Thursday, August 21, 2008

The New Contrarian Investment Strategy: Chp 2: Can You Read the Future?

Dreman educates readers on two of the main schools of thought regarding stock market pricing. He wants readers to understand the origin of many of the prevalent theories that he feels won't help investors much and yet are common on Wall Street. The two market schools of thought are referred to as the fundamentalist and the technical schools.

The fundamentalist school assumes a rational market and that inherent stock values can be calculated by examining detailed information about the economy, the industry and the individual company.

The technical school views stock prices as already reflecting all the known information and attitudes regarding stocks and that only supply and demand factors need to be examined to determine a stock’s future price. According to the technicial analyst, all the hopes, fears, greed, and other emotions are synthesized across all market participants and reflected currently by the price of the stock. Technicians use charts of price and volume to determine trends. Some theories are complex and are based on wave theory, Fibonacci numbers and other charting techniques.

Interestingly, academic findings suggest that technical analysis doesn't work. In the early part of the 20th century, Bachelier, a brilliant French mathematician, showed in this work that past market prices don’t help in predicting future prices. Today, an overwhelming body of evidence supports the idea that future prices cannot be predicted from past changes. Without exception in these academic studies, prices were found to act randomly relative to past prices. The random walk hypothesis grew out of this academic work and indicates that technical analysis is not useful. Dreman singles out works by Arnold Moore, Clive Granger, Oskar Morgenstern and Eugene Fama as the academic underpinnings of the random walk hypothesis.

It’s instructive to note that despite the damaging academic research, technical analysis is still flourishing on Wall Street today. Dreman insightfully observes that many market theories survive due to the willingness of people to believe in them as opposed to rational analysis of fact. He ends the chapter with the relevant Einstein quote “the theory shapes the observations”

1 comment:

Reyer Barel said...

Lots more detail in this chapter. The book is quite colorful in descriptions with lots of anecdotes. This book should be in every value investor's library.