37 - 1991 Spring

SPRING 1991
ISSUE 37
A PUBLICATION OF THE MARKET TECHNICIANS ASSOCIATION

71 BROADWAY, 2ND FLOOR, C/O NYSSA l NEW YORK, NEW YORK 10006 l (212) 344-1266
MARKET TECHNICIANS ASSOCIATION JOURNAL
Issue 37 spring 1991
Editor
James J. Bohan
Merrill Lynch
New York, New York
Associate Editors
John R. McGinley Michael J. Moody

Technical Trends Smith Barney Harris Upham
Wilton, Connecticut Los Angeles, California
Manuscript Reviewers
Charles D. Kirkpatrick II David Upshaw, C.F.A.

Kirkpatrick & Company, Inc. Waddell and Reed Investment Management
Philadelphia, Pennsylvania Shawnee Mission, Kansas
Frederick Dickson Anthony W. Tabell

TDA Capital Delafield, Harvey, Tabell
Westport, Connecticut Princeton, New Jersey
Richard Orr, Ph.D. Henry 0. Pruden, Ph.D.

John Gutman Investments Golden Gate University
Lexington, Massachusetts San Francisco, California
Frank D. Korth
Kemper Financial Services
Chicago, Illinois
Printer Publisher
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MTA JOURNAL / SPRING 1991 1

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MTA JOURNAL /SPRING 1991 3

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TAl3LE OF CONTENTS
Moving Share Repurchase

Averages Announcements:
Revisited . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 19851989 . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Fred Dickson Fred Dickson has made a G. Gernon Brown III The bull market of
number of contributions to the Journal over the 1980’s was fueled by a new source of buy-
the years. The current article on moving ing power. Mergers and acquisitions as well
averages fulfills his CMT requirements. The as corporations repurchasing their own stock
moving average is an old tool which has added to the traditional sources of liquidity
been used primarily to identify trends. The for the equity market. Gernon Brown takes
use of moving averages to determine trading a look at the effect of repurchase announce-
signals has produced more questionable ments on individual stocks and arrives at
results. By raising the issue of risk, however, some interesting conclusions which could be
Fred has shown that the moving average of practical use.
still serves a useful function.
Stock Market Price Behavior:

Random Walks and
Gauging Nonlinear Dynamics . . . . . . . . . .28
Investor Peter A. Mulieri Early studies using tra-
Sentiment . . . . . . . . . . . . . . . . . . . . . . . . .I3 ditional linear statistical testing techniques
Ginger Kock Mutual fund cash has been claim that market price changes follow a
a popular indicator among technicians. The random walk pattern. Some of the early
validity of the indicator was questioned work which refuted the random walk theory,
in an article appearing in the Financial however, has shown evidence that price
Analysts Journal. The article was reprinted changes are not random because of the
in the August 1989 MTA Journal. Ginger existence of nonlinear relationships. Peter
Kock questions the methodology behind the Mulieri provides us with a discussion of how
1988 article and shows that mutual fund nonlinear dynamics can apply to stock mar-
cash can still be a useful tool. ket price changes.
MTA JOURNAL I SPRING 1991 5

The Use of Price-Volume The Dow Jones
Crossover Patterns in Industrial Average
Technical Analysis. . . . . . . . . . . . .35 Alternative Computation
S. Kris Kaufman and Marc Chaikin Tra- Methods . . . . . . . . . . . . . . . . . . . . . . . . . . .52
ditional technical analysis involves the sub- Walter J. Mar&lo Many investors quote
jective evaluation of chart patterns. There the Dow Jones Average and use it synony-
are rules but chart interpretation has been mously as the “market.” For a variety of
considered an art form. For many the eval- reasons, the average has been considered an
uation of price and volume patterns will imperfect measure of the market. Walter J.
remain in the art sphere. More technical Marullo shows alternative methods for con-
analysts, however, are using computers to structing the average discussing there biases
identify patterns. Pattern recognition meth- and distortions. A suggestion for change is
ods have come into vogue because of more made in the current method of computation.
individuals with quantitative skills and
because of advances in computer technology.
Kris Kaufman and Marc Chaikin have pro-
vided us with a glimpse at their approach
by identifying patterns that tend to be suc- Membership and
cessful, and by providing the probability of
success. Affiliate
Information.. . . . . . . . . . . . . . . . . . . . . . . .2
Pattern Recognition
Signal Filters . . . . . . . . . . . . . . . . . . . .42 Style Sheet for the
David Aronson In November of 1989, Submission
Futures magazine published an article, titled of Articles.. . . . . . . . . . . . . . . . . . . . . . . . . .3
“Using pattern recognition to find trading
signal filters,” by David Aronson and John
Stein. The article was extracted from a more
comprehensive paper by David Aronson. We MTA Officers and
thought that a full exposition of the article
Committee
would be worthwhile. There has been a pro-
liferation of system development in recent Chairpersons.. . . . . . . . . . . . . . . . . . . . . .4
years. The article goes a step further, how-
ever, by using artificial intelligence to filter
the signals from an existing system. The
result is improved profitability, a reduction Editor’s
in risk and a greater chance of success. Commentary . . . . . . . . . . . . . . . . . . . . . . .7

Editor’s Commentary
James Bohan, Editor
The appearance of the Journal improved significant- John Brooks and also by the Journal committee.
ly in the past year due to the efforts of the previous Those starting the accreditation program this year
Journal editor John McGinley. The double column will be required to write a paper as the third level
type set allows us to print more information in a of the CMT program. With that in mind, we have
smaller space and improves readability. John has decided to conduct a workshop at the seminar in San-
also helped in the transition to a new editorial board ta Barbara in May, entitled “How to write a CMT
and has agreed to stay active in the Journal. We will paper for the Journal.” A number of Journal staff
try to make further improvements, but the current members, former and present, will be on hand to of-
format will suffice for now. We are, however, open to fer suggestions. From the workshop, we hope to
suggestions from the membership. Mike Moody also develop more specific guidelines on writing an arti-
helped in assimilating the current Journal. Mike is cle for the Journal. If you think that you would like
in Los Angeles and having geographical diversifi- to work on the Journal, please contact the Journal
cation on the editorial board should help identify editor. Your expertise in a certain area of technical
sources for new articles. analysis could be helpful in guiding another member
The initial problem facing the Journal editors through a CMT paper.
last fall was a dearth of articles. In the last couple Contributions from graduate students have
of months, however, the number of articles submit- opened up a new source of research material. Three
ted has increased, thankfully. We will put out articles from students at the University of Virginia
another Journal in the not too distant future. Colgate Darden School of Business Administration
At a board meeting last Fall it was decided that appear in this Journal. We have other articles under
the MTA would publish two regular Journals a year consideration. Ralph Acampora is responsible for de-
instead of three. The seminar edition has been elim- veloping the program at UVa. Members of the MTA
inated from the regular Journal series. It was felt have been asked to provide a topic and give guidance
a compilation of the papers presented at the seminar to students who may have limited exposure to tech-
did not meet the requirements of the Journal. If the nical analysis but are well versed in research tech-
flow of articles continues at a high level we will pub- niques and have good writing skills. No doubt the
lish another edition of the Journal. Failing enough program will add to the storehouse of technical
articles, we have the option of compiling the best knowledge. Ralph is also heading discussions with
articles on a topic from the old Journals (15 years the University to provide a course on technical anal-
worth) and presenting them together in a special ysis. A movement to seek relationships with other
edition. Issue 31 Winter 19831989 was devoted to Universities is also underway.
statistics. An issue with the best articles on senti- It is interesting to see the areas technicians are
ment or momentum would be a welcome edition to exploring. The topics submitted for publication have
our libraries. been diverse, but some trends are prominent. There
We are always trying to develop new sources is a strong interest in quantitative techniques
for articles. The CMT program should generate a spawned by the increased availability of cheap com-
significant number of papers in coming years. puting power. Chaos, artificial intelligence and
Writing a paper instead of taking part two of the ex- pattern recognition are prominent topics. Trading
amination is an option we have been urging in the systems are also in vogue.
past few years. For instance, Fred Dickson’s article A good portion of the membership is primari-
on moving averages in this edition of the Journal is ly interested in traditional technical techniques
for fulfillment of the CMT requirements. which can provide help on the job. Therefore, we do
An article for the CMT must be approved by need more practitioner articles from the regular
the accreditation committee currently chaired by membership. Astroanalysis and the stock market,
MTA JOURNAL/SPRING 1991 7

technical analysis and bonds, and the usefulness of
interest rate forecasts represent some of the topics
we have in the works.
The MTA Board of Directors, at its March
meeting, approved the following definition of tech-
nical analysis.
Technical analysis is the study of data generated
by the action of markets and by the behavior of market
participants and observers.
For the definition to be included in the MTA
constitution it will have to be approved by the entire
membership. If included in the constitution the def-
inition will be followed by the following statement.
Such study is usually applied to estimating
probabilities for the future course of prices fir a
market, investment or speculation by interpreting the
data in the context of precedent.
The definition is short, but appears to include
most of what is commonly accepted today as tech-
nical analysis. If need be the board can amend the
definition. It is important to have a definition of tech-
nical analysis. It should help the Journal, the CMT
accreditation committees and members in deciding
on the appropriateness of topics for papers which
will be published in fulfillment of accreditation
requirements.
Those who read Steve Leuthold’s article in
the Summer issue of the Journal, “E.S.C. ‘Sedge’
Coppock and VLT Momentum,” will be interested to
know that The Encyclopedia of Stock Market Tech-
niques, published by Investors Intelligence, has an
article, “Practical Relative Strength Charting,” by
Coppock, assisted by Charles Bleser.
If you have input or comments on the articles
in the Journal feel free to pass them on.

Moving Averages Revisited
Frederic H. Dickson
Overview of the price/earnings ratio. In particular, I began to

Over the last ten years products such as Computrac, use moving averages to identify price trend reversal
Technifilter and Technifilter Plus have provided the points at an early point in my career and out of hab-
Technical Analyst with excellent tools to test various it continued to employ them even as their effective-
technical indicators and trading systems including ness was being seriously challenged by other practi-
moving averages of various lengths. In general, tests tioners and serious students of technical analysis.
conducted using the analytical software show that About ten years ago, computerized software for
the use of moving averages for market timing pro- testing technical analysis strategies became widely
duces inconsistent or poor results when compared to available. Programs such as Computrac, Technifilter
a benchmark buy and hold strategy. As a result, and Technifilter Plus made possible testing a wide
many analysts have discarded the moving average. array of technical indicators and trading systems.
Results of tests using an analytical approach These programs brought a sense of objectivity to the
borrowed from the academic world of quantitative evaluation process in that they provided a disciplined
portfolio management, the risk/return scatter dia- structure for evaluating a specific tool on a consistent
gram and a testing procedure which considers aver- basis with real-life constraints. The programs elimi-
age daily performance over the test period, strongly nated the emotional element from the evaluation
suggest that moving averages do provide valuable process by making sure that decision rules were fol-
information for purposes of market-timing. The ap- lowed precisely without fail.
preach presented provides the serious technical ana- In general, these programs provided simulation
lyst with a model which can be used for testing mov- capability for a specific indicator based on a specific
ing averages and other technical tools. This paper start and stop date or a single testing period. In ad-
strongly suggests that any investment technique dition, they consider execution costs and delays in
must be considered in terms of both risk and return. buy and sell transactions after a signal. They pro-
duced detailed profitability results of the simulation
Analytical Role of Moving Averages as well as percentage success/failure rates and tests
My basic equity investment philosophy revolves of significance. Applying these tests to tried and true
around an assumption that future stock price move- indicators, I discovered (along with many other ana-
ments are caused by changes in the market senti- lysts) that tools such as the moving average by itself
ment. Market sentiment is measured by the price/ performed poorly and probably should be abandoned.
earnings ratio, changes in earnings expectations for However from practical experience, I still believed
the company and changes in investor sentiment their use added value even though I did not know how
toward the company measured by the price/earnings to measure it and sensed that the testing procedures
ratio relative to the market. As a portfolio manager were missing a key aspect of performance.
and market technician, my efforts have been spent
trying to observe the dynamic interplay between Are Moving Averages Effective Tools?
these fundamental and expectational properties by Shown in Chart One is a graph of the Standard
watching prices fluctuate over time. Investors univer- & Poors 500 Composite Index daily price history be-
sally agree that skillful market timing improves the tween December 31, 1985 and December 31, 1990.
price performance from investing in individual Also shown on the graph are two moving averages,
stocks. 80 days and 200 days. Using this data set, I will pre-
Since I regard changes in the market price/ sent a simulated test of buy/sell rules (consistent with
earnings ratio as a primary variable which impacts the methods commonly used in the analytical soft-
stock prices, I rely on using various technical tools to ware packages) using these moving averages, and
help monitor both the price and earnings components then compare the results to another testing process

r
STANDARD AND POORS 500 INDEX Profits are calculated for each trade including exe-
80 AND 200 DAY MOVING AVERAGES cution costs and cumulative profits are calculated
over the entire simulation period. Comparison would
“m be made between the profits earned from strategies
assuming the investor made “long” purchases only,
350 -
made “short” sales only and was invested either long
or short over the entire simulation period. The
300 - benchmark would be profits earned from a buy and
hold strategy covering the entire time period.
Using this approach, the following table pre-
250 -
sents the simulation results using moving averages
of various lengths. On the basis of these simulated
test results, most analysts would probably conclude
the use of moving averages of any periodicity for
market timing “long” trades would be unproductive.
12/31/8! 12m%6 12/29/87 121’27188 12/26/89 12R4190 From the array of averages tested, the 160 and 200
_ 200 DAY MOVING AVERAGE w 80 DAY MOVING AVERAGE day moving averages posted the best results based
on profitability. The 200 day moving average was
which evaluates the moving average signals giving profitable slightly more than 50% of the time (not
equal consideration to risk as well as expected return. significant using the Chi Square statistical test of
The classical testing programs suggest discarding significance) however, underperformed the buy and
these tools based on the profits generated in a sim- hold benchmark strategy by more than 10% over the
ulation over the time period under consideration. four year test period. The 160 day moving average
The refined test results, which consider average prof- produced profitable signals only 25% of the time,
itability and risk reduction on an average daily however, even with this low batting average, it was
performance basis within the time period under con- the most profitable system tested. The results of the
sideration, suggest a different conclusion. test seem convincing. Why use a tool that signiticant-
ly underperformed the benchmark and at best was
Classical Testing Procedure an accurate predictor only 65% of the time?
Daily prices for the S&P 500 Composite Index
between December 31,1985 and December 31,199O Chart One
were captured from the FACTSET pricing database
48 Profit- % profit
and entered into a Lotus l-2-3 spreadsheet. Moving %Cum
Description able per
averages of various lengths from 20 to 240 days were HOLD LONG ONLY # Trades Trades Trade Profits
calculated across the time period. In order to facilitate 52 44.2% -.43% -22.19%
20 DAY hfA
consistent comparison of the results using moving 40 DAY MA 35 48.6% -.18% -6.30%
averages of different lengths of time, a test period 60 DAY MA 34 41.2% -.15% -4.93%
beginning December lo,1986 and ending December 80 DAY MA 23 65.2% .52% 11.92%
100 DAY MA 21 38.0% .16% 3.43%
31,199O was selected. Simulations for each moving
120 DAY MA 20 45.0% .24% 4.80%
average would begin and end on these dates. 140 DAY MA 20 40.0% .36% 7.29%
For evaluation purposes, it was assumed that 160 DAY MA 12 25.0% 1.74% 20.92%
the investor would have followed the system for the 180 DAY MA 14 42.8% 1.01% 14.20%
entire length of the simulation. A buy signal occurs 200 DAY MA 11 54.5% 1.77% 19.48%
220 DAY MA 15 40.0% 0.43% 6.40%
when the closing price moves above the moving av-
240 DAY MA 12 25.0% .75% 8.96%
erage and a sell signal occurs when the closing price
BUY AND HOLD 1 lOO.% 30.98% 30.98%
moves below the moving average. Buys would be BENCHMARK
made at the closing price on the day following a buy
signal as indicated by the moving average and execu-
tion costs would be assumed to be 0.5%. Sells would Test Results Using a Risk/Reward Framework
be made at the closing price on the day following a Many investors look to technical analysis as a
sell signal as indicated by the moving average and tool to help reduce market timing and stock selec-
executions costs would also be assumed to be 0.5%. tion risk. The classical performance test considers
It is assumed that during periods when the system in detail the profitability of a technical trading sys-
dictates being out of the market, the cumulative tem but fails to address the risk reduction proper-
profits are held in a non-interest bearing account. ties which are produced by the technical tool. After

recognizing that trading profits generated using
Chart
RISK/RETURN FRAMEWORK
3
1
even the optimum 200 day moving average failed to FOR EVALUATING MA STRATEGIES
beat the buy and hold strategy by a wide margin, BENCHMARK IS BUY AND HOLD STRATEGY
0.06
the analyst should not discard the tool without cdn-
sidering whether it is effective in reducing risk. 0.05 LONG
The academic community has developed a
basic model for evaluation of risk and return, the
capital asset pricing model. The basis for measur-
ing return is the average daily % profit generated
by the asset (or in this case trading system) and the
PROFITABLE
basis for measuring risk is the standard deviation
of daily % returns. Even technical analysts agree
that increased risk must be compensated by in- z 40
60
cremental expected return. By measuring return us- a -0.01 - UNPROFITABLE

ing average daily % profit, any bias generated from 3 I I
2.0
selecting a specific start and stop date for measur-
-0.03 1 I
ing tests results is minimized. Chart 2 presents a 0.00 0.50 1.00 1.50
framework which allows comparison of various re- RISK-% STD DEV OF DAILY RETURNS
turns (or technical trading systems) on the basis of Chart 4
risk and reward tradeoffs. RISK/RETURN FRAMEWORK
The average daily returns of the buy and hold FOR EVALUATING MA STRATEGIES
strategy were 0.35% and the standard deviation BENCHMARK IS BUY AND HOLD STRATEGY
(risk) was 1.31% per day and shown on the chart as
point BH. By connecting a line starting at the 0.0
point and extending to the point marked BH, the
analyst has a benchmark which allows comparison
of various strategies to the buy and hold strategy.
If a tested strategy produces results which are
3
plotted above the diagonal line, the strategy has ap 003.
more favorable risk/reward properties than the
benchmark. If the results are plotted below the diag- %
002
onal line, the strategy is inferior to the benchmark B /..
on a risk/return basis.
The simulated test results for the various mov-
ing averages are plotted on Chart 3. The risk and
return statistics for the various moving averages are 0.00 v I
0.00 0.50 1.50
Chart 2 RISK-% STD DEV OF DAiL! RETURNS
RISK/RETURN FRAMEWORK
also shown in Appendix A. The 160 and 200 day mov-
FOR EVALUATING MA STRATEGIES
ing averages produced results which were superior
BENCHMARK IS BUY AND HOLD STRATEGY
to the buy and hold strategy. Thus, when risk is con-
sidered, these strategies are preferable to the buy
and hold benchmark. The other moving averages
produced results inferior to the buy and hold bench-
mark. The decision about whether to abandon the
160 and 200 day moving average is no longer so clear
cut. These tools produce valuable information when
both return and risk reduction is considered. In ad-
dition, it should be noted that by using average daily
performance as the measurement basis the results
are not biased by the selection of a specific start and
stop date. The results give a consistent picture of risk
and return over the entire test period.
-00.5 I The risk/return framework presented above as-
0.M) 0 50 1.00 1.50 sumes that only “long” trades would be undertaken.
RISK-% STD DEV OF DAILY RETURNS

