T
he first Wednesday of every month was when the Chicago Mercantile Exchange (CME) board of directors would meet. This was preceded by a strategic planning committee meeting on Monday and an executive committee meeting on Tuesday. Leo Melamed, chairman of the strategic planning committee, asked me to sit on his committee and Scott Gordon, then chairman of the CME, asked me to be a member of the executive committee. The strategic planning and executive committees constituted the board within the board, the group that set the policy and the agenda for the upcoming board of directors meeting. Every facet of the policy-making process was of great interest, but the highlight of the month was when I would get a chance to sit and talk with some of the greatest minds in the world.Before the board meetings, lunch would be served in the executive meeting room just down the hall from the boardroom. During those lunches I was able to meet and have dialogues with Senator Paul Simon and Professor Merton Miller. During one of our lunches, the subject of the rallying stock market became the topic of discussion. Everyone had an opinion on why the tremendous movement in tech stocks was happening. One of the more informed opinions came from Ward Parkinson, who had founded Micron Technologies but had since left the day-to-day activities for a semiretired life in the western United States. Parkinson observed that the world was going through a technological revolution that could make the industrial revolution look small in comparison—a very insightful comment from a man who was an integral part of the deployment of technology to the mass market.
As the discussion turned to Dr. Miller and his thoughts on the market, I noticed an interesting change in his appearance from the relaxed posture he normally assumed to one that was upright and serious. I had a feeling he was about to say something of significance. (Either that, or he was simply tired of sitting in the same position.) Fortunately, he was serious, and he talked for the next 20 minutes about the movement of equities and the random walk theory. I sat in awe, listening to what many have paid thousands of dollars to hear—Merton Miller’s Nobel Prize–winning thoughts on the mar- kets and the economy.
Coming from the University of Chicago business school, Merton was a classic random walk theorist. In fact, it was largely his work that was used as the basis for what we consider today to be the random walk theory. During this particular speech, he made many cogent observations about the euphoric condition the market was then experiencing, but the one con- sistent theme was that the market will do whatever it wants and that the market is organized chaos. He told me that the first serious work on random walk theory was done by Paul Samuelson in 1965, explained in an article entitled “Proof That Properly Anticipated Prices Fluctuate Randomly” and the other academic works that followed.
As we left the lunchroom for the boardroom that day, I walked with Merton and asked him whether he considered himself a random walker. His response was pure Merton: “Jack, my boy, every theory and invention evolves over time. Who remembers today that steam engines were originally invented to pump water out of coal mines?”
A Random Walk Down Wall Street was written by Burton Malkiel in
1973 and put into print the fundamental premise that it is impossible to outperform the market on a consistent basis. In other words, all the technical work in the world will not help in the grand scheme of things because in the end, investors are better off buying and holding rather than trying to time the market—it is too efficient. Malkiel’s work, which was adopted by a majority of the academics at the time, questions the validity of both technical analysis and fundamental analysis.
To the trader who spends hour upon hour staring at charts looking for a chance to identify a pattern, the thought of randomness in price action is tantamount to heresy. The random walk theory also suggests that any success in timing the market is nothing more than sheer luck. The law of averages would also suggest that if enough people are trading the market, some will make money—but in the long term, these individuals still can’t outperform the market.
Listening to Merton talk about random walk theory was very insightful. It gave me an idea of what is being taught at the major business schools and, better yet, how they are being taught the theory. I don’t think that Merton subscribed to the idea that all price action is random. He found that
most technical analysis was a waste of time because price movements on a daily, intraday basis are random. Prices have no memory—they have no past or present—that’s why they can’t be used in analysis to predict where the market will be in the future. He went on to say that any movement in prices is due to information that hits the market at that moment. As soon as the information becomes available, the prices are adjusted accordingly. The only difference is that the speed at which information is disseminated to- day gives the entire trading universe access to much the same informa- tion, creating a more level playing field. Merton asked me, “How many mu- tual funds have outperformed the S&P 500 index consistently over the last 20 years?” He had a point—fund managers were having a difficult time matching the averages, let alone outperforming them. In the long run, in- dexing the market would prove to be the most profitable.
One of the first things that hits someone who ventures to any of the futures exchanges that still use the open outcry method is the chaotic con- dition that prevails during the trading session. When I first began to trade, it was virtually impossible to detach myself from the noise and emotion that were all around me. I wondered if there was any reason for the price action, or was the movement in the market simply a product of the order impact hitting the market at any given time?
The concept of the random walk is one that many traders have a difficult time digesting. The problem lies in the fact that pattern recognition is the basis for every type of analysis, whether it is technical or fundamental. It seems fairly clear that a fundamental approach to the market relies on the past to understand the present and, hopefully, result in a profitable future. A technical trader looks for the same pattern to repeat itself, thus finding a high-percentage trade from the available information.