Equity Valuation and Portfolio Management

CHAPTER 7

Equity Analysis in a Complex Market

Bruce I. Jacobs, Ph.D.

PrincipalJacobs Levy Equity Management

Kenneth N. Levy, CFA

PrincipalJacobs Levy Equity Management

Scientists classify systems into three types—ordered, random, and complex. Ordered systems, such as the structure of diamond crystals or the dynamics of pendulums, are definable and predictable by relatively simple rules and can be modeled using a relatively small number of variables. Random systems like the Brownian motion of gas molecules or white noise (static) are unordered; they are the product of a large number of variables. Their behavior cannot be modeled and is inherently unpredictable.

Complex systems like the weather and the workings of DNA fall somewhere between the domains of order and randomness. Their behavior can be at least partly comprehended and modeled, but only with great difficulty. The number of variables that must be modeled and their interactions are beyond the capacity of the human mind alone. Only with the aid of advanced computational science can the mysteries of complex systems be unraveled.¹

The stock market is a complex system.² Stock prices are not completely random, as the efficient market hypothesis and random walk theory would have it. Some price movements can be predicted, and with some consistency. But stock price behavior is not ordered. It cannot be successfully modeled by simple rules or screens such as low price–earnings ratios (P/Es) or even by elegant theories such as the ...