Chart 4 presents the simulated results assuming Appendix A
that both “long” and “short” trades were executed Simulation Results-Moving Averages of Differing Lengths
as signalled by the moving averages. This is perhaps Applied to the Standard & Poors 500 Composite
the most reliable guage to test the effectiveness of December 1986-December 1990
the various moving averages in market timing. Long +
As seen in the Chart 4, seven of the eleven mov- Long Long + Short
ing averages tested produced risk adjusted results Long 96 std. Short 96 std.
46 Daily Dev. of % Daily Dev. of
in excess of the buy and hold benchmark. The 80 day Description Return Return Return Return
moving average was the most profitable trading
20 DAY MA - .021% BOO% .044% 1.397%
strategy when applied to both “long” and “short” 40 DAY MA - .003% .801% .046% 1.395%
sales. It should be noted that the improved results 60 DAY MA - .002% .807% .043% 1.398%
were the result of improved profitability as measured 80 DAY MA .013% .762% .056% 1.394%
100 DAY MA .006% .776% .037% 1.397%
by the average daily percent profits, not reduced risk.
120 DAY MA .008% .761% .035% 1.398%
In fact, the test results suggest little differential in 140 DAY MA .OlO% .773% .034% 1.403%
risk regardless of which moving average was em- 160 DAY MA .021% .756% .044% 1.399%
ployed to generate the trading signals. From this per- 180 DAY MA .016% .752% .039% 1.400%
spective several strategies should be regarded as pro- 200 DAY MA .0200/c .747% .042% 1.400%
viding useful information to the analyst involved in 220 DAY MA .020% .753% .023% 1.404%
240 DAY MA .Oll% .761% .024% 1.401%
market timing.
BUY AND HOLD .035% 1.354% .0350/o 1.354%
BENCHMARK
Conclusion
The inferences drawn from the tests presented
above are by no means exhaustive. They are present- Personal preference may lead an individual to choose
ed as a challenge to the serious student of technical a system which generates greater return at a higher
analysis to stimulate reevaluation of moving aver- risk or a lesser return at reduced risk.
ages as a working tool and to introduce a testing
Frederic H. Dickson is a founder and Managing Direc-
framework which considers both risk and return. It
r tor of TDA Capital Manngement Company, Westport, CT
is easy to jump to an erroneous conclusion by look- Fred is apast President of the MTA and has previously
ing at simple tests of significance or cumulative prof- contributed several articles to the MTA Journal on
vwioz~~ subjects. As Chairman of the Education Commit-
its over a single simulated period for the test strategy tee, Fred was involved in thepreparation ofthe original
versus the benchmark. If a system provides greater CMT Part I examination in 1988 and currently serves on
profits with no increase in risk it is clearly superior. the Editorial Board of the M!l’A Journal.
L

GAUGING INVESTOR SENTIMENT
Ginger Kock
Overview thesized that changes in odd-lot trading reflect

The mutual funds’ cash ratio attempts to give an in- changes in market sentiment among small investors.
dication of institutions’ short-term ability to invest Unfortunately, in recent years, the odd-lot ratio
in the stock market. Also regarded as a sentiment has lost much of its usefulness, because small inves-
indicator, this ratio can gauge whether fund man- tors no longer trade as much in odd-lots. With other
agers are scared or greedy by virtue of their liquidi- investment alternatives available in the market,
ty level. In 1981, a study was released which casts these investors are now able to turn to mutual funds,
doubt on using this ratio to predict changes in stock options, futures and even money market funds as
prices. In this paper, I will bring the 1981 study up vehicles in which to place their funds in anticipa-
to date and will determine if my conclusions confirm tion of market moves.
those reached previously. In addition, I will question We are obligated to find other ways to measure
the validity of the analytical approach used for part market sentiment and coincidentally potential mar-
of the 1981 study and show that a more feasible ap- ket demand, because when money is on the side, ifsen-
proach can be taken. timent changes in favor of the market, then these un-
invested funds may return to the market. In this study
Market Indicators I will examine one of the ways to measure this de-
For years stock market technicians have mand: institutional cash levels and what they may say
sought simple and useful indicators to indicate about these managers’ collective mindset. As we shall
whether the market was too high or too low, thereby see, by studying the data, it is clear that when fund
signalling an impending trend reversal. Their managers have been convinced to hold large amounts
numerous studies have examined the relationship of cash-thereby signalling bearish sentiment-it has
between indicators and stock prices to assist them been a good time to be fully invested, and vice versa.
in strategic investment decisions. One group of such
indicators monitors investor sentiment. Notable 1981 Study
among these indicators are the mutual funds’ cash In 1981 Ranson and Shipman released a study
ratio, the short interest ratio, and the odd-lot ratio. (see MTA Journal, August 1989) in which they tried
One sentiment indicator useful at market bot- to determine whether a relationship exists between
toms, once extremely popular, is somewhat neg- stock prices and the cash-asset ratio of equity mutual
lected today: the odd-lot ratio. It monitors small funds. They calculated the cash-asset ratio from 1967
investors’ trading activity through the percentage to 1978 by dividing funds2 liquid assets by total
of odd-lot sales to odd-lot purchases. According to assets, and tested this ratio against the Standard &
conventional wisdom, odd-lotters are the most con- Poor’s 500 index for the time period.
sistently incorrect of all market spectators, and Ranson and Shipman presumed-and logic
thus they represent something one could go con- argues-that the cash-asset ratio would be low at
trary to. Technicians believe odd-lotters’ increased market troughs and high at market peaks, because
selling shows pessimistic sentiment and marks a fund managers theoretically would be fully invested
time to buy stocks. Garfield A. Drew was the most at times prior to upswings and lightly invested at
advent supporter of the Odd-Lot Theory. After exam- times when the market is about to decline. This
ining yearly data of stock transactions of less than theory makes sense on paper, but their study in fact
loo-share lots, Drew concluded that “the pub- showed quite the opposite: “the cash-asset ratio
lic-although not necessarily ‘wrong’ in the end- tends to be low at market peaks and high at market
does tend to become less correct in its actions just troughs,“3 as any technician will tell you.
before the market embarks on an important change The study noted two different considerations
in trend.“’ Further, and more importantly, he hypo- to account for the cash-asset ratio’s divergence. First,

fund managers were likened to our old odd-lotters, the difference between the change in the cash posi-
in that they too can’t time the market right. Second, tion associated with the S&P change and the change
the raw liquid asset figures were thought to be one in total assets associated with the same S&P
of the prime culprits uficting stock price movement. change.“5 By breaking out the ratio’s parts, the
When managers carry low cash levels, there are no authors’ study showed that the percentage changes
excess funds to put into the stock market. Since the of the raw cash position had no correlation whatever
market can not rise without buying, this would limit with the S&P 500 (R-squared .087), the percentage
the upside and possibly result in a market top. Both changes of the raw total assets position had an over-
explanations were disregarded by the authors of the whelmingly positive correlation with the S&P 500
study. “In the first case, it is just as difficult to be (R-squared .957), and the cash-asset ratio had an
consistently wrong at market turning points as it overall negative correlation (- 97) with the S&P 500.
is to be consistently right. And, with respect to the The percentage changes of the cash position did not
second, changes in buying power per se do not nec- explain any significant fraction of the changes in
essarily imply changes in investors’ perceptions.“’ stock prices, while the percentage changes of the
A third and more viable alternative presented total assets position did.
by Ranson and Shipman concerns the correlations The 1981 study concluded that “the negative
between changes in the cash-asset ratio’s numerator correlation between changes in the cash-asset ratio
(liquid assets) and denominator (total assets), and and changes in the S&P 500 is fully accounted for by
changes in stock prices. In order to explain the cash- the almost tautologous relation between total assets
asset ratio’s components, “the equation states that and the market index.“6 In other words, the assets’
the change in the cash-asset ratio that corresponds tigure is so large, it is the functional equivalent of the
to a given percentage change in the S&P 500 equals market. Thus you are in essence using the market as
LIQUID ASSET RATIO VS S&P 500

Exhibit 1
S&P 500 LIQUID ASSET RATIO
r 6%
0 llllllll”llllll~llllillllllllllllllillllllllillllllllilillllllllllllllillllllliilllllllllll~l’llll”l’lllllllll II 1”,I,,,:,“’ “I ,,,

‘1” .,~ 0%
79 80 81 82 83 84 85 86 87" 88 ‘I 89 90
YEAR
- LIQ ASSET + S&P 500

Source: Investment Company Institute
14 MTA JOURNAL/SPRING 1991

-1
an indicator to track the market, a tautology. Prom obtain the higher yields, instead of investing these
this, Ranson and Shipman deduced that the liquid funds in equities. In addition, huge net redemptions
asset ratio could not be proven as a reliable indicator of equity funds during bear markets (such as in 1962,
of market movement. 1966, 1970, and 1974) required fund managers to
However, there are two important additional have cash on hand to meet these commitments. As
influences on cash levels other than sentiment: a result, the cash position could have been distorted.
(1) the existence of more attractive high yield in-
vestments available during the time period; (2) the 1990 Study
need for high cash reserves to meet net redemptions I have brought Ranson and Shipman’s 1981
during bear markets. The cash (liquid assets) posi- study up to date through the 1979-1990 time period
tion of mutual funds includes its cash, receivables, to determine whether their results still hold. Using
government securities and other short-term debt in- monthly data, I constructed Exhibit I which shows
struments, less its current liabilities. In the 1960- the liquid asset ratio tracked against the S&P 500.
1978 time frame, interest rates progressively rose As one can see, the cash-asset ratio appears inverted
from the 2-4% level in 1960-1964 to the 59% level to the market index; a pattern consistent to that
in 1966-1970 and finally to the 9-12% level in found in the 1967-1978 time period. A regression
1973-1974, before backing down to the 4-6% level in analysis of the data shows that the percentage
1976-1977. After the study period in 1978, interest changes of the raw cash asset position (Exhibit 2)
rates ranged from 5% in 1986 to 17% in 1981. With have effectively no correlation with the S&P 500, but
short-term instruments providing investment the percentage changes of the raw total assets posi-
returns of this caliber, fund managers would have tion (E&bit 3) have an extremely high positive cor-
been correct in holding more cash than normal to relation with the S&P 500, and the cash-asset ratio
% CHANGE IN CASH VS % CHANGE S&P 500

JANUARY 1979 - AUGUST 1990
Exhibit 2
-20% ! I I I I I I
-25% -20% -15% -10% -5% 0% 5% 10% 15%

S&P 500

% CHANGE ASSETS VS % CHANGE S&P 500
Exhibit 3
ASSETS
20 %
-30% I I I
-25% -20% -15% -10% -5% 0% 5% 10% 15%
S&P 500
has a high negative correlation with the S&P 500. correlated with the market index. Therefore, the
Clearly, the percentage changes of the cash position ratio in this time period continues to be suspect, be-
(R-squared .164) still do not significantly explain cause the numerator explains nothing of the S&P
the changes in the S&P 500, while the percentage 500, yet its denominator does.
changes of the total assets position (R-squared .913) Although the commercial paper method showed
continue to do so. From this data, my analysis recon- alternative investments did not seem to entice fund
firms the conclusions derived by Ranson and Ship- managers, one can hypothesize that these invest-
man in 1981. ments may have a greater effect when they are at
In pursuing whether sensitivity existed in the extremes. Logically, when rates are astronomical (at
data, I invoked three methods to alter the data for 20-25%), it would be foolish for fund managers not
the time horizon. First, I adjusted the raw cash and to capture these yields for brief periods, as they
total asset figures by three-month lead and lag times would find it difficult to accomplish the same returns
to see if fund managers anticipated or reacted to in the equity market. These periods would not ef-
market information. Second, I adjusted the raw cash feet the overall correlation figures in any meaningful
and total asset figures for net cash flows, i.e. cash way. In the 1979-1990 time frame, interest rates rose
flows in minus cash flows out. Third, I adjusted the from the 9-11% level in 1979 to peak at the 15-17%
raw liquid asset ratio figures for commercial paper level in 1980-1981; before dropping to the 9-12% level
rates to see how attractive alternative investments in 1983-1984, falling further to the 5-8% level in
were to fund managers. Under all three scenarios, 1986-1987, and settling in at the 6-9% level in 1988-
the percentage changes of the cash position still had 1989. At the end of the period in 1990, interest rates
no correlation with the S&P 500, while the percent- were hovering around the 8% range. (See A Final
age changes of the assets position were again highly Thought.)

RAW CASH FIGURES VS RAW S&P 500
Exhibit 4
Cash (billions)
35
-1
0
0 100 200 300 400
S&P 500
RAW ASSET FIGURES VS RAW S&P 500

Exhibit 5
Assets (billions)
300
0
0 100 200 300 400
S&P 500

An Argument Over Approach tire ratio into correlation, no matter what the cash fig-
While I have validated the results of the 1981 ures might be. Despite this distortion, I believe the li-
study, I question whether its authors in fact used the quid asset ratio continues to be a valid coincident in-
correct method to test the data. As mentioned earlier, dicator. Observations of the data show that fund
Ranson and Shipman focused on the percentage managers have been consistently wrong in their mar-
changes of the cash and total assets positions in their ket timing. Knowledge of this behavior pattern can be
analysis, thereby suggesting that a causal relation- useful to analysts. Perhaps the fund managers of to-
ship exists between a change in each position and a day are the odd-lotters of the past; in any case, one
change in the S&P 500. It is my opinion that the would surely be well advised to go contrary to them.
authors chose the wrong statistical test on which to
A Final Thought
base their analysis for this part of the study. The
While I have identified a more valid method of
analysis above clearly shows that percentage changes
studying this data, at best I can only show it is a coin-
of the cash position have no eftrect on or correlation
cident indicator because no improvement was gained
with the market.
by advancing the data. Analysts have found that
I believe Ranson and Shipman should have used
monitoring extremes in this ratio have produced pro-
the raw figures themselves-not the percentage chang-
fitable future investment results. This involves not
es-of the cash and total asset positions and their cor-
correlation analysis, but threshold analysis (i.e., above
relations with the S&P 500. My tests show that
one benchmark is bullish and below another bearish
technicians are correct to be more concerned with
etc.). Perhaps a future study will consider this aspect
fund managers’ cash levels, not changes in their cash
in greater detail.
levels, in using this indicator to assess market senti-
ment and predict market direction. FOOTNOTES
With further regression analyses of the data, I 1. Garfield A. Drew, “A Clarification of the Odd Lot Theory,” Financial
Analysts Journal, Vol. 23 (September-October 1967), p. 107.
determined that the raw cash position (R-squared
2. R. David Ranson and William G. Shipmen, “Institutional Buying
.957) now significantly explains the S&P 500, and the Power and the Stock Market,” Financial Analysts Journal, Vol. 37
raw total asset position (R-squared .987) continues to, (September-October 1981), pp. 62-68.
naturally. Additionally, I altered the data with the 3. Ibid, p. 63.
4. Ibid, p. 63.
three methods used above, finding that correlations of
5. Ibid, pp. 64-65.
adjusted data did not significantly improve the cor- 6. Ibid, p. 65.
relations of unadjusted data. 7. Ibid, p. 62.
My results can be seen in Exhibits 4 and 5. Ex-
BIBLIOGRAPHY
hibit 4 shows a scatter diagram of the raw cash figures
Books
plotted against the raw S&P 500 figures. The points Edwards, Robert D. and John Magea Technical Analysis ofStack Trends
are clearly clustered, demonstrating the two variables Boston: John Magee Inc., 1966.
have a much better fit than before and that the raw Fogler, H. Russell. Analyzing the Stack Market: Statistical Euia’ence and
Methodology. Columbus: Grid Inc, 1978.
cash figures do in fact correlate with the S&P 500
Hardy, C. Colbum. The Investor’s Guide to Technical Analysis New York:
(compare with Exhibit 2). Exhibit 5 shows a scatter McGraw Hill Inc., 1978.
diagram of the raw total asset figures plotted against Lorie, James H., Peter Dodd and Mary Hamilton Kimpton. The Stack
the S&P500. Again, the points show a cluster forma- Market: Theories and Evidence Homewood: Richard D. Irwin Inc, 1985.
tion with an even tighter tit than in Exhibit 3. The raw Articles
Drew, Garfield A. “A Clarification of the Odd Lot Theory.” Financial
total asset figures clearly explain movements in the Analysts Journal Vol. 23 (September-October 1967): pp. 107-108.
S&P 500 to a significant degree, for the obvious Gup, Benton E. “A Note on Stock Market Indicators and Stock Prices.”
reasons discussed above. Journal ofFinancial and Quantitative Analysis Vol. VIII (September
1973): pp. 673-682.
Kewley, Thomas J. and Richard A. Stevenson. “The Odd-Lot Theory as
Conclusions Revealed by Purchases and Sale Statistics for Individual Stocks.” Finon-
When Ranson and Shipman released their cial Analysts JournalVol. 23 (September-October 1967): pp. 103-106.
study in 1981, they stipulated that “information con- Ranson, R. David and William G. Shipman. “Institutional Buying Power
and the Stock Market!’ Financial Analysts Journal Vol. 37 (September-
cerning the deployment of (mutual funds’) assets is of October 1981): pp. 6268.
little value in forecasting stock price changes.“’ It Slat&, John. “New Market Guide?’ Barron’s(February 6,1967): p. 5.
created quite a stir among stock market technicians,
as many had given great emphasis to the mutual Ginger Kock is a second-year student at the Darden Gradu-
ateSchaolofBusinessAdministrationin Charlottesville, VA.
funds’ cash ratio. Ginger will graduate in May 1991 after which she plans to
By updating the 1981 study to the present, sev-
eral conclusions remain: the denominator of the liq- ment. Ginger wrote this article for her Supervised Business
Study with the cooperation ofJohn R. McGinleyof Wiltan, CT
uid asset ratio (total assets) is so large it drags the en-

