Lehman, Far from Random

Richard Lehman’s Far from Random: Using Investor Behavior and Trend Analysis to Forecast Market Movement (Bloomberg Press, 2009) is a deceptively easy read and, for anyone steeped in market literature, covers some familiar ground. But Lehman applies behavioral finance to the markets in an imaginative, thought-provoking way and offers some important if tentative first steps toward constructing a new model for valuing indexes and ETFs.

His argument, in brief, is that every stock price has two components—fundamental value and subjective value. Fundamental value is similar to the value assigned to private companies; that is, it does not include the earnings multiples that analysts tack on to the intrinsic value of the company “on behalf of the market.” (p. 50) Subjective value includes such components as going concern premium, convenience premium, popularity premium, and anticipation premium. Subjective value, Lehman argues, is driven by the kinds of decisions described by behavioral finance. (Lehman devotes a chapter to an overview of behavioral heuristics.) Moreover, subjective value contributes more than fundamental value in determining the price of a stock; it also accounts for much of the risk in the stock.

Lehman quickly moves on to overall market value. If you diversify away individual stock risk, you are left with market risk (which Lehman measures using volatility). This is essentially the subjective value of the market. And it is this subjective component that explains why “markets actually exhibit nonrandom characteristics in both the short and long term.” (p. 84) Behavioral deviations from the rational actor model lead to market anomalies.

The challenge is how to measure the subjective value of markets. Lehman’s answer is to use trend channel analysis. As is usually the case with any transition from theory to practice, from thinking about the markets to making money in the markets, this is the weakest part of the book. Trend channel analysis may be useful, but it is not an adequate measure of the subjective value of markets.

One could criticize Lehman for not providing rigorous arguments for his theses and for blurring the boundaries between concepts. But I think this is a challenging book that should prompt more, undoubtedly much less readable research.