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.