Share Repurchase Announcements: 19854989
G. Gernon Brown III
Introduction and Methodology ranged from those addressing only odd-lot share-
Between 1984 and 1990 the supply of common stock holders to those involving only one shareholder or
decreased about $100 billion, largely due to compa- family to share repurchase announcements accom-
nies repurchasing their own shares. Amidst ar- panied by news that the company would be selling
guments about the wisdom of repurchases-about off businesses-that is, those buybacks publicly an-
whether buybacks come at the expense of future nounced to be only part of what is often termed a
growth (suggesting that companies should preserve “massive restructuring plan.”
equity), about whether buybacks offer a cheap way To find “clean” buyback announcements, I us-
to boost per-share earnings, even about the psycho- ed the CD-based UMVINFORM database of
logical value of announcing a share repurchase that newspaper abstracts, restricting my search to items
will not in fact be completed-several interesting appearing in the Wall Street Journal. Listed below
and practical questions arise: What is the effect of is the total number of items retrieved each year for
share repurchase announcements (and of actual 1985-1989:
share repurchases) on the stock price of individual
companies? Does the stock of these companies, on 1985: 236 items
average, outperform the S&P 500 in the year follow- 1986: 264 items
ing the share repurchase announcement? More spe- 1987: 321 items
cifically, of the companies announcing repurchases, 1988: 224 items
why do those shares that produce excess returns do 1989: 235 items
so? Is such performance linked to the amount to be
repurchased, to the actual reduction in outstanding By noting the company mentioned in each item
shares, to the earnings trend, even to the time of and using the market capitalization list, I de-
year the repurchase is announced? termined whether the company’s market value
To answer these questions, I limited my study exceeded $1 billion. If the company met the market
to share repurchases announced between January value test, I then read the abstract of the item
1985 and February 1989, the latter bound enforced to determine the exact nature of the repurchase.
so that I could examine a full year of performance A further criterion required that the company
following the announcement. In addition, each com- still exist in the same form. (Hence, I discarded
pany and each share repurchase announcement Time, Inc, now Time-Warner, and Smithkline-
used in the study met certain criteria. First, the Beckman, now Smithkline-Beecham.) Finally, I
market capitalization of each company exceeded eliminated share repurchase announcements fol-
$1 billion at the time of the share repurchase an- lowed less than one year later by another repur-
nouncement. To impose this criterion, I screened chase announcement.
the 12,000 companies in the Lotus One Source The above search resulted in 78 share repur-
database, finding 555 companies of greater than chase announcements involving 66 companies. As
a billion dollars in market value. An alphabetical I hoped would be the case, the 66 companies repre-
list of these companies served later as a reference sented a diversity of industries.
source. The sample of share buyback announce-
Just as important, share repurchase announcements, stretching from March 1985 to February
ments included in the study appeared as discrete 1989, proved to be diversified over time as well.
items in the Wall Street Journal and were, as often The specific nature of this diversity manifests itself
as possible, “clean” common stock buyback annotmce- when we overlay onto a time line each of the 78
ments unencumbered by additional news or restric- twelve-month periods following the share repur-
tions. Buyback announcements omitted, for example, chase announcements.
MTA JOURNAL/SPRING 1991 19

Monthly Intensity of Sample probable day the share repurchase announcement
Month Total Month Total was released on the wire services-to Day 250 one
year later.
3185 1 9187 10 For an index I used the S&P 500 to obtain a
4185 3 10187 10 broadly based standard against which to compare
5185 4 11187 14 each stock’s return. Despite the larger average size
6185 6 12187 18 of the 30 companies that constitute the Dow Jones
7185 7 II88 18 Industrial Average, the DJIA seemed too narrow an
8185 8 2188 21 index and, because it is price-weighted, less true a
9185 8 3t88 20 measure of market performance. Moreover, by re-
10185 9 4188 22 gressing the S&P 500’s daily return to that of the
11185 11 5188 24 DJIA over the entire five-year period of the study,
12185 13 6188 27 I derived a greater than 99% correlation between the
1186 15 7188 27 two indexes. (As one would expect, however, during
2186 17 8188 27 shorter periods of time one index often outperformed
3186 16 9188 28 the other.)
4186 15 10188 28
5186 15 11188 24 General Results
6186 14 12188 24 After computing daily excess returns for each of
7186 15 l/89 24 the 78 buybacks, I then averaged the excess returns
8186 18 2189 26 for each day from Day - 1 to Day 250. E&bit1 graphs
9186 18 3189 26 these excess returns on a noncumulative basis. While
10186 18 4189 24 these returns appear essentially random for much of
1 l/86 18 5189 22 the one-year period-there are, for example, both
12186 17 6/89 18 many positive and many negative excess returns, as
II87 15 7189 18 well as positive and negative spikes-salient aspects
2187 13 8189 17 of these returns do reveal themselves. Most notewor-
3187 15 9189 14 thy (but not surprising) are the huge excess returns at
4187 14 10189 13 the time of the announcement on Day - 1 and Day
5187 13 11189 11 O-1.36% and .65% respectively. Day -1’s 1.36% ex-
6187 13 12189 6 cess return, the largest one-day excess return in the
7187 11 1190 6 one-year period, confirms that news of a forthcoming
8187 8 2190 1 repurchase becomes public the day before an item ap-
Of the 936 (78 x 12) “sample months,” no more than pears in the Wall Street Journal. Note also the greater
3% fall in any one of the 60 calendar months from number of positive excess returns than negative-
March 1985 to February 1990; the average number namely, 150 positive versus 102 negative-and the
of sample months per calendar month is 15.6. Fur- many clusters, or streaks, of positive returns, especial-
ther diversity in the 78 buybacks included company ly in the first few months. Finally, at the very end of
stock betas ranging from .60 to 1.70; split and unsplit the one-year period, note the preponderance of strong-
shares; and both rising and falling earnings trends ly positive excess returns.
both before and after the buyback announcement. By then cumulating these average excess
To compute excess returns, I first accessed returns, beginning at Day -1, we can observe that on
through Lotus One Source the Compustat database average, for the 78 buybacks in this study, there was
of daily closing prices for the five-year period be- indeed an excess return in the year following the share
tween March 1985 and February 1990. By subtract- repurchase announcement. Exhibit 2 depicts
ing each day’s S&P 500 return from an individual graphically these cumulative excess returns, while
stock’s return, I derived that stock’s daily excess the figures below note the cumulative excess return
return-that is, the daily return above that of the at points during the one-year period.
S&P 500. A negative excess return implied a return Cumulative Average Excess Returns
lower than the S&P 500’s. To diversify away the pos- Days - 1 + 0 (“announcement day”) 2.02%
sible effects of seasonality and the individual cir- Day 5 (one week) . . . . . . . . . . . . . . . . 1.96%
cumstances of each company, I then “stacked” the Day 20 (one month) . . . . . . . . . . . . . . 1.71%
78 buyback periods upon one another, from Day Day 62 (three months). . . . . . . . . . . . 3.90%
-l-the day before the buyback announcement ap- Day 125 (six months) . . . . . . . . . . . . 5.15%
peared in the Wall Street Journal (on Day 0) and the Day 250 (one year). . . . . . . . . . . . . . . 6.80%
20 MTA JOURNAL /SPRING 1991

Exhibit 1
NON-CUMULATIVE AVERAGE EXCESS RETURNS

(vs. s & P 500)
1.40% ,
1.30%
1.20%
1.10%
1 .OO%
0.90%
0.80%
0.70%
0.60%
0.50%
I
0.40%
0.30%
0.20%
0.10%
0.00%
-0.10%
-0.20% II’ll I ‘”
-0.30%
-0.40%
-0.50%
-0.60%
-1 20 41 62 83 104 125 146 167 188 209 2x)
Day Relative to Announcement
Exhibit 2
CUMULATIVE AVERAGE EXCESS RETURNS

(vs. S&P 500)
7.00%
6.00%
3.00%
2.00%
1 .cm%
0.00%
-1 20 41 62 83 104 125 146 167 188 209 230
Day Relative to Announcement

The graph of the cumulative average excess returns chased. Note as well that for the buybacks in this
makes clear the pattern during the year following study the average percentage of stock to be repur-
the repurchase announcement: First, the immediate chased is 7.1%, the median 6.0%.
excess returns of the announcement day period abate To explore whether stock performance related
somewhat in the weeks following the announcement, to the percentage of stock to be repurchased, I
with the minimum cumulative excess return occur- grouped the buybacks into five quintiles determined
ring on Day 12 (1.24%). A strongly rising trend by the percentage of shares to be repurchased. The
describes the ensuing months, with a peak just past table below gives the average figures for each
the six-month point. After falling slightly, the quintile:
amount of cumulative excess return rises just before
the nine-month point and then again, strongly, be- Percentage to Be Repurchased Excess Returns
fore the one-year point. The maximum cumulative Range Average Days -l+O Day 250
average excess return, in fact, occurs on Day 249 Ql LO-3.4% 2.2% .67% 8.70%
(6.94). Q2 3.6-5.0% 4.2% 1.01% 4.58%
Q3 5.0-7.0% 5.8% 2.75% 3.87%
Percentage to Be Repurchased Q4 7.0-9.3% 8.2% 3.24% 6.60%
While the stock performance of companies an- Q5 9.4-37.0% 15.0% 2.64% 8.87%
nouncing share repurchases exceeded that of the
S&P 500-on average-for the year following the Using the average figures for each quintile, one ob-
buyback announcement, the performance of in- serves a modest correlation between the percentage
dividual companies’ stock varied widely. To under- of shares to be repurchased and the excess return
stand better the reasons for this variability, I ranked during the announcement day period of Days - 1 and
and grouped the 78 buybacks in the study according O-although no such correlation exists with the one-
to different criteria that I believed might affect per- year performance. An examination of the individual
formance. In having done so, however, I readily ac- stocks’ excess returns in each of the five quintiles
knowledge the dangers that lie in drawing conclu- reveals well-above-average announcement day excess
sions from an even smaller sample of companies. returns-greater than 4%, say-in quintiles 3,4, and
The first criterion applied to the 78 share 5 and an absence of such large excess returns in
repurchases was the percentage of stock to be repur- quintiles 1 and 2. As one might expect, then, the av-
chased. The actual percentage used for each buyback erage excess return for the announcement day period
was either that given in the Wall Street Journal item in quintiles 3,4, and 5 is above the average of 2.02%
(whose accuracy I checked) or a figure derived from for the entire group of 78 buybacks. Interestingly,
other information provided such as the number of the number of negative excess returns for Days - 1
shares to be repurchased or their current market and O-the frequency of underperformance during
value. When a range was given for the number of the announcement day period, that is-is exactly the
shares to be repurchased, I used the midpoint of the same for quintiles 1-4 and only slightly less for quin-
range. Two additional aspects of share repurchase tile 5.
announcements are important to note here. First, an- It is important to emphasize that the modest
nouncements are often phrased in terms of repur- correlation suggested above between the percentage
chasing not a definite amount but “as many as” a of stock to be repurchased and announcement day
certain number of shares or “as much as” a certain performance holds only when average figures for
dollar amount. Second, the period during which the each quintile are used. No such correlation exists
repurchase is to take place varies from a few months when individual percentages are regressed against
to a few years. For the repurchase announcements individual excess returns.
used in this study, the typical wording suggested
that the company would ‘during the next year” or Actual Reduction in Outstanding Shares
“from time to time” repurchase shares “on the open Awaiting an answer as a natural extension of
market or in private transactions.” Such equivoca- the investigation above was the question of whether
tion, in both cases, I accepted as being a matter less the actual amount of stock a company repurchased
of substance than of form. in the year following a buyback announcement cor-
Exhibit 3 lists the 78 buybacks and the percent- related with its performance for that year. Also, did
age of common stock the company announced would the stock of companies that had actually repur-
be repurchased. Note that one company in the study, chased the announced percentage one year after the
Dow Jones & Co., did not know at the time of its an- announcement outperform other stocks in the study?
nouncement the percentage of stock to be repur- Unfortunately, because the number of shares actual-

Exhibit 3
SHARE REPURCHASE ANNOUNCEMENTS Household Intl. HI2 871103 6.0%
(In Order of Percent to be Repurchased) Salomon, Inc. SB 880609 6.1%
Dow Chemical DOW2 870612 1.0% Cap. Cities/ABC CCB 880523 6.2%
Abbott Labs ABT2 881212 1.3% Raytheon RTN 861023 6.5%
Dow Chemical DOW1 850322 1.3% Westinghouse Elec. WX 860731 6.5%
Intl. Bus. Mach. IBM1 860528 1.6% Unisys UIS 871215 6.7%
Kellogg K 880328 1.6% Automatic Data Proc. AUD 881107 7.0%
Minn. Mining & Mar&. MMMl 860620 1.7% Syntex SYN 890126 7.0%
General Mills GIS 860919 2.0% Schlumberger SLBl 871210 7.2%
Coastal Corp. CGP 871020 2.2% Ralston Purina RAL 881212 7.4%
Digital Equip. Corp DECP 880119 2.3% Rockwell Intl ROK 860318 7.4%
Pacific Telesis PAC 881212 2.4% Apple Computer AAPL 860722 7.6%
Merck MRKl 850807 2.5% Union Carbide UK 871023 7.6%
Quaker Oats OAT 880202 2.5% United Tech UTX 860204 8.1%
Archer-Daniels-Midland ADM 851111 2.9% DuPont DD 890126 8.3%
Intl. Bus. Mach. IBM2 880928 3.0% K-Mart KM 871125 8.7%
American Home Prod. AHPl 860701 3.3% Sun Co. SUN 850308 8.8%
American Home Prod. AI-B’2 870828 3.4% Teledyne TDY 881031 8.8%
Johnson & Johnson JNJ 880614 3.6% Dana Corp. DCN 851119 9.0%
First Union FTU 880420 3.7% Halliburton HAL 851122 9.2%
Genuine Parts GPC 850401 3.7% American Cyanamid ACY 850531 9.3%
Digital Equip. Corp. DECl 861107 3.9% Schering-Plough SGP 860129 9.3%
Merck MRK2 870729 3.9% May Dept. Stores MA 880902 9.4%
MCA MCA 860806 4.0% Golden West Fin. GDW 871204 9.6%
Schlumberger SLB2 890127 4.0% Federal Express FDX 880607 10.0%
Wells Fargo WFC 871119 4.1% Ford Motor F2 871113 10.1%
Minn. Mining & Manuf. MMM2 881116 4.4% Times Mirror TMC 850701 10.4%
Amer. Express AXP 860429 4.5% Ford Motor Fl 851115 10.5%
Union Pacific UNP 850531 4.5% Penney, J.C. JCP 880831 11.0%
Merrill Lynch MERl 870224 4.7% Tandy TAN 890130 11.0%
General Public Util. GPU 880205 4.8% CIGNA CI 890223 12.0%
Snap-On Tools SNA 880830 4.8% Dayton-Hudson DH 871022 15.4%
Abbott Labs ABTl 851216 5.0% Allied Signal ALD 850930 16.0%
Kerr-McGee KMG 850509 5.0% Hilton Hotels HLT 871020 16.0%
Merrill Lynch MER2 881206 5.0% Georgia Pacific GP 880330 19.0%
Nynex NYN 870918 5.0% General Motors GM 870304 20.0%
Seagram VO 870909 5.0% Household Intl HI1 860115 22.0%
Dow Chemical DOW3 880803 5.3% Polaroid PRD 890131 37.0%
MCI Telecomm. MCIC 861203 5.3%
State St. Boston Corp. STBK 8805 13 5.4% * (Not included: Dow Jones & Co.; DJ, 860724;
GEICO GEC 880303 6.0% % unknown to company at time of announcement)
ly repurchased during a given one-year buyback no change or an increase in outstanding shares.

period is difficult to obtain (the annual report, for Moreover, the average one-year excess return for the
example, includes only the number repurchased dur- 17 buybacks with either no change or an increase
ing the fiscal year), I was forced to use as a proxy in outstanding shares was 11.02%-significantly
the actual change in outstanding shares. higher than the 7.71% average one-year excess re-
An examination of these data provides clear return for the 19 buybacks with greater than a 5%
sults-namely, that for the buybacks in this study reduction in outstanding shares.
there exists no correlation between the actual reduc- In addition, for only 19 buybacks did the ac-
tion in common shares and one-year performance tual reduction in common shares equal or exceed
relative to that of the S&P 500. This conclusion holds 90% of the announced buyback percentage (which
true even when one omits the buybacks with either for these 19 ranged from 1% to 22%, with an average

of 6.3). The average one-year excess return for this Earnings Trend Group Performance
group-6.75-proved virtually identical to the aver- Earnings Percent Cumulative Excess Returns
age excess return for the entire group of 78 buybacks. Trend to be
Interestingly, only a small correlation was found be- Group Repurch. Days -l+O Day 250
tween the announced buyback percentage and the 5.7% 1.82% 9.14%
t-4)
actual reduction in common shares. Even when buy- 11.6% 1.25% 9.09%
03)
backs with no change or an increase in outstanding 6.5% 1.93% -6.53%
(C)
shares are omitted, this correlation is best described 7.3% 4.07% 6.62%
CD)
as modest.
In the main, the results are what one would expect.
Earnings Trends Those buyback announcements preceded by falling
Accepting the natural bias toward rising ear- earnings (groups B and D) were characterized by a
nings but wanting to examine the relationship be- larger percentage of shares to be repurchased-
tween earnings trends and performance following a 9.84% on average-than those preceded by rising
buyback announcement, I divided the study’s 78 earnings (groups A and C), which averaged a 5.82%
buybacks into four groups: those with rising earn- announced buyback. Also as expected was the supe-
ings both prior to and during the buyback period; rior performance of the 58 buybacks in groups A and
those with falling earnings prior and rising during; B with rising earnings following the buyback an-
those with rising earnings prior and falling during; nouncement: These buybacks averaged a 9.13% one-
and those with falling earnings both prior to and year excess return. Interestingly, the 20 buybacks
during the buyback period. To obtain earnings with falling earnings following the buyback an-
trends, from the O’NeiZ Database volumes I noted the nouncement (groups C and D combined) achieved,
quarterly earnings percentage changes and the slope on average, exactly the market return and did not
of each company’s earnings line. Virtually flat earn- underperform the market.
ings I classified as falling, and earnings at the end
of the one-year buyback period weighed more heavily Seasonality
in determining the trend during that buyback period To determine whether performance differed ac-
than those at the beginning. cording to the time of year a buyback was announced,
Listed in the table below are the number of I grouped the 78 buybacks by quarter (based on the
buybacks in each of the four earnings trends groups: date of the Wall Street Journal item announcing the
planned buyback). The table below summarizes the
Earnings Trends results:
(A) Rising before, rising during: 43
Average Cumulative Excess Returns by Quarter
(B) Falling before, rising during: 15
QtG X Days -l+O Day 5 Day 20 Day 62 Day 125 Day 250
(C) Rising before, falling during: 10 1 20 3.13% 3.54% 2.16% 2.42% 2.20% 1.24%
(D) Falling before, falling during: 10 2 14 1.14% .57% -.280/c 3.20% 4.62% 2.31%
3 18 1.98% 1.58% 1.44% 2.24% 2.27% 5.56%
By combining the appropriate groups, one then ar- 4 26 1.66% 1.77% 2.15% 6.57% 9.70% 14.35%
rives at the following figures:
Note that the 34 buybacks in the first and second
Total, rising before: 53 quarters-on average-performed significantly less
Total, falling before: 25 well than the average for all 78 buybacks (although
Total, rising during: 58 they still outperformed the S&P 500), and that the
Total, falling during: 20 26 fourth-quarter buybacks achieved more than dou-
ble the 6.80% average excess return for all 78
The relatively few buybacks in groups B, C, and D buybacks.
and the admittedly crude categorization suggest that A closer look at the data reveals the following
one must be cautious in drawing conclusions. Fur- about the first- and fourth-quarter extremes: that the
thermore, within each group-as is the case through- average beta for the buybacks in these two quarters
out most of this study-there exists huge variability is exactly the same; that both quarters comprise a
in performance. Finally, it is important to remember variety of earnings trends; that the percentage of
that I did not consider earnings relative to expecta- stock to be repurchased is actually higher on average
tions but only the absolute trend of earnings. for first-quarter buybacks; that the excess returns
The table below lists-by earnings trend group- for the individual buybacks in each quarter vary
the average figures for the announced percentage of widely; that the probability of outperforming the
stock to be repurchased and the excess returns: S&P 500 is only 52% for first-quarter buybacks but

