Non-Random Walk Theory
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- 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.
- Malkiel's Response
- 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.
- Malkiel's Response
- 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.
- 2.Price - Earnings Multiples
- Malkiel's Response
- FINISH
- Malkiel's Response
- The Size Effect
Random Walk | Efficient-Market Hypothesis | Fundamental Analysis | Technical Analysis | Non-Random Walk Theory | Market Efficiency vs. Behavioral Finance