Random Walks, Flash Boys, and You: Beating the Market in 2024 and Beyond

Markets may be efficient, but they’re not perfect. Discover how to navigate the noise and seize real opportunities.

Practically perfect in every way. I have caught myself speaking about a core construct in finance an awful lot lately. I first learned about it in my undergraduate studies, and it seemed to me – to be rather useless – at the time. However, it kept coming back in the many countless finance courses I took over the decades. Alas, it is still one of the first things we teach in finance today.

Its modern form came from one of Eugene Fama’s seminal works in finance; that’s right, there are more than one, but let’s focus on this one for today (Fama EF. Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of finance (New York). 1970;25(2):383-. doi:10.2307/2325486). As you can see by the citation, Fama introduced in 1970 what is known today as the Efficient Market Hypothesis (EMH). He later won a Nobel Prize related to this work, which should underscore for you the importance of the concept. When I learned about it in the early 1980s, it appeared to me as an outdated academic concept which was promptly parked in the “remember for the exam then erase it from memory immediately after” file.  Was I wrong.

First, what in the world is the Efficient Market Hypothesis? I will teach it to you in a more practical way than I was taught it 😉. The concept boils all market behavior down to these assumptions: 1) investors act rationally, 2) information is widely available and reflected in asset prices, and 3) markets instantly adjust to newly available information. There, I made it really simple for you, no so-called "weak or strong forms,” no, it is that simple, the market reflects all available information. So, simple, that I thought it to be bunk the minute I learned it. I rationalized that, if the theory was correct, nobody could actually get a leg up in the stock market, and as I had dedicated my life to Wall Street already at that tender age, I thought I would have two choices: 1) refute Fama’s assertions and go on to prove him wrong, or 2) go back to the engineering program and make my father happy. You all know which path I took.

Now, it is important to note that Fama was not really the first superstar academic to come up with the broader concept. You just have to check his citations to see a procession of important names that date back to 1900. Notable was Louis Bachelier, the French mathematician, who wrote about the concept in his 1900 doctoral dissertation. In it—and I am taking a lot of liberty here (sorry academic friends)—he applies an earlier physics concept called "Brownian motion” to finance to describe what ultimately came to be recognized as a random walk. 💡

You may have heard of the famous 1973 book by Burton Malkiel, “A Random Walk Down Wall Street.” You may have read it. Please do, if you haven’t. In the interim I will summarize it here. Malkiel argued that stock prices are random, or unpredictable, and that past price movements have no impact on what happens in the future. In other words, markets are efficient and there is no active strategy that can beat the market. This assertion was, of course, built on the works of Bachellier, Fama and a short list of other very famous finance and economic luminaries.

Ok, so you can see why I chose to write that one off. Why dedicate your career and decades of academic pursuits if you can accomplish all that you need with a dart and the stock market closes from the Wall Street Journal. So, yeah, I ignored it, but as I said before, it kept coming up, and as I progressed in academia through graduate studies, it came up yet again, even in my more practical, applied courses. Eventually, I simply decided to just put it down in a notebook of things to consider, and that was it.

And that was it… until I started to work on Wall Street. In my first job as a bond trader, I quickly figured out that if I could get to the office before everyone else, I was able to take advantage of what I could learn from the trading session in Japan. Remember this is before the internet. Ok, so early bird gets the worm, we get it. But still, I was not the only nut-job on the downtown Lexington Ave 4,5,6 train. No, there were quite a handful of other espresso’ed up insomniacs out there, but still, we had an edge over the majority.

Soon I found that I could use an early form of spreadsheets (VisiCalc the Lotus 123) to track lots of markets at once. This enabled me to outperform the other traders in arbitrage trades. They simply could not efficiently calculate all the necessary numbers using pen, paper, and adding machine. OK. So, I thought I had proven the theory wrong… until more and more firms began to apply technology to solving the problem. That technology made the market more efficient as more and more traders found the same anomalies that I found. Those trades quickly became crowded, and the profits diminished.

Turn the clock forward to the late 1990s with the advent of the internet and Yahoo! Finance. Having a Wall Street Journal tucked under the arm suddenly became more of a fashion statement than a necessity for success. The decade that followed saw the world became one giant, connected information repository. News now travels at the speed of light, which is pretty fast. Then came the fiber optics war where high-frequency traders (HFT) spend tens of millions of dollars trying to get closer and closer to the market in order to be the earliest bird to get the worm. This was popularized in the 2014 book “Flash Boys: A Wall Steet Revolt” by famous Wall Street (and others) author Michael Lewis. Those antics by HFT traders made the market more efficient yet, literally closing any potential arbitrage opportunities in a flash of light, literally.

SO, here we are, a whole decade after the book was published and a new generation of traders have emerged with new sources of information. These traders also get information at the speed of light and some even rely on their smartphones to make trades in a split second. Institutional high-frequency traders have evolved their tactics as well. Today, they use AI to try and anticipate market moves in response to a single word on the news feeds and make massive speculative trades which are most likely closed, reopened, and closed again way before you will ever find out. In fact, their big trades push markets around causing even the most sophisticated traders to react, usually after the fact… and too late.

The EMH has been proven. Or has it? Well, the markets are indeed more efficient than ever in history, but does that mean that you cannot beat the market? I am proud to report to you that you can beat the market. CALM DOWN, it isn’t easy, though. There have been more than 400 proven anomalies to the efficient market hypothesis. If you stick around with me long enough, I will teach you some. But for now, I will tell you that even without complicated computers or reading reems of boring academic literature, it can be done.

Here it is: SOMETIMES THE MARKET GETS IT WRONG! Sometimes, because the market is “so efficient,” a stock may trade up or down for the wrong reason. If you are astute, you do your homework, you are patient, and you stick to your plan, you will be able to go against the crowd and win. You may find a stock tick down on some potentially negative news, but if you know what you are doing, you may know that the newly exposed risk, is not new at all and it was already factored into the stock’s price before the dip. Further, the news in no way affects the stock’s fundamental strength. Finally, your initial investment thesis may still hold. The stock is down for the wrong reason, which means that you don’t sell, or possibly buy more.

I am re-telling this tale today because we are about to embark on a period where the market will be inundated with information. Some of it will be relevant and some will not. Regardless, stocks will certainly react, and the reactions will likely be large given the overbought state of the market. You want to be successful. Be astute, do your homework, be patient, and stick to your plan. By the way, supercooled coaxial cable has the potential to transfer data faster than fiberoptic cable… just some food for thought.

YESTERDAY’S MARKETS

Stocks declined yesterday as traders contemplated the potential for a world of stalled, sticky inflation which could stall the Fed’s rate-cut journey. This is the season of speculation, window dressing, and tax-loss harvesting which can mean more volatility than usual.

NEXT UP

• NFIB Small Business Optimism (November) jumped to 101.7 from 93.7 beating analysts’ expectations. This is a 3-year high; that is optimism.
• This morning, AutoZone missed EPS and Revenue estimates. After the closing bell we will hear from Dave & Busters and GameStop (🙃☝️).

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