77% for fourth-quarter buybacks; and that the 26 As shown, groups 1 and 2 achieved one-year excess
fourth-quarter buybacks include 11 from the months returns just slightly below the average of 6.80% for
following the crash (9 of which achieved significant the entire study, while groups 3 and 4 significantly
one-year excess returns). Omitting the 1987 fourth- outperformed and underperformed, respectively, the
quarter buybacks reduces the average excess return average one-year excess return for the study.
for this group to 9.&!?still much higher than that Especially telling is the strong performance of the
of the other three quarters. group 3 stocks. While some concern accompanies any
conclusions about the performance of groups 2 and
The Crash 3 due to the small sample size-10 and 11 buy-
The extraordinary performance of the 1987 backs-two relevant points must be noted: 1) Both
fourth-quarter buybacks raises the question of how group 2 and group 3 include a diversity of industries,
these immediately post-crash buybacks affected the and 2) These industries during the relevant time
study’s overall results. By omitting these 11 buy- period did not outperform the market, implying that
backs from the study’s original 78, the average cu- the outstanding performance of group 3 resulted
mulative excess returns are as follows: from the strength of individual stocks and not from
the industries as a whole. In fact, according to the
Average Cumulative Excess Returns
O’Neil Database volumes, many of the group 3 stocks
(Fourth Quarter 1987 Buybacks Omitted)
were at that time one of the top three performers in
Days -l+O Day 5 Day 20 Day 62 Day 125 Day 250 industries with flat or falling relative strength lines.
2.35% 2.10% 1.57% 2.89% 3.34% 4.48%
(all) 2.02% 1.96% 1.71% 3.90% 5.15% 6.80%
Implications for Investment Strategy
As is clear, while the announcement-day period and The value of any conclusions to be drawn from
one-week returns are slightly higher with the fourth- this study-for the pragmatic among us, at least-
quarter 1987 buybacks omitted, the more important lies in their real-world potential for application. Most
one-year excess return is about one-third lower. fundamentally, for example, do the conclusions im-
Another interesting question is how the buy- ply strategies that employ information an investor
backs whose one-year performance period was inter- can reasonably be expected to know or find at the
rupted by the October 1987 crash fared versus those time of the buyback announcement? Also, can an in-
whose performance periods either entirely preced- vestor capture most or all of any excess returns? And
ed the crash or began more than a few months after to what extent do transaction costs diminish or elim-
the crash. To answer this question, I arranged the inate excess returns?
78 buybacks chronologically and then divided them The latter two questions above have great rele-
into four groups. Listed below for each group are, Vance for traders, for whom the best advice seems
first, the time period encompassed (measured from to be this: 1) Buy the stock of companies announc-
the announcement of the first buyback in a group ing large repurchases-say, 10% or greater of the
to the end of the last’s one-year performance period); common shares; 2) Buy immediately after the repur-
second, the S&P 500’s performance during the peri- chase announcement becomes public (on Day -1);
od; and third, the cumulative average excess returns. 3) Sell after five trading days. (On average, ignoring
Note that the time periods necessarily overlap. transaction costs, a 3.89% excess return should
(1) PRE-CRASH (March ‘85September ‘87) result.)
S&P 500 up 78% For investors, the study’s general results sug-
(2) CRASH-INTERRUPTED (October ‘86- gest greater rewards but demand more caution.
September ‘88) Despite an average one-year excess return of 6.80%,
S&P 500 up 16% the buybacks in the study evinced huge variability
(3) IMMEDIATELY POST-CRASH (October ‘87- in excess returns. The standard deviation of 20.43%
December ‘88) for these one-year excess returns implies only a 63%
S&P 500 up 12% probability of any positive excess return at all-and
(4) POST-CRASH (January ‘88-February ‘90) this ignores transaction costs.
S&P 500 up 34% Fortunately, two investment strategies present
themselves that are more specific, less risky, and
Cumulative Average Excess Returns
more rewarding than simply buying large-cap com-
Days -l+O Day 5 Day 20 Day 62 Day 125 Day 250
panies announcing a buyback: 1) Buy the stock
(1) 2.62% 2.52% 55% 1.21% 2.44% 6.43%
(2) 1.60% .99% .95% 2.08% 3.62% 6.16% of large-cap companies announcing share repur-
(3) -.04% 1.10% 2.51% 10.03% 16.16% 20.90% chases during the fourth quarter of the year-in Oc-
(4) 2.36% 2.11% 2.70% 4.68% 4.07% 2.18% tober, November, or December; or 2) Buy companies

announcing repurchases with rising earnings prior mentioned 33% for the study as a whole); 2) the now
to the buyback announcement and for which com- greater percentage of best-performing buybacks with
panies the confident forecaster expects rising earn- rising earnings prior to the buyback announcement
ings in the ensuing year. (83% versus 68% for the entire study); and 3) the con-
To help corroborate these strategies, I first tinued evidence of extraordinary performance by the
listed all 78 buybacks in order of their one-year per- third month. At least 10 different industries consti-
formance and then examined the extremes. Exhibit tute this group of 17 buybacks, although pharma-
4 lists the top 25% of buybacks in terms of one-year ceuticals now boasts four representatives.
excess return. Thirteen of the 20 best-performing At the other extreme, 26 buybacks underper-
buybacks (65%) were fourth-quarter buybacks (as formed the S&P 500. The underperformance mani-
compared with 33% of all 78 buybacks). Note that fested itself within one month of the announced
the extraordinary performance was in evidence by buyback and the average one-year performance was
the third month and that these 20 buybacks repre- more than 15% below that of the S&P 500. Of fur-
sented at least 13 different industries, with only ther note is that the percentage of fourth-quarter
pharmaceuticals having as many as three repre- buybacks in this group is somewhat lower than that
sentatives. As for the earnings groupings, while the for the study as a whole (27% versus 33%). As for
percentage of best-performing buybacks with rising earnings, it was not surprising to find a higher
earnings prior to the buyback announcement ap- percentage of buybacks with falling earnings dur-
proximated that for the entire study, the percentage ing the one-year period following the buyback
with rising earnings during the buyback period was announcement. Interestingly, this group of under-
85% as compared to 74% for the study as a whole. performers contained about the same percentage as
(One must be cautious, of course, about basing in- the entire study of buybacks with rising earnings
vestment strategy on information that cannot be prior to the buyback announcement. The range of
known at the time of the investment-namely, future industries among the under-performers proved
earnings.) narrower, with capital-intensive oil and oil service,
To account for what some may argue was the aerospace, and computers having the most
uniqueness of the 1987 fourth-quarter, I omitted representatives.
these 11 buybacks and then examined the top 25%
of the remaining 67 buybacks. Of particular note are F’urther Study
1) the now reduced but still higher-than-average per- Several areas of study offer promise. In no par-
centage of fourth-quarter buybacks among the best- titular order they are as follows: A) A comparison
performing buybacks (41% versus the previously of the excess return for companies with a history of
Exhibit 4
TOP 26% IN ONE-YEAR EXCESS RETURN
QTR. MONTH EARN. l COMPANY SYMBOL DA!l’R + TO BE REP. DAY&l+0 DAY 5 DAY20 DAY62 DAY125 DAY250
1 1 (A) S&lumber SLRP 890127 4.0% 0.59% 3.71% 2.28% 10.54% 8.01% 19.18%
4 11 (A) K-Mart KM 871125 8.7% -0.90% 1.26% 6.85% 14.53% 11.60% 19.40%
4 12 (A) Pacitic T FAG 881212 2.4% -0.77% - 1.23% -3.33% 4.86% 10.75% 20.31%
4 12 (A) Abbott La ABTl 851216 5.0% 3.60% -1.06% 3.17% 0.88% 21.09% 20.52%
2 5 (A) State St. STBK 880613 5.4% 2.20% -2.24% 4.74% 14.10% 15.61% 21.00%
4 12 (A) Abbott La Awl-2 881212 1.3% 0.01% -1.35% - 1.93% 3.91% 11.04% 21.18%
1 2 (A) Quaker On OAT 880202 2.5% 2.65% 2.41% 2.23% 9.75% 3.59% 22.88%
4 11 (A) Digital E DECl 861107 3.9% -0.75% -3.53% -0.02% 23.98% 37.06% 23.42%
3 7 (A) Dow Jones DJ 869724 TJnknown to co -0.65% 3.00% 1.22% 9.63% 21.86% 23.44%
4 12 0) Golden We GDW 871204 9.6% 8.65% 15.82% 8.44% 26.37% 10.26% 25.54%
4 10 (B) DaytmHu DH 871022 15.4% -3.91% 3.94% -2.25% 7.17% 26.34% 27.33%
4 11 (A) Ford Mote F2 871113 10.1% 3.44% 5.12% 5.45% 12.38% 24.61% 30.70%
4 10 (B) Hilton Ho IiET 871020 16.0% -5.83% -3.74% 7.04% 6.72% 22.11% 32.13%
4 11 (A) Household HI2 871103 6.0% 5.27% 2.71% -1.01% 5.58% 25.99% 32.72%
1 3 CC) Dow Chemi DOW1 850322 1.3% 0.04% 1.17% -0.30% 13.71% 19.87% 36.24%
4 11 @3) Ford Mota Fl 851115 10.5% 8.70% 9.82% 10.04% 26.45% 33.38% 42.26%
3 8 (A) Merck MRKl 850807 2.5% 1.21% 3.36% 3.98% 5.14% 11.19% 43.38%
4 11 (B) Wells Far WFC 871119 4.1% -0.03% -0.78% -1.66% 15.72% 23.35% 43.99%
4 12 (III) MCI T&c MCIC 861203 5.3% 7.69% 12.61% -0.03% -26.47% - 10.84% 51.87%
3 7 (A) Apple Corn AAPL 860722 7.6% 8.10% -0.37% 7.51% 5.79% 27.90% 72.50%
- - -- - -
AVERAGE 6.4% 1.97% 2.53% 2.62% 9.54% 17.74% 31.50%
*Earnings: (A) = Rising before, rising during l (R) = Falling before, rising during l (C) = Rising before, falling during l 0) = Falling before, falling during
26 M’IA JOURNAL/SPRING 1991

buybacks with those announcing a rare buyback; B)
A study of excess returns based on the actual num-
ber of shares a company repurchases; 0 A more rig-
orous study of the effect of industry performance on
individual buyback performance; D) A comparison
of excess returns for the months preceding the buy-
back announcement and the returns for the year
following the announcement; E) A study of the effect
of earnings surprises among buyback companies and
a more rigorous study of earnings trends before and
after repurchase announcements; F) The inclusion
in the study of two sets of excess returns, one using
the S&P 500, the other the DJIA; and G) Specific
sell disciplines for whatever investment strategies
result from the preceding work.
G. Gernon Brown III, a recent graduate of the Univer-

sity of Virginia’s MBA program, is an Investment Sales
Associate with Kidder, Peabody in Baltimore

Stock Market Price Behavior: Random
Walks and Nonlinear Dynamics
Peter A. Mulieri
Introduction inferred from the results and some thoughts on

A substantial amount of time and money has been promising paths of research are presented.
spent to predict the movement of stock market
prices, but despite these efforts, accurate forecasts Random Walk Hypothesis
have eluded the time series analyst. Technical anal- For many years, researchers in the academ-
ysts and chartists believe past prices contain infor- ic and business communities have attempted to
mation, which may be nonlinear, that can predict determine the nature of stock market price be-
prices with accuracy sufficient to out-perform a buy havior. Pursuit of an answer to this question has
and hold strategy. Others believe that past prices are evoked a considerable amount of controversy that
independent of future prices, or that the statistical still exists today. One school of thought believes
behavior of stock market prices emulates a random past prices contain trends or patterns that can
walk. The possibility that nonlinear structure exists predict future prices, while another, the proponents
is important, because it has been shown that non- of the random walk hypothesis, believe the future
linear deterministic equations can generate chaotic movement of prices are unpredictable. Statistically,
time series that are indistinguishable from a ran- the random walk hypothesis states that succes-
dom walk series using traditional linear statistical sive price changes, for any time interval, are inde-
testing techniques. pendent and identically distributed (IID) random
Farmer and Sidorowich (1988a) have shown variables.
that the accuracy of forecasts could be significantly Empirical tests of the random walk hypo-
improved by using nonlinear modeling techniques. thesis, employing a multitude of statistical tests,
Their work in chaotic dynamics and nonlinear have not come up with any conclusive evidence that
modeling demonstrates that if the source of ran- supports or refutes the theory. These tests fall into
dom behavior comes from a system characterized two categories: 1) those that test for independence
by low dimensional nonlinear relationships (rela- of price changes, and 2) others that test for con-
tively few terms required to explain the system), formity to some probability distribution. Price
nonlinear forecasts will be much better than those change independence is the most important aspect
of linear models. Hence, finding evidence of low of the random walk hypothesis, and consequently
dimensional activity in a stock price time series has been the topic of most debate.
is an essential step in improving the accuracy of A vast majority of the empirical studies em-
forecasts. Preliminary results of a Scheinkman and ploying traditional statistical techniques to date
LeBaron (1988) study of an aggregate stock return support the random walk hypothesis. However,
series using a Grassberger-Procaccia (1983) algo- among the researchers who argue against the ran-
rithm to estimate correlation dimension (a measure dom walk hypothesis, the concept of nonlinear
of the randomness of a system in the nonlinear dependencies in the data is a common theme. Levy
sense), have shown indications of nonlinear depen- (1967, p.69) mentions that there are serious
dence in the data. weaknesses in the statistical tests for time series,
Application of correlation dimension analysis since “they are not capable of detecting nonlinear
techniques to four individual stock price series, and patterns which the chartists claim exist.” Cootner
a composite of the four, is the focus of this paper. A (1964, p.191) discusses a test based on the range
brief overview of the random walk hypothesis is of the random walk, where the “power of the range
presented, followed by a discussion of the relation- test lies in its sensitivity to nonlinear dependence.”
ship between nonlinear dynamics and stock market Alexander (19641 developed a test that claims to be
price fluctuations, definitions, data description, and capable of detecting nonlinear dependence in a stock
empirical results. Finally, conclusions that can be price series.

Nonlinear Dynamics may be an exponential separation of the trajectories
Recently, an abundance of research has been which is characteristic of a nonlinear deterministic
conducted in nonlinear deterministic dynamics (the system.
mathematical behavior of nonlinear equations or Scheinkman and LeBaron (1988) have calcu-
models) in the natural sciences and economics. Fluc- lated correlation dimension estimates for aggregate
tuations occurring in nature and economic systems, weekly U.S. stock return data and a selected indi-
once thought to be purely random, have been ex- vidual stock using the Grassberger-F’rocaccia (1983)
plained by nonlinear deterministic models. Extend- algorithm. They find strong evidence of nonlinear-
ing this notion to the random walk hypothesis, one ities in the aggregate data but find no evidence in
can postulate that the possibility exists that a stock the individual stock return series. Brock’s (1988)
return time series, which appears to be random, analysis of the same aggregate data set supported
might contain an underlying nonlinear determinis- their evidence, while the results for another individ-
tic explanation. ual stock series provided no indication of an underly-
Brock and Sayers (19871, and Scheinkman and ing nonlinear structure. Scheinkman and LeBaron
LeBaron (1988) consider a simple example of a non- (1988) describe the failure to detect nonlinearities
linear equation that illustrates how a time series can in the individual stocks as a result of inherent
be generated from a purely deterministic process and idiosyncracies and the presence of noise.
be indistinguishable from a random series. This ex- Let us assume that the null hypothesis of the
ample takes the form of a difference equation, presence of nonlinearities in stock return data is, in
fact, true. One then might ask, what is the process
where by which these nonlinear deterministic fluctuations
:$I zAT)for OlxlyZ
are created? A number of possible explanations have
fix) = 2(1 - x) if M<x<l,
and been proposed. Shiller (1984) postulates that the
t is time.
variability in stock returns is due to social-psycho-
It has been shown that the time series generated by logical factors, where there are two types of investors,
this difference equation form a chaotic time series. the “smart money” investor and the “ordinary” in-
Bunow and Weiss (1985) have analyzed this series vestor. The “smart money” investor would react
and their results indicate that the autocorrelations quickly to any new information and properly assess
(a measure of the linear dependencies in the data) the expected returns on stock. An “ordinary” inves-
are essentially the same as that of a sequence of tor can be expected to overreact to new information
pseudorandom numbers (random numbers that are such as dividend/earnings announcements or major
not purely random but close enough for practical events, causing the price of the stock to be under or
purposes). Consequently, an analysis of a time series over valued. The “smart money” investor will prop-
employing standard statistical techniques that rely erly assess the actions of the “ordinary” investor
on autocorrelation and functions could overlook an creating a feedback process similar to the dynamics
underlying nonlinear deterministic explanation. It of a difference equation model. This dichotomy of in-
can be argued that this example is too simplistic to vestor types could induce a nonlinear deterministic
model the true dynamics of a typical time series, pattern in a stock return series that is not detectable
however, higher order models are even more likely by linear forecasting methods or standard statistical
to generate deterministic chaotic trajectories that tests. Additional explanations (Brock, 1988) might
look like pseudorandom numbers. include: the Monday effect (lower returns from the
The inadequacies of standard statistical tech- Friday close to the Monday open than over the rest
niques in uncovering nonlinearities in time series of the week), the monthly effect (similar to the Mon-
fluctuations create a need for alternative testing day effect), and systematic movements in the tradeoff
methods. Among the alternatives are two methods between risk and return.
commonly used by researchers: the estimation of cor-
relation dimension, and the largest Lyapunov expo- Correlation Dimension
nent (not examined in this paper). In general, if the For the purposes of this paper, a description of
correlation dimension estimate of a time series is low the concept of correlation dimension will suffice. Ac-
relative to a truly random time series, then there cording to Ramsey, Sayers, and Rothman, 1988, p.3)
is an indication that nonlinear deterministic rela- correlation dimension is “a measure of the relative
tionships may exist in the data. Lyapunov exponents rate of scaling of the density of points within a giv-
provide a measure of the rate at which average near- en space. . . If the time series is a realization of a ran-
by trajectories separate (Farmer and Sidorowich, dom variable, the correlation dimension estimate
1988b). If any of the exponents are positive, there should increase proportionately with the dimension

ANALYSIS PROCEDURE
TESTSFOR
NONLINEAR DEPENDENCE
COMSINED rrsT RESULTS CONCLUSIONS
._-._ _.__._._ - .___ - .-.-.-.__. ~
-hr ‘f-f [-==++E]

