AAII Investor Update: Are Stock Prices Random or Chaotic?

Thursday, March 29, 2012
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Picking the Right Stocks Using Charts
Tips on how to identify stocks with upward momentum.

Stock Price Movements Are Unpredictable
Statistical analysis shows stock prices are random.

AAII Discussion Boards
Do you use fundamental or momentum indicators?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 42.5%, up 0.1 points
  Neutral: 32.0%, up 2.2 points
  Bearish: 25.5%, down 2.3 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


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Price momentum is a key component of chart analysis. Traders commonly look for stocks moving in a certain direction or signs that the direction of a stock’s price is about to change. The idea is that momentum is a trader’s friend, if it can properly be identified and analyzed.

The argument against price momentum is that price movements are random. Share prices, many argue, adjust quickly to reflect new information, and new information cannot be predicted. Thus, trend analysis does not lead to improved long-term performance.

A study recently published by the American Institute for Economic Research (and recommended to me by an AAII member) suggests that price momentum may actually be the result of traders adjusting prices to incorporate trend information. Research fellow Shelly Liang points to the Positive Feedback Trading Hypothesis (PFTH), which says traders may buy a stock simply because the price is going up. Such decisions are therefore rational, as opposed to a reaction to a random event, because traders believe the existence of momentum is a reason for the stock price to rise higher. Hence, stock prices are chaotic, but not random. (I intend to publish the study in a future issue of the AAII Journal.)

How much validity you should assign to PFTH depends on whether you think stock prices move in a chaotic manner or follow a random walk.

The case for PFTH is that price momentum is driven by the actions of market participants. As a stock’s price begins to move in one direction, traders place orders to take advantage of the trend. As more traders buy (or sell) the stock, the upward (or downward) trend is extended. The trend then continues until new information emerges that warrants selling (or buying) the stock. Thus, price direction is chaotic, but not random.

The case for the random walk argument is that trends can appear in patterns that are actually random. Think of a coin toss. A coin can land on heads for several consecutive tosses. Yet, for each toss, the odds of landing on heads remain a very steady 50%, regardless of how often the coin landed on heads for the previous 10 tosses. Put another way, the chance of a roulette wheel ball landing on red or black is in no way tied to any of the previous spins; the odds stay at a steady 47%. Those who adhere to the random walk theory also point out that the timing of new data and news is unpredictable, and that stock prices react quickly to the introduction of new information.

I don’t think the argument that stock prices are random can be dismissed. The introduction of news, such as a merger announcement or revised earnings guidance, is often unpredictable. Economic conditions also change in ways that are not predictable in advance. On the other hand, it is important to note that incorporating price momentum indicators, such as relative strength, do help improve the performance of otherwise fundamentally-based stock screens.

The middle ground may be that while long-term price movements are random, over shorter periods, trends that attract investment dollars emerge. Thus, stock prices can be both chaotic and random over the short term (due to the combination of price trends and the introduction of new information) and random over the long term. The key is to realize that momentum should never be used as a sole strategy for selecting securities and that the mere existence of a trend does not imply that it will continue into the future.

More on AAII.com

The Week Ahead

If you turned 70 1/2 last year, you have until tomorrow, March 30, to take your first required minimum distribution (RMD). See IRS Publication 590 for more information.

The U.S. financial markets will be closed next Friday, April 6, in observance of Good Friday.

The only S&P 500 member company scheduled to report earnings next week is Constellation Brands (STZ) on Thursday.

The week’s first economic reports will be the March ISM manufacturing survey and February construction spending, published on Monday. Tuesday will feature March factory orders and the minutes from the March Federal Open Market Committee meeting. The March ISM non-manufacturing survey and the March ADP employment report will be published on Wednesday. Friday will feature March jobs data, including the unemployment rate and the change in nonfarm payrolls.

Three Federal Reserve officials will make public appearances next week. Cleveland President Sandra Pianalto will speak on Monday, St. Louis President James Bullard will speak on Monday and Thursday, and San Francisco President John Williams will speak on Tuesday and Wednesday.

AAII Sentiment Survey

Bearish sentiment fell to a seven-week low, while bullish sentiment stayed above average for the 15th time in the past 16 weeks in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 0.1 percentage points to 42.5%. This is the 14th consecutive week and the 15th out of the last 16 weeks that bullish sentiment has been above its historical average of 39%. This is the longest streak that bullish sentiment has been above its historical average since the period of September 9, 2010, to February 17, 2011, when optimism stayed above average for 24 consecutive weeks.

Neutral sentiment, expectations that stock prices will remain essentially unchanged over the next six months, rose 2.2 percentage points to 32.0%. This is a nine-week high and puts neutral sentiment above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 2.3 percentage points to 25.5%, a seven-week low. This is also the 13th consecutive week and the 14th out of the last 15 weeks that bearish sentiment has been below its historical average of 30%.

The difference between bullish and bearish sentiment, the bull-bear spread, is at 17.0 percentage points. This is the 13th consecutive week that the bull-bear spread has shown a positive double-digit differential, tying with streaks recorded in 2004 and in 2005. The bull-bear spread stayed in positive double digits for 35 consecutive weeks between July 2003 and March 2004.

Driving the optimism about the short-term direction of stock prices are continued signs of an improving economy and the market's strong first-quarter performance. Tempering this optimism are concerns about the slow pace of economic growth, rising gas prices, and Europe’s sovereign debt problems.

This week's special question asked AAII members how often they buy or sell when their sentiment about the short-term direction of stock prices changes. The overwhelming majority of respondents said they do not buy or sell stocks based on changes in their short-term sentiment.

Here is a sampling of the responses:

  • “I rarely sell on short-term direction, but I will buy if a good stock becomes a bargain.”
  • “Never, if the only reason is the short-term direction of stock prices.”
  • “Rarely; it's difficult to outguess the market.”
  • “Short-term direction has no effect on my buying or selling, as I am looking long-term. However, if the short-term market is down, I am more likely to buy.”
  • “I trade based on the expectations for a particular stock, not on short-term market direction.”
  • “It depends on what is else happening in the world and how that affects stocks.”

» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor