Wednesday, July 4, 2012

Commentary on Richard Lehman’s "Far From Random"

This blog approaches markets from the perspective of technical analysis and, within that broad domain, focuses in particular on price channels. A relatively recently published book, Richard Lehman’s Far From Random, covers price channels in considerable depth, and this post is a brief commentary on Lehman’s work.

Richard Lehman is an Instructor of Finance and Derivatives at UC Berkeley Extension and a Vice President in the Wealth Management group at Mechanics Bank in Richmond, CA. Far From Random: Using Investor Behavior and Trend Analysis to Forecast Market Movement, published in 2009 as the subprime housing financial crisis was already biting savagely, is Lehman’s contribution to the well-populated bookcase of work that is critical of the Efficient Market Hypothesis and Random Walk Theory.

In the opening chapters of his very accessible work, Lehman combines standard critiques of the classical finance approach to valuing securities with his own experience in the trenches of Wall Street banking. Ultimately, these chapters have little in the way of novelty – it’s well known that fundamental analysis relies on often tenuous assumptions and that Wall Street equity research departments are prone to conflicts of interest. This lengthy prologue is nonetheless understandable given the financial market tumult that was present just before the work’s publication.

The book’s final chapters comprise its main value, for Lehman here discusses a relatively unstudied concept: continuous application of price channels in a technique that the author calls trend channel analysis (TCA).

TCA as described by Lehman is a quite specific methodology. The practitioner first obtains a chart of security prices – the time frame is irrelevant, although the market type matters; Lehman advocates using indices or extremely liquid securities. The analyst then draws two parallel lines that enclose all data points, with at least one of the lines touching at least two points in the data series.

Unlike traditional approaches to price channels, which demanded more pronounced channeling behavior before a set of parallel lines was drawn (e.g. 2 or 3 touches of both the lower and upper boundary), TCA is a continuously available tool because its minimal criteria – a line connecting two extreme minima or maxima, and a parallel line enveloping the rest of the data – can be satisfied in any data series whatsoever.

In regard to its theoretical justification, TCA builds from the premise, discussed in the early chapters, that stocks are a combination of fundamental or economic value and subjective value. Lehman argues that fundamental value is relatively static, i.e. it does not generally change over the interval of minutes or hours, and that it is only a subset of a stock’s total price, with the balance composed of a subjective value that is driven by investors’ collective psychology.

Given this premise that a security’s price is in large part a function of collective market psychology, the study of past manifestations of collective psychology, i.e. study of past prices, holds the promise of better understanding (and forecasting) a security’s price. Moreover, Lehman tacitly posits that a good method of studying past prices is the analysis stock charts, which are graphical representations of former prices.

From these premises, Lehman motivates his focus on TCA: his empirical observation of stock charts reveals that prices often bounce off the channels drawn in accordance with TCA principles, and such predictability of behavior is (to some degree) understandable when the flaws of EMH are acknowledged and a framework of investor psychology as a partial driver of price is applied.

I was quite heartened when I first came across Far From Random in 2011. Like Lehman, I was drawn to price channels by their often profound explanatory power and ubiquity. Yet prior to uncovering Lehman’s book, I found no mention of continuously drawn price channels in the technical analysis literature – thus my relief at reading Lehman and finding that I’m not the sole eccentric focused on drawing trendlines instead of relying on more quantitative and automated tools like moving averages and various indicators (the relatively respectable methodologies in technical analysis).

The above notwithstanding, I don’t view Lehman’s TCA uncritically. Indeed, I practice the application of price channels quite differently – chiefly because I discard the requirement that a channel enclose *all* of a data series. Instead, I allow for an analyst’s discretion in drawing price channels that connect points on a chart that exhibit marked support or resistance, regardless of whether these points are local minima or maxima. This methodology allows for drawing a greater diversity of price channels and gives the analyst a greater number of moments at which her methodology offers a forecast of future price movement. And the approach is not wholly incompatible with Lehman’s TCA as the practice of enclosing an entire data series also connects areas of marked support or resistance, with the caveat of focusing only on support or resistance areas that are also local minima or maxima.

In sum, this blog finds that Richard Lehman’s Far From Random makes excellent arguments for the theoretical justification of using price channels to forecast securities prices. The book’s practical guidelines concerning TCA are also worth reading, although the reader should bear in mind that alternate applications are also possible.

This has been a review of: Lehman, Richard. Far From Random: Using Investor Behavior and Trend Analysis to Forecast Market Movement. Bloomberg Press, New York. 2009.  

SeekingAlpha's review is here.

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