EMsEDoINoDlM WJmw I
DWERGENCE 7
DATA CORRELATION
COLLECTION _ To-
’ INCREASE
IN DATA SET
Figure 1
of the space within which the points are contained.” ~~mension by Grassberger and Procaccia (1983) and
However, if the estimate of correlation dimension Takens (19831, has been extended by Scheinkman
does not increase proportionately, then this is an in- and LeBaron (1988) by incorporating the concept of
dication that an underlying deterministic structure embedding dimension (see the references for the
exists in the time series. mathematical derivation). Embedding dimension is
To understand this concept more clearly, con- introduced as a method for testing empirical data.
sider a series of pseudorandom numbers generated In the case of a stock price change series, if we con-
by a digital computer. Researchers have found that struct a set consisting of every combination of three
for most computer generated random number gen- price changes, the embedding dimension is three. In
erators the correlation dimension estimates tend to general, the “true” correlation dimension of a time
be around 20 (in reality, if the numbers were truly series is the point at which the correlation dimen-
random the estimate should be infinite, but random sion estimates do not increase proportionately with
numbers generated by a computer are created by a increases in the embedding dimension.
deterministic algorithm). If we apply the correlation
estimation technique to a series of stock returns and Description of the Data
find the dimensionality estimate to be greater than Inspired by the strong evidence of nonlinear-
or equal to 20, this would support the random walk ities in stock return data found by Scheinkman and
hypothesis. Conversely, if the estimate is significant- LeBaron (1988) using correlation dimension analy-
ly lower, then there exists evidence of an underly- sis, I decided to apply these techniques to some se-
ing nonlinear deterministic structure. lected individual stock price series. A limited num-
The mathematical definition of correlation di- ber of empirical analyses of individual stock issues

ORIGINAL SERIES CORRELATION DIMENSION ESTIMATES
12
u EMBEDDlrdG DIM=9 q EMBEDDING DIM= 10
7 10 -
0
z
5 8-
>
E
;:,.:‘:.’
‘.
z 6- .“.““..
,,..’,...,:,
.:ry
F 1
4
4- ‘:::::.
E .:. ,:.:. i
E
0 2- ..:
0 1
MD GQ GD BA COMP
Figure 2
have been conducted using these techniques, there- tor that could contribute to this effect include: 1) the
fore, a more thorough investigation seemed prudent. ability to properly evaluate the future effect of an
The analysis, so far, has not been successful in the advanced technology breakthrough; 2) more accu-
detection of nonlinearities for individual stock price rate projections of the future level of defense spend-
series. Scheinkman and LeBaron believe that the being; 3) proper assessment of the effect of catastrophes
havior of individual stocks might contain idiosyn- (e.g., airline crashes) and defense related scandals;
cracies or be too noisy, thereby hiding a possible non- 4) knowledge of foreign competition.
linear structure. Cognizant of this belief, a compos-
ite series was constructed from the selected individ- Analysis Procedure
ual stocks, to see if some of the idiosyncracies and The first step in the analysis is to take first dif-
noise might be “washed out”, thereby increasing the ferences for each of the five weekly closing stock
nonlinear deterministic signal, if one exists, relative price series (see Figure I), resulting in a time series
to the noise (higher signal to noise ratio.) of weekly price changes, then estimate a model for
Four individual New York Stock Exchange is- each of the time series using your favorite linear re-
sues were selected from the aerospace/defense indus- gression technique. The purpose of this technique is
try: 1) McDonnell Douglas, 2) Grumm an, 3) General to remove long term linear dependency due to stock
Dynamics, and 4) Boeing. Each data set consisted of price appreciation. In this analysis, the Box-Jenkins
104 weekly closing prices from 22 February 1985 to Autoregressive Moving Average (ARMA) (Box and
13 February 1987. Aerospace/defense stocks were se- Jenkins, 1970, Hoff, 1983) modeling process has
lected with the hypothesis that the “smart money” been implemented. Using this estimated model and
and “ordinary” investor effect postulated by Schiller the associated time series, a residual time series is
(19841, might be stronger due to factors that are calculated for each stock and the composite. The
unique to the industry. Some of the “smart money” residuals will then be checked for significant auto-
assessment factors relative to the “ordinary” inves- correlation coefficients in the lags. If significant
MTA JOURNAL. / SPRING 1991 31

ORIGINAL AND SCRAMBLED SERIES CORRELATION
DIMENSION ESTIMATE COMPARISON
12
MD GD BA COMP
Figure 3
coefficients exist, the ARMA modeling process is the correlation estimates for the original series are
repeated. After completion of this process, each resid- significantly smaller than the “scrambled” series,
ual series now satisfies the IID assumptions of the then we can conclude that original series contains
random walk hypothesis. Correlation estimates for nonlinear dependence.
each of the resultant residual series are calculated
according to the method described in Scheinkman Correlation Dimension Analysis Results
and LeBaron (1988). The estimates of correlation dimension at
Three independent but similar measures of embedding dimensions 9 and 10 (Figure 2) for all
nonlinear dependence using correlation dimension stock return series show no clear indication of
estimates were applied: 1) Correlation dimension es- nonlinear dependency relative to the first measure,
timates that continue to grow with the correspond- since the estimates of correlation dimension for all
ing embedding dimension indicate no nonlinear time series increase with the embedding dimension.
dependence; 2) Correlation dimension estimates that However, the absolute correlation dimension esti-
are small relative to the associated embedding mate of the composite series is small relative to the
dimension imply the presence of nonlinear depen- corresponding embedding dimension, implying the
dence in the data; and 3) Scheinkman and LeBaron possibility of nonlinear dependency. The comparison
(1988) developed a test called the shuffle diagnostic of the original to the scrambled residual series
This procedure consists of forming a “scrambled” (Figure 3), we observe no significantly higher
residual data set by sampling from the residual time scrambled series estimates for the individual stocks,
series at random with replacement, and then com- but the composite series estimates for the scrambled
paring the relative correlation dimension estimates data are significantly higher than the original series
of the original and “scrambled” residual series. If at embedding dimensions 9 and 10.

COMPOSITE SERIES CORRELATION DIMENSION ESTIMATES
14
ORIGINAL SERIES SCRAMBLED SERIES

A .-.-~.‘-.-.
,,Q
7 l2 ,’,’,’
;
0 .’.’
,’
,’
u> ,’,’
7 ‘0 - &”
,a-*
g _,a-
E a- //o...=*~‘-’
./* _.-’
g
0 I I I I I I
6 7 8 12 13
EMBED;ING DIMENSION’
Figure 4
Additional correlation dimension estimates excessively small. Even data sets containing 6000
were calculated for the composite series data at observations are considered, by most researchers, to
embedding dimensions 7,8,11, and 12 to substan- be too small to obtain accurate estimates of correla-
tiate the initial findings. Estimates of correlation dition dimension. Second, the estimation process
mension for the original and scrambled data at might not have removed enough linear dependence
embedding dimensions 7 through 12 (Figure 4) sup- (due to long term appreciation of the stock price) in
port the hypothesis that nonlinear dependence ex- the data, and the process itself could have induced
ists in the original series for all three measures: some dependence in the residuals. Finally, the
1) the scrambled series estimates continue to grow evidence of nonlinearity could be due to the presence
with the embedding dimension, while the original of nonstationarities (the statistical properties of the
series levels off at about 5.5; 2) the original series data set are not uniform) and heteroscedasticity (the
estimates are small relative to the associated embed- variance of the data is not constant as a function of
ding dimension; and 3) the estimates are significant- time) in the residual series.
ly different between the scrambled and original Nevertheless, the results and processes of the
series at all embedding dimensions. analysis did indicate some avenues of further re-
search. Conducting an analysis for a much larger
Conclusions data set of the stocks considered, giving special at-
Apparent indications of nonlinearities in the tention to the problems of the estimation process and
composite stock time series data are encouraging, residual structure, will provide a better basis for the
however, the evidence could be challenged for a num- formulation of any conclusions about the data. Lower
ber of important reasons. First, and most important, estimates of correlation dimension for the composite
the number of observations in the data sets are relative to the individual series indicate the possi-

bility that idiosyncracies and noise of individual Center for Nonlinear Studies, Los Alamos National Laboratory.
series were removed, implying that an analysis of Farmer, J. D., and J. J. Sidorowich. “Can New Approaches to
comprehensive industry indices might produce some Nonlinear Modeling Improve Economic Forecasts?’ In P W. Ander-
son, K. J. Arrow, and D. Pines, editors, The Economy as an Euolu-
interesting findings. ing Complex System, Addison-Wesley, 1988b.
Knowledge of the existence of nonlinear depen-
Grassberger, P and I. Procaccia (19831, “Measuring the Strange-
dency in the data alone is not sufficient to capital- ness of Strange Attractors,” Physicu 9D, 189-208.
ize on market price fluctuations. Research and Hoff, J. C., A Practical Guide to Box-Jenkins Forecasting,
development of nonlinear prediction and classifica- Wadsworth, 1983.
tion techniques applied to market price data can po- Levy, R. A. (1967), “Random Walks: Reality or Myth,” Financial
tentially provide the most promising prospects for Analysis Journal 23, 69-77.
characterizing a significant portion of the time series Ramsey, J. B., and C. L. Sayers, and I? Rothman (19881, “The
Statistical Properties of Dimension Calculations Using Small
that has been traditionally referred to as pure ran- Data Sets: Some Economic Applications,” New York University,
dom error. Application of nonlinear regression and and University of Houston.
neural network techniques have great potential. For Sayers, C. L. (1988), “Diagnostic Tests for Nonlinearity in Time
instance, by fitting a nonlinear model, that is in the Series Data: An Application to the Work Stoppages Series,”
form of a simple or complex difference equation, the Department of Economics, University of North Carolina.
estimated value of the coefficients can provide infor- Scheinkman, J., and B. LeBaron (1986, revised 1988), “Nonlinear
Dynamics and Stock Returns,” University of Chicago; Journal
mation on the cyclical state of the system (i.e. 1 cy- of Business, forthcoming.
cle, 2 cycle,. . . , n cycle,. . . , chaos) and potentially
Scheinkman, J., and B. LeBaron (1987), “Nonlinear Dynamics and
predict near term price magnitude and direction. GNP Data,” University of Chicago, and CEREMADE (Universi-
Neural net models, which are inherently nonlinear ty of Paris IX), unpublished.
in their computational elements, provide potential- Shiller, R. J. (1984), “Stock Prices and Social Dynamics,” Brook-
ings Papers on Economic Activity 2, 457-498.
ly the greatest opportunity for exploiting time series
with low correlation dimension estimates. Combina- ‘B&ens, E (19831, “Invariants Related to Dimension and Entropy,”
Proceedings of the Thirteenth Coloquio Brasileino de Matematica.
tions of these methods along with other emerging
nonlinear techniques, and the availability of low cost
high speed processors should produce some signifi- Peter Mulieri has spent several years in aerospace and
cant breakthroughs in the next five years. advertising holding operations research, systems anal-
ysis, and programmer analyst positions. This paper is
a summary of his master’s thesis work fir an M.S. degree
REFERENCES in applied mathematics and statistics from the State
University of New York at Stony Brook. He is currently
Alexander, S. S., “Price Movements in Speculative Markets:
a member of the Investment Technology Group at Jef-
Trends or Random Walks.” In P H. Cootner, editor, The Random
feries and Company, Inc.
Character ofStock Market Prices, Cambridge: M.I.T. Press, 1964.
Box, G. E. P., and G. M. Jenkins, Time Series Analysis, Forecasting
and Control, Holden-Day, 1970.
Brock, W. A. (1986), “Distinguishing Random and Deterministic
Systems: Abridged Version,” Journal of Economic Theory 40,
168195.
Brock, W. A. “Nonlinearity and Complex Dynamics in Econom-
ics and Finance.” In I! W. Anderson, K. J. Arrow, and D. Pines,
editors, The Economy us an Evolving Complex System, Addison
Wesley, 1988.
Brock, W. A., W. D. Dechert, and J. Scheinkman (1988), “A Test
for Independence Based on the Correlation Dimension,” Depart-
ment of Economics, University of Wisconsin, Madison, Universi-
ty of Houston, and University of Chicago, unpublished.
Brock, W. A., and C. L. Sayers (1988), “Is the Business Cycle
Characterized by Deterministic Chaos?’ Journal of Monetary
Economics 22, 71-90.
Bunow, B., and G. H. Weiss (1979), “How Chaotic is Chaos? Chaotic
and Other “Noisy” Dynamics in the Frequency Domain,”
Mathematical Biosciences 47, 221-237.
Cootner, l? H. (ed.), The Random Character of Stock Market Prices,
Cambridge: M.I.T. Press, 1964.
Fama, E. F. (1965), “The Behavior of Stock Market Prices,” Jour-
nal of Business 38, 34-105.
Farmer, J. D., and J. J. Sidorowich (1988a), “Exploiting Chaos to
Predict the Future and Reduce Noise,” Theoretical Division and

The Use of Price-Volume Crossover Patterns
in Technical Analysis
S. Kris Kaufman and Marc Chaikin
Abstract: Background and Methods. The routine the same number of days. We used approximately
use of price-volume crossover signals as a means of one hundred and twenty five thousand days of daily
forecasting future stock or commodity price move- stock and commodity data bundled together in our
ment has been gaining popularity lately due to the evaluation. At least 100 occurrences for each cross-
availability of software to simplify the analysis. In over pattern were used in the analysis.
this study we tested 24 unique crossover patterns Results: The results suggest that several pat-
and identified their forecasting performance. Cross- terns are significant and could be used to improve
overs are classed by both pattern and the elapsed a stock or commodity price forecast. The most nega-
time for the pattern to develop. For each pattern, we tive cross within the test window was II-B, which
analyzed how much better one could forecast price occurs when price drops on decreasing volume, rises
direction 5,10,15, and 20 days in the future, given on light volume and then drops again on increasing
that the elapsed time for the cross to develop spanned volume. It was interesting that the converse pattern
TITLE: Price-Volume Crossover Derivations
PRICE-TIME VIEW
A
2 4
P
Fi
I 0 P
C
E 1 PRICE-VOLUME VIEW
3
o,,j$, 4 2
IIIIII II>
P
TIME
\ R
VOLUME-TIME VIEW C 1
f
’E X> ’ 3
VOLUME
TIME
Figure 1: DERIVATION OF PRICE-VOLUME CROSSOVER

I-B is not as bullish as II-B is bearish. The I-B results linked to the crossing of two price-volume lines. Ben
show that you will generally move up immediately Cracker, for one, has long been a proponent of price-
after the cross, only to fall later. The utility of this volume charting and has studied some of the basic
technique is its ease of use by computer and the in- patterns as well as pattern groupings. In this study
tegration of price and volume which is achieved. we will test each of the 24 basic single cross patterns
on four time periods using very diverse stock and
Introduction commodity data.
Market technicians usually study time-based
charts in order to identify price and volume patterns. Crossover Patterns
There is a large body of technical knowledge about The price-volume view is formed by plotting
the combinations of price and volume behavior that the closing price on a vertical axis versus volume on
lead certain types of market price action [Bring et a horizontal axis (Figure 1). Each day a new point
al.]. The price-volume chart provides a different way is added and then connected to the previous days
of viewing the data. In fact, the two major reasons point by drawing a line. For this discussion we will
for using this view are that it leads to a single indi- refer to the “final” segment as the most recent
cator integrating price and volume and the data can price-volume line. The “initial” segment is the one
be easily tracked by computer. The identification of which occurred further back in the past and is
these patterns on the price-volume chart has been crossed by the final segment. Crossover patterns are
TITLE: PriceVolume Crossover Patterns I
P
FINAL SEGMENT: PRICE INCREASES R
VOLUME INCREASES I
i”
C
I
E
VC .Ij:J(E
5 I -0.2 5 I -1.4 5 I -1.6

10 I 0.8
A
15 I 0.4
~ y-2.1 lB lg~-~~~ : ,viiii
VOLUME VOLUME VOLUME
Figure 2

classified by the direction of the initial and final following a certain crossover. Within a particular
segments, and by the elapsed time between them. time frame, more than one crossover pattern may
The pattern shown in figure 1 shows price rising on complete They have different initial segments with
increased volume (1 to 21, then declining with the the same final segment, but they still occur together
same level of volume (2 to 31, before finally rising in terms of the evaluation. We have chosen a simple
on decreasing volume (3 to 4) to complete the pat- least-squares approach to solve for the relative im-
tern. The dashed line indicates that an unknown portance of the crossovers. This approach neatly sep-
number of days may have elapsed between the initial arates each pattern by assigning it a weight as part
and final segments. There are 24 patterns in all (Fig- of a linear sum. Figure 6 shows the least-squares ma-
ures 2 through 5). The patterns have been divided trix equation Aij * Wj = Bi, where the A’s are zeros
into four groups based on the direction of the final or ones depending on whether one of the 24 cross-
segment. Each of the figures shows one of the four overs occurred within the analysis window, the W’s
final segment possibilities with all possible initial are the unknown pattern weights, and the B’s are
segment choices. the answers to what happened next in the market.
If the market went up after 5 days (or any fmed num-
Analysis her), a plus one is entered. Otherwise, a minus one
The best way to judge the benefit of using cross- is used. Since we have so much data (roughly 125,000
over signals is to analyze the actual price action days), the problem is very well constrained. The re-
TITLE: Price-Volume Crossover Patterns II
P
FINAL SEGMENT: PRICE DECREASES R
VOLUME INCREASES I
\
C
I
E
VOLUME
5 I -3.9 5 I -8.3 5 I -0.2

10 I -0.7 10 I -5.5 10 I -1.7
A 8 C
15 I -1.1 15 I -3.8 15 I -2.8
20 I -0.5 20 I -2.3 20 I -2.0
; L+ ; ix 1 ‘\
5 I -4.6 5 I -4.1 5 I -8.1

10 I -1.3 10 I -0.8 10 I -0.9
D 15 I -2.9
20 I 1.6
~ \ iE g:i:l iF gi
Figure 3

sulting weights will tell us whether a pattern is In evaluating the results it is apparent that all
bearish (W < 0) or bullish. Also note that we added patterns with the same final segment do not have
a constant term to the weighted sum model to pick the same forecasting utility (see Figure 7). One
up any price trend bias over the whole data set. This might expect that days following a move higher on
turned out to be positive 1 to 2% which is due to the increasing volume (figure 2 patterns) would always
80’s bull market. be more positive, independent of the crossover. Our
The equation was solved for four cases. All results show that patterns I-C and I-F predict very
crossovers occurring within 5 days coupled with the negative price action 5days out, before turning and
resulting price behavior 5 days out, and the same becoming very positive later. Other members of that
for 10,15, and 20 days. The results are shown in the group, including I-A, I-B, and I-C show no clear pat-
upper right hand corner of each pattern on figures tern, while I-D is positive early and negative late,
2 through 5. The weights may be interpreted as an the opposite of I-C and I-F. Group II however, does
average percentage deviation from the random case. show universally negative behavior, but there are
In other words a 5.2 weight indicates that the pat- two patterns which are much more negative than the
tern predicted higher prices about 5% better than rest. Table 1 is a summary of the signiticant results.
random. When the weights flip-flop between positive
and negative without any clear pattern, the cross- Discussion
over has little or no significance in forecasting. The results suggest that several of the price-
TITLE: Price-Volume Crossover Patterns Ill
P
FINAL SEGMENT: PRICE DECREASES R
VOLUME DECREASES
/
C
II-
E
VOLUME
5 I -6.4 5 1 -6.2
5 I -7.0
10 I -0.9 10 I -2.5 10 I -5.6
iA +-= iB kii:- / Jjl:::

