Non-Random Walk Theory

• Economists Andrew W. Lo and A. Craig MacKinlay criticized Malkiel's Random Walk theory in their book, A Non-Random Walk Down Wall Street

Criticisms

• Short Term Momentum, Including Underreaction to New Information

Lo and MacKinley pointed to the presence of some "momentum" in short-run stock prices. Momentum is a series of repeated price changes in the same direction. Lo and MacKinley also addresses what they believed to be a common phenomena of underreaction to new information. This means that the stock is undervalued and that you can profit by accurately assessing the new information in its entirely.

Malkiel's Response

The statistical dependencies giving rise to momentum are extremely small and unlikely to provide the opportunity to achieve excess gains. Momentum strategies (buying stocks that show positive serial correlation) produced positive relative returns in the 1990s but negative relative returns during 2000. The most predictive patters seem to disappear as quickly as they are published.

• Long Run Return Reversals

Fama and French found that up to 40% of variation in long holding periods can be predicted with a negative correlation with past returns. This supports the contrarian strategy.

Malkiel's Response

Return reversal may be accounted for by efficient function of markets based on the volatility of interest rates. Stock prices must rise and fall to be competitive with bond prices. If interest rates revert to the median over time, this generates return reversals. Malkiel used a thirteen year experiment and simulated a strategy of buying stocks over a thirteen year period during the 1980s and 1990s that performed particularly poorly in the past 3-5 years. These stocks had higher returns in the next 3-5 years after performing poorly in the previous years. After this period the strategy failed.

• Predictable Pattern Based on Valuation Parameters

Valuation ratios such as the price-earnings multiple or the divident yield of the stock market as a whole have considerable predictive power.

1. Initial Dividend Yields

Ratio of dividend to stock prices

Campbell and Shiller claim that initial dividend yields account for 40% of stock price variations

Experiment:Divided the S&P 500 into deciles based on their initial dividend yields

Conclusion: Investors experience a higher returns on market baskets comprised of equities with high initial dividend yield (Insert Graph)

2.Price - Earnings Multiples

A similar experiment was done with price-earnings multiples of the S&P 500. As you can see from the graph (insert graph) the deciles with higher price-earnings multiples generated lower returns relative to stocks of companies with lower price-earnings multiples. Again, Shiller claimed that study of the price-earnings multiples could account for 40% of all variations.

Malkiel's Response

FINISH

• The Size Effect

One of the most accurate and consisten predictors of returns is the size effect. Smaller companies generally have higher relateve returns to their large company counterparts. Since 1926, small company stocks have had annual rates of return 1% greater than American large corporations.

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Random Walk | Efficient-Market Hypothesis | Fundamental Analysis | Technical Analysis | Non-Random Walk Theory | Market Efficiency vs. Behavioral Finance