Vol 3, Issue 7. Quarter 1 – 2026.

As a Professor of Operations Management I am often reminded of the huge contributions of Andrey Markov.

(Who the hell is that?)

Markov was a Russian mathematician who dedicated most of his professional life to the study of stochastic processes.

(The study of what? )

A stochastic process is one that moves from one position (or state) to another in a random way. In fact the timing of the move, the direction of the move, and the size of the move can all be random variables.  Such processes can be notoriously difficult to understand and are typically impossible to predict.

However, Markov specialized in a small subset of these processes that were “memoryless.”0

(I am forgetting ths already!)

Memoryless means that the path taken to the current state or position tells us nothing about the next step. In such cases, the best that can be done is to use history to estimate the distributions that define the step timing, direction, and size. These processes ultimately came to be known as Markov processes. The analysis of Markov processes have found applications in a wide array of problem settings including queueing theory, inventory theory, and Yes – stock prices.  In fact, much of the research on stock prices in the first half of the 20^th century focused on estimating the parameters needed to define a Markov process that described price movements.

(English please!)

The most widely heard representation of such processes is probably the “random walk.” This is the idea that we if we look at price movements over some longer span of time and estimate the share of movements that are up or down, that is the best that we can do, in terms of prediction. Just as a point of reference, the S&P 500 went up roughly 56% of the time and knowing what happened the previous day, or the two previous days, etc. adds no predictive power. If stocks follow such a process then the answer to the question “what direction will prices move tomorrow” is always the same.  “I don’t really know but there is about a 56% chance that it will go up.”

Such a statement enrages the stock picker who is typing right now to call me every synonym for idiot that he can think of. “Movements are not random, dumbass. There is always a reason!!! You are a moron.” Fortunately, multiple things can easily be true. I probably am a moron, and there is always an explanation for the price movement – AFTER THE FACT!! Turn on the financial news television or radio after the closing bell and you will hear a beautiful narrative about why “the market” went up or down that day.  “The market rose on expectations of rate cuts,” or “The market fell due to tensions in the middle east,” or “the market went up and then fell because Mars was in retrograde until 11 AM and Taylor Swift sneezed in the afternoon.”  OK, I made that last one up. The point is that social, pattern seeking animals (like humans) will universally grab hold of a good narrative that “explains” what just happened. Every story that they tell you as an explanation is one that they made up. Furthermore, after we hear the story we will almost always conclude that we saw it coming anyway – “its just common sense” we will say – – after we know the outcome.

Here is how you show TRUE brilliance!

Perhaps you recall that fine spring day in 2008 when Ford stock sold for $0.97 per share, or that obvious opportunity in 1997 when Apple sold for roughly $3.75. We all “KNEW” that was a great deal – right??? That’s why you bought all of those shares at those great prices and you are a billionaire now.

One small correction – you didn’t buy any of it on those days did you? You know why? Because it wasn’t at all obvious at the time that this was a good buy. In fact, common sense screamed the exact opposite. Writing the story after the data is in is always easy, but irrelevant. The trick is to see the story before the data writes it. If you can consistently do that (and you can’t) then you are a great stock picker. If you cannot – then you are not a great stock picker. Go back to work, let the market do its thing and check on it a little later – like after a decade or so and see what you have.

The fundamental value of a share of stock is the present value of future related cash flows, including dividends and profits. This does not change because the stock rose from where it was last week, or last month, or shows some pattern relative to its 200-day moving average. (Many readers just lost their minds. Hold on. It gets worse.) Note that this is not to say that history doesn’t matter. McDonalds historically has done better when the economy slumps because it will attract bargain shoppers in tight economic times. This isn’t changing any time soon. In that sense, history certainly does matter. But that history has already been “baked in” to the current price because it sets up expectations about the future. The exact pattern of price movements over the last 30, 60, 90, 180, or 360 days has nothing to do with any future price changes.

The simple explanation as to why looking for patterns is the wrong way to pick stocks is this. You don’t invest in stocks. You invest in companies. Companies organize the ways that people manage assets and products while other people (called customers) interact with those products and assets. The real people involved did not change their behavior this morning because they saw some perfectly random pattern in the price of the stock last night, last week, last month, etc.

The worker, manager, customer, or competitor is not managing the chart. They are managing their work, employees, household budget or business. This is why I cannot buy into the basic argument of the technical analysts. It’s not that history doesn’t matter. It is that the type of history that does matter is already accounted for and the next move is a result of the actions of thousands or even millions of people reacting to NEW information that wasn’t there when that pattern emerged. The folks that matter now don’t take what the old chart shows into account when they go about their lives.

My stock picking strategy is just too sophisticated for you to understand!

Let me deal with the 800 pound gorilla in the room. Many stock pickers and technical analysts will try to claim that I am saying that patterns don’t matter because markets are perfectly efficient. I am a bit slow, but I have  never been dumb enough to say that, and for very good reason. Just as an example consider a famous  paper on the topic that is both simple enough to explain, and sufficiently powerful to make a useful point. In 1988, Andrew Lo and Craig MacKinlay (Lo & MacKinlay, 1988) published a paper that dealt with 2 simple questions. If stock prices follow a random walk then a number of things must be true. First they asked whether weekly returns are trule uncorrelated, and second, whether the variance of the total return grows linearly with time. These statements are true if (and only if) prices follow a random walk. In other words the return from week i should bear no relationship to the return from week i + 1. Looking at data from 1962 to 1985 for small company stocks they found that the weekly returns had a correlation of about 30% and the variance grew faster than it should. They argued (correctly) that if this is true then one can make millions trading short term options on small company stocks. They then demonstrated this using historical data. Many professors and other eggheads were outraged over this finding and argued that there had to be some mistake. They were wrong. There was no mistake. If the price for the stocks that they were studying rose in one week, there was a better than even money bet that it would rise in the next week as well. You could leverage this fact using options or by active trading and make a lot of money.

But Chester, you said that markets are highly efficient, and that means that this can’t work – what gives? Nothing. The authors were correct, and a few people did make a killing. In fact, this worked until lots of people figured out the game. When that happened, they looked to buy the options needed to use the strategy. Once the demand for such options rose, their prices rose, and the easy profit went away. As Lo and MacKinlay put it, markets are not perfectly efficient, but they are Adaptive. Some information is absorbed almost instantly, while other information takes longer to filter through the system. However, it will happen after some lag. Once that happens, the glitch that you saw goes away and you have to come up with a more esoteric strategy that might work for a while, until the market adapts to that. You then have to move on to the next trick in your bag, and so on. If you are smart enough to pull that off, knock yourself out.

But here is the dirty little secret – you’re probably not that smart. And by “probably” I mean I am about 99.9999% sure of it. Most of the people who thought that they were smart enough to pull this off lost their shirts. A few did make a killing, but the vast majority made nothing, or at best made what the market averaged. Never forget this simple fact. If a million people try random strategies, one of them will do better than the other 999,999. That doesn’t prove that they know what they were doing, or that you can ever replicate that success. At the same time, I can use simple index funds to buy the outcome that beats the overwhelming majority of those speculators with no effort, almost no cost, and I have the advantage that this approach will last as long as I may live and centuries after that. My only claim is that, that’s the best deal out there, and you should take it NOW, ALWAYS, and FOREVER.