5 1 -0.8 5 I -0.9 5 I -5.4
10 I -0.2 10 I -4.8
10 I 1.2
iD j-t:: iE g=- ~ F &Ii::
Figure 4

volume crossover patterns are significant and could The use of the price-volume crossover techni-
be used to improve a stock or commodity price fore- que is a practical way of integrating two charts into
cast by generally +/- 5%. It is interesting to note one for analysis. Since a computer can easily be pro-
that down moves are much more easily forecast grammed to pick out these patterns, this indicator
using price-volume patterns than up moves. Also, the should continue to gain in popularity over time. Fur-
group II pattern results suggest that any time one ther study should be devoted to combining crossover
sees a price drop on heavy volume, a hasty exit is patterns with other technical indicators, analyzing
in order. weekly and monthly data, and also to special se-
The most negative cross within the test win- quences of these patterns.
dow was II-B, which occurs when price drops on
decreasing volume, rises on light volume and then REFERENCES
drops again on increasing volume. It was very Cracker, Benjamin B., The Computerized Investor, The Cracker
interesting to note that the converse pattern I-B is Report,
M. 320 West California Blvd., Pasadena, CA 91105, Volume
not as bullish as II-B is bearish. The I-B results show

Pring, Martin, Technical Analysis Explained, McGraw-Hill,
that you will generally move up immediately after Second Edition, 1985.
the cross, only to fall later.
TITLE: Price-Volume Crossover Patterns IV
P
R
FINAL SEGMENT: PRICE INCREASES
VOLUME DECREASES T
C
I/
E
VOLUME
5 I -3.1 5 I -0.8
B 10 I 4.4 C 10 I 0.8
A 10 I 2.5
15 I 2.6 15 I 2.8 15 I 0.0
20 1 3.1 20 1 1.4
20 I 2.5
; \ ; x ; .p,102
5 1 -3.9 5 I 5.2
5 1 -9.2
D 10 I -2.8
15 I -2.5
; x-1.3 iE gy= (F <-ii:
Figure 5

r
TITLE: Crossover Evaluation using Lea3bSqwre~~
WAS THE MARKET HIGHER

MATRIX EQUATION: OR LOWER 5 DAYS IN THE
PAlTERN
FUTURE?
WEIGHTS
24 Patterns /
> -1 = LOWER
- -- --
IL 1 = HIGHER
Wl 1
0 0 1 0 0 0 1 o....
w2 1
w3 -1
-1
1
-1
=
125,000
Days A
of Data IS THERE A NO. 3
CROSSOVER TODAY
--
1 = YES
O-NO
- --
Figure 6: LEAST-SGUARES EOUAllON TO SOLVE FOR CROSSOVER WEIGHTING
TITLE: Crossover Pattern Evaluation
SET OF ALL MARKET DAYS WHEN

PRICE WAS UP ON DECREASED
P VOLUME FROM THE PRIOR DAY
R
I
c 2
VOLUME
ON INCREASED VOLUME
Flgure 7: PATTERN EVALUATION: HOW DIFFERENT ARE CROSSOVER CASES FROM THE NORM 3
40 MTA JOUFWAL I SF’FLING 1991

TABLE 1
Price Action
Pattern Description Early Late
I-C Price is up strongly on increased volume followed later by price up less

with more volume. DOWN UP
I-D Price is down strongly on slightly decreased volume followed later by price
moving up strongly with increasing volume. UP DOWN
I-F Price is up somewhat on greatly increased volume followed later by price
up more on less volume DOWN UP
II
(all) Price decreases on increasing volume. Note that II-B and II-F are very
negative patterns within the group. DOWN DOWN
III-A Price is up slightly on large volume increase followed later by a strong
price decrease on decreased volume. DOWN UP
III-B Price moves down on increased volume followed by price drop on decreased
volume. DOWN DOWN
III-C Price is down strongly on slightly lower volume followed later by smaller
decline on much lower volume. DOWN DOWN
III-F Price is down slightly on much lower volume followed by greater decline
on slightly decreased volume. DOWN DOWN
IV-A Price is down slightly on increased volume followed by a higher price on
decreased volume. DOWN UP
IV-B Price increases on increased volume followed by a price increase on
decreasing volume - UP
IV-D Price decreases strongly on slightly higher volume followed by a rising
price on much lower volume. DOWN DOWN
Kris Kaufman is a senior geophysicist with a leading

oil exploration software company and president of
Parallax Financial Research. Parallax publishes the
PRECISION TURN trend change indicator quarterly
and provides computer research and consulting services
to several Wall Street firms.
Marc Chaikin graduated from Brown University with
a degree in Finance He was the head of the Options
Department at Tucker Anthony fir five years Later Marc
joined Drezel Burnham Lambert and for five years he
worked with technically oriented traders and investors.
Two years ago he, along with his partner Bob Brogan,
firmed Bomar Securities, L.P, a technical research bou-
tique with a computer-based product which gives buy-
side portfolio managers and block trading desks quick
and easy access to technical data. Marc is a frequent
guest analyst on FNN, is often quoted in Investor’s Daily
and recently wrote an article fir Wall Street Computer
Review’s July issue titled “Technical Analysis Systems:
A User’s Perspective’:

Pattern Recognition Signal Filters
David R. Aronson
Derived with a statistically based artificial intelli- terized by indicator readings that are similar to some
gence technique, they can significantly enhance the of the analyzed signals).
perfbrmance of mechanical trading systems, but prop In an operational mode, SPR signal filters
er development is precarious. qualify new trading signals by determining if the
current indicator pattern (i.e., set of indicator read-
Introduction ings) is similar to those associated with prior unprof-
Unprofitable trading signals, particularly when they itable signals. Signals matching the “unprofitable”
arrive in strings, are the bane of all traders who em- pattern would be rejected.
ploy mechanical trading systems (MT’S). This has led Tests of SPR signal filters on out-of-sample
many systems traders to attempt the development data (i.e., data other than that used to develop them)
of signal filters, supplementary criteria designed to have demonstrated both enhanced profitability and
eliminate signals with a high probability of loss. An reduced risk. Typical SPR filters eliminate about one
ideal filter would reject all loss signals and accept third to two thirds of all signals. However, those sig-
all profitable ones. Though this is an impossible goal, nals qualified as acceptable are of a much higher
a filter that eliminates significantly more losers merit. In terms of the Profit Factor, an effective in-
than winners is an achievable goal, provided proper dex of MTS performance improvements of over 50%
statistical methods are employed. have been attained. In addition, the magnitude of
The attempt to develop filters is not new. The equity draw-downs has been reduced as much as
basic approach involves an analysis of prior signals 65%. The enhanced signal quality afforded by SPR
to discover the characteristics that distinguish win- filters permits the trader to deploy capital more ag-
ners from losers. Unfortunately these well motivated gressively, thereby enhancing net trading profits
efforts often go astray, producing overfitted or (curve with no more risk than the unfiltered system.
fitted) filters. The key symptom of overfit is excel-
lent discrimination on the analyzed signals which Mechanical Trading Systems
is not evidenced when the filter is applied to an in- A mechanical trading system @ITS) is a set of
dependent set of signals. In other words the filter was definitive rules that generates clear-cut buy and sell
so highly “tuned” to a particular set of prior trades signals in a given financial market. A well known
that it lacked sufficient generality to be effective on example is the “four-week” break-out system which
other (i.e., future) signals. They are the filter signals long positions when prices exceed the high-
developer’s version of “fools gold”. est price established in the preceding four weeks and
This article espouses a new approach to filter short positions when prices trade below the low of
development that overcomes the overfitting problem. the prior four weeks.
It utilizes a highly computer intensive technique MTS vary in terms of their underlying philos-
called statistical pattern recognition (SPR), a branch ophy. Three broad categories are trend-following sys-
of artificial intelligence (AI). The AI aspect permits terns, counter-trend systems, and cycle systems.
SPR to “learn” through trial and error the distin- Trend-following systems, based on the assumption
guishing characteristics of unprofitable and profit- that price trends, once established will continue,
able signals. Should none exist that is discovered as assume long positions upon initial evidence of ad-
well. More importanly, SPR is able to discern the vancing prices and short positions upon initial evi-
proper degree of fit thus greatly reducing the over- dence of declining prices. Counter-trend systems as-
fit problem. Therefore, when a filter is produced, it sume that extended price trends will reverse and sig-
is likely to discriminate well when applied to an in- nal positions opposite to the recent trend. Cycle sys-
dependent set of signals, provided however, they are terns assume recent periodic behavior in prices will
statistically similar to historical ones (i.e., charac- persist and attempt to position the trader at antici-
42 MTA JOURNAL I SPRING 1991

pated crests and troughs in prices. Hybrid systems that would lead to an expectation of low signal
blend a number of these approaches. MTS also dis- accuracy. LRV states that mechanisms designed to
play a wide range in their degree of complexity, with predict or control the behavior of a complex system
some based on a few simple rules such as the four- are required to embody a degree of complexity that
week break-out system, while others are based upon approaches that of the system itself. Therefore, com-
much more complex signaling criteria. plex financial markets can not be beaten with sim-
MTS are attractive for several reasons. In fu- plistic MTS. In this context complexity refers to a
tures trading trend-following MTS have been hand- “rich” variety of properly integrated information.
somely profitable demonstrating real-time com- Financial markets are examples of complex
pounded returns in excess of 30% per year over 10 systems. Yet the vast majority of MTS are relative-
or more years. Even after adjustment for risk (i.e., ly simple. Trading signals are typically generated
equity volatility, draw-downs, etc.) , few investment solely from price data, massaged in a limited num-
strategies can boast such results. In addition, they ber of ways (i.e., averaging, differencing, etc.). Low
provide a consistent strategy that eliminates emo- degree of signal accuracy are not surprising. Yet, at
tional trading decisions. Moreover, their exact nature the same time, LRV suggests how to improve a pre-
allows for computer based design, optimization and scription for enhancing MTS signal accuracy; aug-
testing on historical data. Finally, their definitive ment it with additional information found in other
historical signals make MTS ideally suited for fil- data series and indicators. Signal filters do just this.
tering via SPR. A second reason to expect low MTS perfor-
But despite their successful track records over mance is the so-called Efficient Market Theory
the long-term, MTS often try the patience and pock- (EMT). It implies that the performance of an invest-
ets of traders over the short-term, because a signifi- ment strategy will suffer if too many employ it be-
cant fraction, typically over 50%, of the signals re- cause its information content has been discounted.
sult in losses. To make matters worse, the false sig- Since many traders use similar MTS, degraded per-
nals tend to be concentrated in strings rather than formance is the natural consequence. To attain su-
being randomly intermixed amongst the profitable perior performance one must employ strategies built
signals. A succession of losers, can produce a dramat- on valid information that has not yet been discount-
ic decline in account equity known as a “draw-down”. ed. Since, to date, few traders are exploiting SPR sig-
Draw-downs of 30 to 50% of trading capital are not nal filters the concept offers significant potential. In
unheard of, and may cause the trader to abandon the addition, because the development of effective sig-
MTS altogether, thus missing out on its long-term nal filters is fraught with pitfalls, many who attempt
profit potential. it will fail, thus maintaining the edge for those who
Such periods of sub-par performance occur when are successful at it.
markets fluctuate, for extended periods, in a manner
that is at odds with the MTS’ underlying philosophy. Signal Filters
Trend-following system suffer in trend-less choppy Signal filters are supplementary rules (models)
markets, while counter-trend systems will be hurt that operate in conjunction with an MTS. The rules
during strong trends. In 1988 one major futures advi- define conditions under which signals ought to be
sor who relied on MTS was not only required to close rejected, due to an above normal probability of loss.
two public futures funds due to large declines in equi- The concept of employing signal filters is not
ty, but gave up on money management altogether. new, however, the use of SPR to develop them is.
Research described in this article suggests that SPR Moreover, it is the author’s contention that SPR,
signal filters can ameliorate equity draw-downs by properly applied, is a superior method of producing
rejecting a majority of signals occurring during the filters. Less rigorous methods tend to produce filters
environment for a given MTS. with better historical (in-sample) than future
(out-of-sample) performance. SPR filters have dem-
Fundamental Weakness of MTS onstrated accuracy on both prior and future signals.
Why don’t MTS have higher levels of signal ac- Filter development via SPR involves a com-
curacy and better overall performance? Two answers puterized analysis of a representative sample of prior
seem reasonable, one based on cybernetics, and a sec- trading signals, each characterized by an array of
ond based on the efficient market hypothesis. statistical data. The statistical data includes the sig-
Cybernetics, is concerned with the analysis nal type (long or short), its date of occurrence, its out-
and synthesis of complex systems of all types. One come (i.e., the gain or loss ultimately realized upon
of its fundamental principles, The Law of Requisite close-out of the trade initiated by the signal), and
Variety (LRV), reveals a design flaw in most MTS the values for a list of candidate filtering indicators.

The indicators are typically designated by the let- duces rules that apply to examples other than those
ter “X” (X,, X,, X,, . . . . . X,,). The indicator val- analyzed.
ues used are those known as of the date of the sig- More specifically, SPR is concerned with the
nal’s occurrence. This is crucial because this is the discovery of rules that differentiate one class of items
date on which the trader must decide whether to ac- from another based on various characteristics. In
cept or reject the signal. It should be emphasized other words SPR permits the computer to discover
that the greater the number of signals the better, class distinguishing attributes and formulate clas-
with 100 or so being the bare minimum. In addition, sification rules. For example, given the problem of
the historical sample should include a range of mar- discovering a rule to discriminate basketball play-
ket environments (up-trend, down-trend, congestion) ers (class l), from jockeys (class 2), and a set of data
and system performance (good and bad). SPR on fifty of each, including their height, eye color,
analysis does not require knowledge of the MTS’s neck size, IQ etc, an SPR system would discover that
underlying rules or trading logic A sample of the the attribute “height” is a useful distinguishing in-
data matrix required for filter development is illus- dicator, but “eye color” is not. In the process, an SPR
trated below: system would generate a classification rule:
If height is greater than 6 feet, then class =
Date Type Outcome X, X, X, XN
basketball player,
750206 Long -20,600 +.25 -.17 -.7 -3.2 If height is less than 6 feet, class = jockey,
750218 Short +3250 +.49 -.67 +.76 +.24
Once formulated, the rule can be used to
SPR analysis is performed by specialized soft- classify individuals whose class is unknown but
ware that permits the computer to discover the set whose height is known. For example the rule would
of indicator characteristics (i.e., the pattern) that classify an individual whose height is 6’ 5” as a bas-
tended to be present at the time unprofitable signals ketball player.
were issued, but not typically present for profitable Signals from an MTS can be viewed as falling
signals. In other words, the software searches for the into one of two classes:
indicators characteristics, which to some degree, val- CLASS 1: signals that are profitable at time of
idly discriminate profitable from unprofitable sig- close out
nals. The operative word is “validly”. CLASS 2: signals that are unprofitable at time
Typically tens or hundreds of indicator candi- of close out
dates need to be evaluated to find a few, that indi-
To give the reader some idea of what a rule (i.e.,
vidually or in combination, serve this purpose. An
pattern) might look like, consider the following pat-
indicator can be any variable, technical or funda-
mental, that can be represented by a number. Ex- tern involving two indicators:
amples are the popular “RSI” indicator, the 5 day If on the day of a signal the following conditions
change in tbill rates, indicators invented by the are present, then do not act on the signal:
analyst, signals from other MTS, etc. In filter devel-
1. The 20 day % change in open-interest is less
opment projects conducted by the author’s firm, as
than -2.5 and,
many as 400 candidate indicators have been evalu-
2. The prior days’ close was in the lower half
ated to find a few that can be used to filter signals.
of the daily range.
Statistical Pattern Recognition A computer “armed” with SPR software dis-
Statistical Pattern Recognition (SPR), the ap- covered that this pattern of characteristics had a
proach advocated by this article for filter develop- stronger tendency to be present when unprofitable
ment, is a branch of artificial intelligence (AD. AI signals were issued. In other words, the pattern was
is the frontier of computer science whose objective correlated with a higher than probability of signal
is endowing computers with abilities that qualify as failure. For example the unfiltered MTS might have
intelligent. The particular aspect of intelligence rep- 50% probability of issuing an unprofitable signal,
licated by SPR is inductive generalization, (i.e., in- the signals given in the presence of the above pat-
ductive reasoning), the act of inferring a principle tern might have a 65% probability of loss, while
or rule from an examination of numerous specific ex- signals given in absence of the pattern might have
amples. The key to valid inductive logic is the abil- 35% loss probability.
ity to avoid rules that are overly tailored to the ex- The reader may wonder why a computer
amples analyzed. Sound inductive inference pro- “armed” with SPR is necessary to discover such a
‘id MTA JOURNAL /SPRING 1991

pattern. Why not just leave it to the unaided human al (1-D) and is composed of a single axis. Such a space
mind? While the mind has an unparalleled ability would be employed if only a single indicator were
to deal with sight and sound patterns, experiments being evaluated for its signal filtering ability. This
performed by cognitive psychologists have revealed is illustrated in Figure 1. Consider indicator X,,
it is not adept at sensing patterns or detecting pre- which can assume values from - 10 to + 10. At the
dictive relationships in factual and statistical data. time of a particular signal, X, had a value of -7.5.
An example of a fact pattern is illustrated by the That signal is depicted by a data point positioned
problem of determining if a set of indicator values at a value “ -7.5” on the indicator axis in figure 1.
correlates significantly with a signal’s outcome. The If our MTS signal history consisted of 100 signals,
brain’s upper limit seems to be three factors, though they would be depicted by 100 data points, each plot-
we do much better with two or one. Other experi- ted at the axis location corresponding to the indi-
ments have shown that not only does the mind fail cator’s value at the time of the signal.
to detect significant patterns, but often “perceives” However, in real-world analysis the analyst
patterns that are not valid. wants to evaluate the filtering potential of several
In contrast, computerized SPR has no such indicators used in combination. In such instances
limits. The machine can tirelessly and objectively higher dimensional spaces, consisting of two or more
search through numerous indicators individually indicators are required. Yet, regardless of the num-
and in multitudinous combination to find valid fil- ber of dimensions, each signal is still represented by
tering criteria. Clearly, computer based SPR, not the a single data point. For example, if each signal were
brain, is the tool of choice in filter development. to be characterized by two indicator values, it would
be represented by a point in two-dimensional or 2-D
How Does SPR Work? space An example is a piece of ordinary graph paper,
The following section will describe how the consisting of two mutually perpendicular axes (see
SPR process discovers patterns and though it in- Figure 2). The data point labeled “A”, positioned at
volves complex mathematics, it has key concepts that coordinates (-7.5, +3.2), indicates that at the time
can be readily grasped by non-mathematicians with of that signal, indicator X, had a value of “-7.5”
the aid of diagrams. The key concepts are: and indicator X, had a value of “+3.2”.
Were three indicators being considered, each
1. Indicator Spaces
signal would be depicted by a point in a 3-D space,
2. Proximity & Similarity
defined by three mutually perpendicular indicator
3. Discrimination & Classification
axes. If four indicators were being evaluated for their
4. Classification of a Current Signal
conjoint filtering power, each signal would be repre-
Indicator Spaces sented by a point in a 4-D space and so on. Though
An indicator space (also referred to as a vector 4-D spaces, and spaces of higher dimensionality can
space, state space parameter space, etc.), is a math- not be visualized, they are easily represented with
ematical convention for representing data and de- the indicator space paradigm. In fact there is no
tecting patterns. The space is a grid of one or more theoretical limit to the number of dimensions (e.g.,
axes, with each axis, or dimension representing an 4,5,10 or even 100) that can be used, though there
indicator. In spaces of two or more dimensions axes are limits imposed by the number of historical sig-
are mutually perpendicular. A specific set of in- nals available for analysis. The greater the number,
dicator readings are represented by a set of coordin- the more dimensions (i.e., indicators) one can consid-
ates that define a point in the space. Therefore, each er in combination.
trading signal is represented by a point whose loca-
tion is determined by the indicator values existing Proximity = Similarity
at the time of the signal. A very important property of indicator spaces
While we will illustrate this concept with sev- is that the distance separating two data points
era1 graphical diagrams, SPR does not utilize graph- reveals their degree of similarity in terms of their
its. Rather, the indicator space is represented inside indicator values. Two data points with similar in-
the computer’s memory by strings of numbers called dicator values will have similar coordinates and will
vectors. In this way patterns, should they exist, can be located close to one another. Highly dissimilar
be detected mathematically rather than visually. data points will be separated by large distances.
This is crucial in problems with many potential di- Figure 3 illustrates this idea. Three MTS signals are
mensions, or high levels of noise (randomness) that represented by the three data points, A, B and C plot-
render visual recognition inadequate. ted in a 2-D space. A and B have similar indicator
The simplest indicator space is one-dimension- characteristics and therefore are located near each

