September 10, 2014

We Interrupt this Random Walk…

The “random walk” is a theory postulating that stock prices evolve randomly and cannot be predicted. A Random Walk Down Wall Street, by Princeton economics professor Burton G. Malkiel, made the theory famous by suggesting that a coin flip would be as accurate as most stock picking strategies.

On August 25th, investors cheered as the S&P 500 Index rallied and touched 2,000 for the first time, pushing stocks’ year-to-date return up toward 9%.

But then, for the next seven trading days, something very unusual happened.

Between August 25th and September 4th, The S&P 500 Index barely budged, closing each day within 4 points (0.2%) of the historic 2,000 milestone. On a percentage basis, it was the narrowest eight-day range of day-end closings since 1968. Why did this happen?

Was this peculiar eight-day range-bound period caused by psychological factors, technical factors, or just pure chance? While we may never know for sure, it’s important to bear in mind that asset prices are ultimately driven by human behavior. As such, they will not always travel in a truly unfettered “random walk,” particularly in the short term.

For the vast majority of us who are focused on a long-term investment horizon, this recent anomaly is more of a curiosity than a concern. Because, to paraphrase Benjamin Graham, the father of value investing, the market acts like a “voting machine” in the short run, showing which firms are popular or unpopular, but it acts like a “weighing machine” in the long run, with long-term prices reflecting companies’ fundamentals. With this in mind, we’ll continue to focus our analysis on the fundamental factors that are the primary drivers of long-term return, and leave these short-term anomalies to the day traders.