any way presented as a crystal ball or as a formula for calling every top and bottom with perfect accuracy. However, it need only provide an edge to be a highly useful and effective tool. A blackjack player doesn’t need to know the order of the deck to beat the house. He just needs to have enough knowledge to put the probabilities slightly in his favor. The same is true for investors and traders.
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