Figure 1 Figure 3
A 1-D indicator Space Proximity = Similarity
Signals represented by points A & B in Xl, X2 space were
The dot positioned at -7.5 in Xl space indicates that characterized by very similar Xl, X2 indicator readings
at the time of that MT5 signal indicator, Xl had a value and thus lie near each other in the space.
Figure 2
A 2-D Indicator Space
The signal represented by point C occurred within a

context of Xl, X2 values very different from signals A
and B, and thus is far removed from them in the indicator
space.
same class with the same symbol. In filter develop-

A 2-D space composed of indicators Xl and X2. On the ment the two classesof interest are: signals that pro-
day of the signal Xl’s value was -7.5 and X2’s was duced profits, and signals that produced losses. In
+3.2. The dot’s position on the grid illustrates this. the illustrations profitable signals are denoted by a
“+” symbol, while unprofitable signals are desig-
other. In contrast, point C, which is characterized by nated by a “0” symbol. The class information enables
very different indicator values, is found far removed the SPR program to evaluate the ability of a given
from both A and B. This property allows degrees of indicator space to discriminate (i.e., separate) prof-
similarity between data points to be measured in itable from unprofitable signals.
terms of the distance separating them. A space is said to discriminate well if unprofit-
When a whole set of points are characterized able signals tend to concentrate in regions that are rel-
by similar indicator values, they will cluster in a relatively distant from regions populated with profitable
atively compact region of indicator space called a signals. In other words the “0” symbols tend to be
“neighborhood”. Points A and B in figure 3 lie in the segregated from the I‘+” symbols. In contrast spaces
same neighborhood, while point C does not. that lack discrimination information display a ran-
dom intermixture of the two classes. Of course, how
Classification and Discrimination well a given spacediscriminates depends upon the in-
Things really become interesting when infor- formation content of the indicators that compose it.
mation about the class membership of each data The goal of an SPR system is the discovery of spaces
point is added. This is accomplished in our illustra- (indicator combinations) with the best discrimination
tions by identifying all members belonging to the power amongst a large set of possible spaces.

Figure 4A shows a two dimensional indicator Figures 4A & 46
space with very strong discrimination . The neigh-
borhood concentrated with “o”symbols is far removed A Space with Good Discrimination
from and easily separable from the neighborhood Power and a Space with Poor
populated with “+” symbols. In contrast Figure 4B Discrimination Power
displays a 2-D space composed of two indicators that
do not contain good discrimination power as evi-
denced by the intermixture of gain and loss trades.
In cases like this no simply shaped region (boundary)
can segregate the bad trades from the good.
It should be pointed out that the illustrations
used in this article are idealized, showing patterns
that are much clearer and stronger than any likely
to be encountered in actual filter development. This Xl
is done to make the concepts readily understandable.
However, SPR employs a very sensitive criterion that
can detect useful discrimination information even
if very weak. In a very real sense, it is much like the
search for gold, that even in the richest ores is hard
to see.
An important aspect of SPR is the com-
binatorial search problem. In its pursuit of spaces Fig. 4A Indicator space Xl, X2 has strong discrimination
with good discrimination power, the SPR program power evidenced by the spatial separation of profiible from
unprofitable signals.
must evaluate a huge number of indicator combina-
tions. For example, given 100 candidate indicators,
there are 100 1-D spaces, 4,950 possible 2-D spaces,
161,700 3-D spaces, almost 4 million 4-D spaces, etc
This very large number of spaces creates two prob-
lems. First, significant computing resources are re-
quired to evaluate all of them. Second, when the
number of spaces is large relative to the number of
signals available for analysis, many spaces that ap-
pear to discriminate, do so only by chance. This bogus
discrimination is a mere statistical accident, and is
unlikely to reappear if another set of trading signals
were to populate the space. This phenomenon is an
aspect of overfitting, a very severe problem that often
thwarts neophytes in their entire effort to develop
useful signal filters. Fortunately sound SPR meth-
ods use techniques such as cross-validation and sig-
nificance testing to avoid overfitting. We discuss these Fig. 46 The intermixture of profitable and unprofitable
signals in X4, X5 space indicates that this pair of indicators
below. is devoid of useful filtering information.
After the search is over, the SPR system will
come to one of two possible conclusions: None of the + = profitable signal 0 = unprofitable signal
indicators are useful discriminators, or one or more
spaces contain valid filtering information and a Cl- tiated by the signal is closed out, the values of the
ter rule can be formulated. filtering indicators are known when the signal is
generated. These values define a point in the indi-
Classification of a Current Signal cator space.
Of course the ultimate objective of SPR is be- Probable class is determined by comparing the
ing able to determine the most probable class of a current signal’s location in indicator space with
newly issued signal before the trader acts on it. Will those of prior signals whose class is known. The fun-
it be profitable or not. . . . That is the question. This damental assumption is that the current signal’s
is referred to as signal classification. Though true class is most probably the same as the signals most
class can not be known until after the position ini- heavily represented in the immediate vicinity of

indicator space. Consider the following example: Figure 5
Suppose today the MTS issues a signal. If current
indicator values define a point in the space that is Classification of a Current Signal
located in or near a region that is dominated by loss
trades, the signal is most likely to be a loser and
would therefore be rejected by the filter. This con-
cept is illustrated in Figure 5. The trading signal of
unknown class is depicted with a “?” symbol.
The Overfitting Problem &

Its Avoidance
Despite the intuitive appeal of SPR concepts,
the proper development of SPR filters is fraught with
a significant pitfall. . . overfitting. Truly useful SPR
methods must safeguard against this ever present Xl
problem.
All data modeling involves fitting. But it is
when this process is carried too far that overfitting
occurs. Properly fitted models (trading systems, fil-
ter, equations, etc) capture the data’s valid patterns,
and are therefore likely to hold true in other sam-
ples of data. In contrast, overfitted models have been
forced to be so specific to the analyzed data that they
inadvertently capture random effects as well. To be
sure, such a model will appear to predict well (fit>
in that data set, but that performance will not hold
up in another sample.
The neophyte data analyst often fails to realize The current MTS signal, whose outcome is not yet
how easy it is to be seduced by the desire to fit. The known, is depicted by the “7” symbol positioned at
the Xl, X2 values at the time of the signal’s occurran-
truth is high degrees of fit can always be achieved As these coordinates place it in a region of Xl, X2
with sufficient effort, misguided though it may be. space dominated by previous loss signals, it is likely
If enough different models without limit on their to be a loser as well. An SPR filter would reject such
complexity are tested, a perfect fit will be found. a signal.
Developers of MTS, utilizing optimizable system
+ = profitable signal 0 = unprofitable signal
development “tool-boxes”, are often guilty of this. In
their desire to produce the “ultimate” trading
system that catches every turning point with no false to segregate profitable from unprofitable signals. In
signals, they keep adding rule upon rule. The in- Figure 6A good and bad signals are highly inter-
evitable result is merely a complex description of the mixed, yet the strangely shaped boundary imposed
analyzed data that is guaranteed to work like the on the same data sample in Figure 6B does separate
“Holy Grail” in that specific data set. But also the unprofitable from the profitable signals. However
guaranteed is the failure of the MTS to repeat this the shape of the unprofitable region is likely to be
brilliant performance when applied to new data. unique to that particular sample of signals and lack-
This often leads to the erroneous conclusion that the ing in sufficient generality to filter a new set of
markets somehow changed just as the MTS was be- signals accurately.
ing installed for actual trading. The hard truth is Another, even more insidious form of overfit re-
the MTS was flawed with overfit from its inception. sults from testing too many spaces. This will produce
The only way to develop a model, be it an MTS or spaces in which winning and losing signals are sep-
a filter, that will perform well in the future is to halt arable with simply shaped boundaries. The cause is
the growth of rule complexity prior to falling into the large number of possible spaces relative to the
the over& trap. number of trading signals available for analysis. As
The key to avoiding overfit is to be aware of how mentioned previously, given 100 candidate indica-
it can come about. Overfit can result in two ways. tors, there am over four million possible l-D, 2-D, 3-D
One type results from allowing the class separating and 4-D indicator spaces. The number of prior trad-
boundaries to assume any contorted shape necessary ing signals typically available for analysis (100

Figures 6A & 6B Cross-validation makes use of two sets of data.
One set, referred to as the “learning set” is used ini-
An Overfitted (Invalid) tially to search for spaces with “potential” classifi-
Discrimination Boundry cation power. A second set, called the “test set” is
used to validate or confirm the discrimination pow-
er found in the “learning set”. Only spaces that show
similar classification boundaries in both the “learn-
ing set” and “testing set” are given a favorable rat-
ing. Most spaces fail this acid test.
The concept of cross-validation is illustrated in
the Figures 7A, 7B, 7C, and 70. Figure 7A shows
a 2-D indicator space populated with signals from
the “learning set”. The pure neighborhoods give
some hope that the space is a good signal discrimi-
nator. If the signals from the test set show a similar
degree of class segregation, such as that seen in fig-
ure 7B, we have good evidence that the space con-
tains valid information. If, however, the test set
shows up looking like figure 7C, with the class pure
neighborhoods but with the good and bad signal clus-
Fig. 6A This 2-D indicator space, based on indicators X4 ters having shifted locations, or as in 7D with class
and X5, has no valid filtering information as evidenced by
the random intermixture of profitable and unprofitable pure neighborhoods failing to appear, the SPR pro-
signals throughout the space. g-ram would reject the space.
Despite its importance, being confirmed by
cross-validation is not certain evidence of validity,
as validation in the test set can be seen if enough
spaces are tested. Therefore, additional safeguards
based on specialized significance tests are employed
to increase the level of certainty that a space is a
valid discriminator. Sophisticated significance tests
can determine if the degree of confirmation in the
“test-set” is large enough such that it is unlikely to
be due to chance. The precautions that need to be
taken to avoid overfitting can not be overemphasized.
Reliability to Future Trading Signals

The key question is how reliable will SPR
signal filters be when applied to previously unseen
signals, even if the over-fit problem has been success-
Fig. 66 Despite the lack of discrimination found in Xq X5 fully avoided? The simple answer is, if future signals
space, an overfitted boundry can be found that partitions are statistically similar in terms of their indicator
profit and loss signals into separate regions. Such a boundry characteristics, then similar levels of discrimination
is invalid and unlikely to be effective on future signals.
should be seen. By statistically similar, we mean
+ = profitable signal 0 = unprofitable signal that the indicator values characterizing new signals
are within the range associated with previous sig-
to 1,000). By chance alone some spaces will appear nals. For example if indicator X,, has taken on val-
to classify well, yet this is a merely statistical acci- ues of - 100 to + 100 in the historical data, but sud-
dent. If such spaces were to be populated with an- denly is at a value of +300 at the time of a new sig-
other sample of signals, the discrimination would nal, the SPR filter prediction is not likely to be
evaporate. reliable. In other words SPR methods don’t extrapo-
So proper fit, not perfect fit, is the real objec- late well to signals that reside regions of the indica-
tive. The key question is how can we know when tor space that are sparsely populated with histori-
proper fit has been achieved and additional fitting cal samples. However, this is true of any intelligent
will result in over-fit? There are two methods: system confronted with a situation for which is has
cross-validation and significance testing. no prior experience to make a judgement. With re-

Figures 7A, 7B, 7C & 7D
Cross-Validation Detects Ovetfitted Spaces
Fig. 7A In the “learning” data this space shows good Fig. 7B If the “test” data shows clusters of profit and loss
discrimination of profit and loss signals. signals similar to the “learning data”, as shown here, the
space is validated for filtering.
Fig. 7C If the “test” data shows pure clusters of profit and Fig. 7D If the “test” data fails to show easily separable
loss signals as shown here, but their locations have shifted clusters of profit and loss signals, as shown here, the space
significantly relative to the learning data, the space is is graded invalid.
graded invalid.
spect to SPR filter development, this is not as big gestion), for it is only in this manner that the SPR
a problem as it might seemat first blush, for the can- system has the opportunity to examine a range MTS
didate indicators can be designed to stay within well performance conditions (good and bad).
defined ranges.
Another more significant issue in SPR filter Results
reliability has to do with the historical data set pro- To display the efficacy of the SPR filtering tech-
vided. It is important that it contain as wide a range nique, we report below the results of two analyses
of market conditions as possible. If the historical sig- carried out by the author’s firm. These analyses were
nal sample is comprised entirely of a steeply trend- performed utilizing PRISM, a proprietary pattern
ed bull market, the SPR system will be unable to recognition system developed by Raden Research
learn the distinguishing characteristics of profitable Group, Inc.. The first case relates to the development
signals in all types of markets (bull, bear, and con- a filter developed for an MTS designed to trade the

Deutsche Mark for the foreign exchange department lated filter rules. Performance of the filter on the his-
of a large money center bank. In a second case, a fil- torical data indicated that signals accepted by the
ter was developed for an MTS used to trade T-Bond filter would be profitable 58% of the time compared
futures. with 44% profitable signals from the unfiltered sys-
tem. The profit factor was increased by over 200%.
Deutsche Mark Filter In addition, the filter reduced the magnitude of
A sample of 208 historical signals issued by an draw-down by over 65%. The system and SPR filter
MTS for Deutsche Mark trading covering the peri- were then used in actual trading for the period April
od January 1975 through November 1987, were sup- 1986 through July 1987. The trading, which was con-
plied by the client. The logic of the MTS were not ducted on behalf of a large international bank, pro-
disclosed. duced profits exceeding 200% on invested capital
The MTS user also supplied historical data on with 62% of all trading signals profitable. Over the
approximately 100 raw economic and market data same period the unfiltered system would have had
series including Euro interest rates, balance of trade 51% profitable trades and experienced a draw-down
figures, employment data, GNP data, industrial pro- 33% larger than the filtered system. Thus in actual
duction data, money supply data, stock prices, retail trading, the filter performed in line with historical
sales, spot currency rates for four countries: U.S., expectations. After July 1987, trading was ceased
England, Germany and Japan. In a cooperative ef- due to factors unrelated to the effectiveness of the
fort, the client and the author’s firm defined a set trading system.
of 300 candidate indicators (i.e., transformations of
the raw data); for example, the ten-day chance in the Conclusion
difference between the Euro dollar rate and the Euro SPR has been shown to be an effective method
Yen rate. These indicators were programmed and for developing filters to improve the performance of
generated with PRISM. All indicators were lagged MTS. The method appears to offer a number of ad-
to take into account reporting and revision lags as- vantages over more traditional methods of analysis
sociated with the data, PRISM was then used to de- that often fall prey to over-fitting. Actual results of
termine which, if any, had valid filtering informa- employing SPR signal filters have shown significant
tion. Three indicators proved useful, and filter rules increases in MTS performance and such filters may
were formulated. offer a new lease on life to existing MTS.
Below, the table compares the performance of
the “raw” (i.e., unfiltered) trading system with the David Aronson is president of Raden Research, a New
filtered version. These results include all trades, and York firm that specializes in applying pattern recogni-
; twn to financral markets. The firms PRISM system has
is therefore a mixture of both cases used for learning developed signal filters for several trading firms.
and testing of the filter:
Performance Unfiltered Filtered
Indicator MTS MTS % Improvemt.
Total Profits $1,578,000 $1,854,00 +17.5
% Profit Trades 50% 56% +12
Profit Factor .39 .57 +47
The Profit Factor is the log of the ratio of all gains

from profitable trades divided by all losses on un-
profitable trades. Alternatively it is the log of:
% signals profitable x Avg gain on profit signal

% signals unprofitable Avg loss on unprofit signal
T-Bond Ml73 Filter

The sample of historical signals used for analy-
sis were 670 trading signals issued by a short-term
volatility breakout MTS used to trade T-Bonds. The
signals covered the period August 1977 through De-
cember 1985. The author’s firm developed a list of
360 candidate indicators. PRISM identified four as
containing valid filtering information and formu-

The Dow Jones Industrial Average
Alternative Computation Methods
Walter J. Marullo
Introduction justed for splits and large stock dividends (greater

