The “random walk” is a near universally accepted axiom of equity markets, and it is a fundamental feature of all institutional investor strategies. It is also why day trading, whilst popular among retail investors, is virtually unheard of in the world of professional money management.
Day trading is largely based on technical analysis of price movements, which assumes that the movements from moment to moment can be predicted by patterns that appear in past price action. Although technical analysis remains a feature of the CFA curriculum and is sometimes used in price discovery, it is not a sole determinant in professional asset allocation and investing for one simple reason: it is not verifiably predictable with any sort of consistency. The reason? The random walk.
The idea of the random walk is that prices more often will move in a random rather than predictable pattern when looking on any short-term basis, rendering technical analysis and thus day trading largely if not entirely ineffective. And recent market movements tend to confirm this theory.
After a 3% drop on January 3 for the S&P 500, the index jumped 3.4% on January 4, mostly erasing the prior day’s losses. These kinds of major moves are unusual for the index, and what makes them even more unusual is that they are unprecedented over the last decade of price action. While some major moves have been observed, since the Great Recession and market downturn ending in March 2009, stocks have rarely seen more than 2% moves, and even more rarely have they moves so much in one day to one side only to be followed by as extreme a move to the other direction on the very next day.
There are many explanations for why this is happening now: the end of quantitative easing and higher interest rates, fears of the trade war, an inverted yield curve coming closer and closer, and a top to liquidity, credit availability, and economic growth. Note that these are all macroeconomic explanations, and none of which have anything to do with the random walk of short-term price movements.
They do, however, imply a longer-term trend: if the fears are warranted (and they may not be), it may signal a bear market and more severe downturn in equity prices in the future. If that is going to happen, some market participants might decide to get ahead of that downturn and sell now. If enough decide that at the same time, you get a 3% drop like the one we saw last week.
The bull case, on the other hand, argues that such a downturn, while definitely possible, may happen at some point far in the future after stocks have already gone up as much if not more as they will temporarily go down. As a result, it makes sense to buy now during this market volatility and hold. If enough buyers think this way, you will get a 3% increase like the one we saw last week.
There are, of course, fundamental considerations as well. Apple (AAPL) gave surprising bad news on Thursday, kickstarting the drop that was seen in the S&P 500, since AAPL is one of the largest constituents of that index. Sympathetic sell-offs of other companies, whom one could argue will suffer similar fundamental headwinds alongside Apple, could exacerbate the pain for the index.
As a result, it’s clear that both fundamental (bottom-up) and macroeconomic (top-down) analyses can explain price movements coherently and consistently more often than technical indicators can. The key for the analyst, then, is to make these analyses often enough and fast enough to anticipate what direction the random walk will go in, even if its randomness means one cannot anticipate them all or even most of the time.