Whenever one inquires about the performance of the than 10 percent) by changing the divisor “Specifical-
U.S. stock market, one usually receives an answer ly, when a DJIA stock splits, the divisor is changed
in terms of the Dow Jones Industrial Average (DJIA). so that the value of the index at the moment of the
Although other indices contain many more com- split is the same, using either the new price and new
ponents and therefore provide much broader divisor or the old price and old divisor.“5 For exam-
coverage, the DJIA, an average of thirty relatively ple, suppose the index comprised only two stocks,
high-grade and well-followed stocks, has become both of which were selling for $100. In this case, the
synonymous with the “market.” Many members of index would have a value of 100 ( 1100 + 1001/2 =
the investment community, however, take issue with 100). If one of the stocks then underwent a 2-1 split,
the DJIA’s lofty distinction. They insist that for a the divisor would have to change from two to 1.5 so
variety of reasons, the average is at best an imperfect that the value of the index would remain at 100 ( 1100
indicator of the overall market and one that is sub- + 50]/1.5 = 100). Under the original method for com-
ject to a number of biases and distortions. The pur- puting the DJIA, the adjustment for the split would
pose of this paper is to probe and to analyze the have occurred in the numerator, and the divisor would
DJIA’a purported limitations and to suggest ways in have remained constant ( [lo0 + 2 x 50112 = 100).
which the average could be improved in the future. The need for simplicity and easy calculation
was the primary reason that Hamilton changed the
History of the DJIA manner in which the index was computed! Know-
“The Dow Jones Industrial Average is the con- ing updated stock prices of the 30 industrials and
tinuous price index of the U.S. stock market from the the current divisor’, one could easily calculate the
late nineteenth century to the present.“’ Charles H. DJIA by hand or with a simple adding machine.
Dow, one of the founders of the Wall Street Journal, Thus, with his new method of calculation, Hamil-
constructed the original DJIA in 1896 from a list of ton could provide hourly quotes of the DJIA using
twelve major industrial stocks! In computing his in- only the crude technology available in 1928. Al-
dex, Dow simply averaged the prices of the twelve though many changes have been made in the stocks
component stocks. If any of the stocks had split or that comprise the present-day DJIA, the average is
paid a stock dividend of at least a hundred percent still calculated using Hamilton’s flexible-divisor
since its incorporation in the index, however, its price method.
was first adjusted by a cumulative split factor. For
example, if one of the component stocks was selling Criteria for Evaluating Stock Indices
at $50 per share but had undergone a 2-1 split some- Before evaluating any stock index, one must
time after its inclusion in the index, Dow assigned consider the purposes for which it is being used. In
that stock a price of $100 before averaging it with general, an index can serve as (1) an indicator of ag-
the prices of the other eleven stocks. Reflecting the gregate market movement&’ and/or (2) a benchmark
expansion of the U.S. economy, Dow expanded his infor measuring the performance of an investment
dex to include twenty stocks in October of 1916.5 portfolio? Different indices will better serve one of
In October of 1928, Peter Hamilton, Dow’s suc- these two main functions. For example, someone in-
cessor as editor at the Wall Street Journal, not only terested in assessing overall market changes would
expanded the DJIA to include thirty stocks but also generally prefer to use a broad, market-value-weight-
changed the method of its calculation? Hamilton ed index. On the other hand, someone evaluating the
continued the practice of averaging the components’ performance of a portfolio manager may rather use
stock prices, but rather than accounting for stock an index in which the individual components were
splits in the numerator of the calculation, he ad- equally weighted, because such a benchmark is a
52 M’J!A JOURNAL / SPRING 1991

more “accurate representation of a typical invest- index has a downward bias.
ment portfolio at its inception, that is, one in which Proponents of the upward-bias argument insist
approximately equal dollar amounts would be invest- that the price of a stock tends to increase abnormal-
ed in each stock.“1° Other criteria one may consider ly during the interval between when a company an-
in assessing a stock index include the ease of calcu- nounces a stock split and when the split actually
lation (although less relevant in the age of high- takes effect. According to these critics, “a proportion-
speed computers) and the longevity of the index, i.e., ate decline in the price of the split stock after the
the extent to which one is able to make comparisons split will not ‘wash out’ the run-up. It will fail to do
between today’s stock market and those that existed this simply because the post-split stock has relative-
in the distant past. All things considered, “it is pret- ly less weight in the DJIA than the pre-split stock.“13
ty well recognized among analysts that there is no Although the increase in the price of the stock is
such thing as the perfect stock index and that the temporary, the change in the DJIA divisor at the
search for one is doomed to failure.“” time of the split is permanent. As a result of the
cumulative effect of past stock splits, the DJIA would
Evaluation of the Present DJIA become upwardly biasedT4
The strong points of the DJIA are its simplici- To illustrate this phenomenon, consider a hypo-
ty, longevity, and timeliness. As mentioned above, thetical index of two stocks, A and B, both of which
the index is very simple to calculate, and it allows are currently selling for $100 per share. Assume that
one to make comparisons with stock markets as far Company B announces a 2-1 split and that the price
back as 1896. Because each of the DJIA’s component of Stock B increases to $120 just before the split date
stocks trades very frequently, the average is much Also assume that the price of Stock B falls from $60
more timely than other indices, whose constituent per share to $50 per share shortly thereafter. The
stocks trade in a less liquid manner. “The DJIA following tables show how the pre-split run-up in
gives one of the few accurate indications of the mar- Stock B causes an upward bias in this hypothetical
ket valuation process as it evolves I31 is an extremely DJIA.
useful index for representing short-tern market
movements.“12 DJIA With Stock B Run-up
As a long-term indicator of the stock market, After
the DJIA has many theoretical limitations and Before After split split
biases. Most of these problems arise from (1) the fact Announcement Announcement Date Date
that the average is a price-weighted index and (2) Stock A 100 100 100 100
Stock B 100 120 60 50
the manner in which the average adjusts for stock Divisor 2.00 2.00 1.45 1.45
splits and stock dividends. DJIA 100.00 110.00 110.00 103.13
As a price-weighted index, the DJIA is influ-
enced more by its higher-priced components than by DJIA Without Stock B Run-up
its lower-priced components. Consider the situation After
at the end of 1989, when Navistar sold for $3.875 BefOlV? After split split
per share, while DuPont sold for $123 per share. If Announcement Announcement Date Date
the price of Navistar’s stock had risen 10 percent, Stock A 100 100 100 100
Stock B 100 100 50 50
the DJIA would have increased by only 0.66 points Divisor 2.00 2.00 1.50 1.50
( 10.1 x 3.8751 divided by the then-current divisor of DJIA 100.00 100.00 100.00 100.00
0.586). On the other hand, if DuPont’s stock price
had risen 10 percent, the DJIA would have increased Although in both scenarios the ending prices
by 20.99 points ( 110.1 x 1231/0.586), illustrating of Stocks A and B are $100 and $50, respectively,
how the index can become dominated by a few, very the ending index value is higher in the scenario with
high-priced stocks. Moreover, although great care the temporary run-up of Stock B than it is in the
has been taken to ensure that a variety of major in- scenario without the temporary run-up. Thus, a pre-
dustries are represented in the DJIA, changing stock split, abnormal increase in the price of Stock B
prices can dramatically alter the relative weightings would cause an upward bias in the DJIA.
of those industries. The theoretical underpinning of the upward-
Most criticism of the DJIA focuses on the theo- bias argument is reasonable; however, proponents
retical biases resulting from the manner in which have not provided much tangible data to support their
the index adjusts for stock splits and stock dividends. contention. On the other hand, E. Eugene Carter and
Interestingly, some critics claim that the average has Kalman J. Cohen, in a study covering the period from
an upward bias, while other critics maintain that the June 1948 to January 1963, found no empirical

evidence to support the notion that the DJIA is up- have contributed 12.38 to the value of the DJIA.
wardly biased?5 Stock splits and anything else that causes
Those who argue that the DJIA has a down- large changes in relative stock prices significantly
ward bias focus on the facts that (1) when a stock influence the differential weightings of the DJIA’s
splits, it has less influence on the value of the DJIA individual components. Some critics of the index
because the average is a price-weighted index and have concluded that “the DJIA is neither a reliable
(2) succesful, high-growth stocks tend to split more indicator of market sentiment nor an accurate
often than unsuccessful, low-growth issues!6 Accord- benchmark for use in measuring market perfor-
ing to the proponents of the downward-bias theory, mance, since its characteristics change randomly
the DJIA becomes more and more influenced by its over time.“”
poorer performing components.
Consider, for example, a hypothetical index of Alternative Computation Methods
two stocks, A and B, both of which originally sell for The present method used in calculating the
$100 per share. Assume that Stock A remains at DJIA creates many theoretical problems for the in-
$100 per share for three years. Also assume that dex. On an empirical level, I therefore wanted to see
Stock B rises to $200 per share in Year 2, splits 2-1, how different computation methods would have
rises again to $200 in Year 3, and than once again changed the value of the DJIA over a particular test
splits 2-l. The following tables show how the split- period. Using data from volumes of the Daily Stock
ting of the high-growth stock causes the index to be Price Record, I calculated four alternative, monthly
lower than it otherwise would have been. ending DJIAs for each month during the period from
June 1979 through December 1989 (test period). The
DJIA With Stock B Splits alternatives were (1) a market-value-weighted index,
Year 2 Year 2 Year 3 Year 3
(2) an equal-weighted index using arithmetically
Before After Before After calculated returns, (3) an equal-weighted index us-
Year 1 Split split split split ing geometrically calculated returns, and a (4) con-
Stock A 100 100 100 100 100 stant-divisor index.
Stock B 100 200 100 200 100
Divisor 2.00 2.00 1.33 1.33 0.89
DJIA 100.00 150.00 150.00 225.00 225.00 Market-Value Weighting
Most of the well-known stock market indices
DJIA Without Stock B Splits such as the S&P 500, the NYSE composite, the
NASDAQ composite, and the AMEX composite are
Year 1 Year 2 Year 3 market-value-weighted indices, i.e., the current in-
Stock A 100 100 100 dex is computed according to the following formula:
Stock B 100 200 400
Divisor 2.00 2.00 2.00
DJIA 100.00 150.00 250.00 Total Market Value of All Components Today x
Total Market Value of All Components on Base Day
In the scenario in which its stock twice splits Index on Base Day
2-1, Company B ends up contributing 50 percent of
the index’s value at the end of Year 3; however, in (Market Value = Price/Share x Shares Outstanding)
the scenario in which its stock never splits, Company
B ends up contributing 80 percent of the index’s Critics of value-weighted indices point out that
value at the end of Year 3. they can become dominated by a few major stocks.
A real-life example of this reduction in the They insist that although these indices may be rep-
weighting of a high-growth stock is provided by the resentative of the overall market, they are less useful
case of Merck & Co. during the lo-year period from as benchmarks for evaluating investment perfor-
June 1979 to December 1989. On June 29, 1979, mance, because few portfolios would have such a
Merck’s stock was selling at $67.50 per share, and heavy emphasis on a handful of stocks. Critics also
it contributed 5.47 percent of the DJIA’s value. Over maintain that value-weighted indices have a long-
the next ten years, Merck’s stock split twice, once term upward bias because the weighting of the more
at 2-l and again at 3-1. On December 29, 1989, successful stocks continually increases over time?
Merck’s stock was selling at $77.50 per share, and In calculating a value-weighted DJIA for each
its weighting in the DJIA had dropped to 4.59 per- month of the test period, I used June 29, 1979, as
cent. If Merck and the other DJIA stocks had not my base day and 841.98, the closing DJIA on that
split at all during those ten years, Merck theoretical- day, as my base index. On four occasions during the
ly would have sold for $465.00 per share and would test period, individual stocks were added and deleted

from the DJIAlg, and it therefore was necessary to weighted index value was equal to 100 in Year 1, the
multiply the simple, value-weighted DJIA by an ad- following table shows the different ending index val-
justment factor so that the value of the index just ues that would result from using arithmetically and
before the substitution equaled the value of the in- geometrically calculated indices?l
dex just after the substitution. The adjustment fac-
tor was carried forward and used in the computation Returns Arithmetically Calculated
of subsequent month’s indices until a further sub- Year 1 Year 2 Year 3
stitution of components necessitated its revision. Stock A 100 50 100
The results of those calculations are tabulated Return on A -50% 100%
in Appendex A and are portrayed versus the actual Stock B 50 100 50
Return on B 100% -50%
monthly closing DJIAs in Graph 1. Critics of value- Average Return 25% 25%
weighted indices maintain that such averages are Index 100.00 125.00 156.25
upwardly biased, and the data for the period between
September 1981 and June 1986 support that conten- Returns Geometrically Calculated
tion. For 58 straight months, the value-weighted
Year 1 Year 2 Year 3
DJIA exceeded the actual average. This apparent up- Stock A 100 50 100
ward bias reversed in later months, causing the Return on A -50% 0%
value-weighted DJIA to be less than the actual DJIA Stock B 50 100 50
Return on B 100% 0%
in 67 of the 126 months of the whole test period (53.2 Average Return 25% 0%
percent of the test months). Moreover, the value- Index 100.00 125.00 100.00
weighted DJIA at the end of 1989 was 2478.34, while
the actual DJIA finished 1989 at 2753.20. The poor Notice that with an arithmetically calculated,
relative performance of the value-weighted index equal-weighted index, the base period index value is
since August 1987 is largely the result of IBM’s fall- simply the index of the previous period, while with
ing from $168.375 per share on August 31,1987, to a geometrically calculated, equal-weighted index, the
$94.125 per share on December 29, 1989-a per- base period index value is the index that prevailed at
annum price depreciation of 22.1 percent. As in- some fixed point in the past (Year 1 in this hypothet-
dicated in Appendix B, IBM’s stock price increased ical example). Considering that the prices of Stocks
at a per-annum rate of only 2.4 percent throughout A and B in Year 3 are no different than they were in
the entire test period, and this may explain why the Year 1, one can see why the geometrically calculat-
value-weighted DJIA was more often less than the ed Year 3-index of 100.00 is more accurate than the
actual DJIA. These results demonstrate the extent arithmetically calculated Year 3-index of 156.25.
to which large-capitalization stocks can influence a Although an equal-weighted index using geo-
value-weighted index. metrically calculated returns is more accurate than
one using arithmetically calculated returns, I con-
Equal Weighting strutted monthly, equal-weighted DJIAs for each
In an equal-weighted index, no stock has a dis- month of the test period using both computation
proportionate influence on the overall average. Such methods.
an index is generally calculated by taking the aver- In calculating an arithmetic, equal-weighted
age percentage return of the individual component DJIA, I took the monthly closing price of each compo-
stocks and applying it to some base period index val- nent stock, adjusted for any previous splits during the
ue. Two types of equal-weighted indices are possible test period, and divided it by the split-adjusted price
depending on whether the individual component per- of the previous month. This ratio was then averaged
centage returns are arithmetically or geometrical- with the ratios derived from the prices of the other 29
ly computed. An arithmetically calculated, equal- components, and the resulting mean ratio was
weighted index is easier to compute, but it tends to multiplied by the previous month’s index to produce
overstate actual performance; a geometrically cal- the new equal-weighted DJIA. As I had done with the
culated, equal-weighted index is more difficult to value-weighted computations, I chose 841.98, the ac-
compute, but it is more accurateTo tual DJIA at the end of June 1979, as my beginning
Consider two hypothetical stocks, A and B. In index.
Year 1, Stock A sells for $100 per share, and Stock The results of those calculations are listed in Ap-
B sells for $50 per share. In Year 2, Stock A falls to pendix A and are pictured versus the actual monthly
$50, and Stock B rises to $100. In Year 3, the prices closing DJIAs in Graph 2. The arithmetic, equal-
of Stocks A and B return to their original values of weighted DJIA was greater than the actual DJIA in
$100 and $50, respectively. Assuming that the equal- 98 of the 126 months of the test period (77.8 per-

Graph 1
ACTUAL DJIA VS. VALUE-WEIGHTED DJIA

Jum 1979 through D~c~mbw 1989
2.800
2.700
2.600
2.500
2.400
2.300
0 2.200
! 2.100
d>- 2.000
B 1.900
fi 1.800
GO
0 J 1.700
*b = 1.600
i 1 so0
‘r: 1.400
1.300
1.200
1.100
1 .ooo
0.900
0.600
0.700 m
1980 1981 1982 1963 1964 1985 1966 1987 1988 1989
0 Actual DJIA + Valua-Walghted DJIA
Graph 2
ACTUAL DJIA VS. EQUAL-WT.(ARITH.) DJIA

Juna 1979 through Oacambar 1989
2.800
2.700
2.600
2.500
2.400
2.300
it 2.200
2.100
d2
5 2.000
1.900
g0: TV 1.800
52
a ii 1.700
1 .600
1
1.500
1.400
1.300
1.200
1.100
1 .ooo
0.900
0.800
0.700 m
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
0 Actual DJIA t Equal-Wt.(Arlth.)
56 hfTA JOURNAL ! SPRING 1991

cent of the test months). In addition, the equal- ican Express for Manville Corporation. I changed the
weighted average finished 1989 at 2763.31, slight- divisor to 1.470 beginning with the February 1984
ly higher than the actual DJIA of 2753.20. These computation in order to adjust for the break-up of
results are consistent with the notion that an equal- AT&l (substituting the new AT&T for the old AT&T).
weighted index calculated from arithmetic returns This divisor was changed to 1.402 beginning with
tends to overstate actual performance. my October 1985 calculation to reflect the addition
To calculate a geometric, equal-weighted DJIA, of McDonald’s and Philip Morris and the deletion
I took the split-adjusted, monthly closing price of of American Brands and General Foods. Finally, I
each component stock and divided it by the split- changed the divisor to 1.386 beginning with the
adjusted price of a base-period month. This ratio was March 1987 calculation to adjust for the substitu-
then averaged with the ratios derived from the prices tion of Boeing and Coca-Cola for Into, Ltd. and
of the other 29 components, and the resulting mean Owens-Illinois Glass. Notice that had a constant-di-
ratio was multiplied by the base month’s index to visor system been implemented in June 1979, the
produce the new equal-weighted DJIA. I originally divisor that would have prevailed at the end of 1989,
set June 1979 as the base month, but as individual 1.386, is much higher than 0.586, the divisor that
component stocks were added and deleted from the actually existed under the present method for com-
DJIA, I had to reset the base to the month just before puting the DJIA.
the substitution occurred. The results of the constant-divisor DJIA cal-
The results of the geometric, equal-weighted culations are tabulated in Appendix A and are por-
calculations are tabulated in Appendix A and are trayed versus the actual monthly closing DJIAs in
portrayed versus the actual monthly closing DJIAs Graph 4. The constant-divisor DJIA was less than
in Graph 3. The geometric, equal-weighted DJIA was the actual DJIA in 105 of the 126 months of the test
greater than the actual DJIA in 83 of the 126 period (83.3 percent of the test months). Moreover,
months of the test period (65.9 percent of the test the constant-divisor index finished 1989 at 2710.97,
months). Nevertheless, the equal-weighted average less than the actual DJIA of 2753.20. These results
finished 1989 at 2707.39, less than the actual DJIA support the theory that the present DJIA has an up-
of 2753.20. Assuming that one can use the geometric, ward bias, or at least that during the June 29,1979,
equal-weighted index as an accurate measure of through December 29, 1989 test period, the factors
market performance, these mixed results do not pro- causing an upward bias in the DJIA, i.e., temporary
vide convincing support for either those who contend price run-ups in stocks just before they split, out-
the actual DJIA is upwardly biased or those who in- weighed the factors causing a downward bias in the
sist the actual DJIA is downwardly biased. average, i.e., the declining influence of appreciating,
splitting stocks in a price weighted index.
Constant-Divisor Method
In addition to calculating value-weighted and Conclusions
equal-weighted indices, I computed monthly closing With the exception of the period from August
DJIAs using the constant-divisor method, which had 1987 through December 1989, the four alternative
actually been used prior to October 1928. Under this DJIAs yielded similar results. Consider, for exam-
method, the current price of each component stock ple, Graph 5, which portrays the arithmetic, equal-
is multiplied by its cumulative split factor before be- weighted index versus the value-weighted DJIA, the
ing summed and averaged with the other component two most divergent averages. The graph shows that
stocks. In other words, the numerator of the index prior to August 1987, the two indices tracked each
calculation, not the divisor, is adjusted for stock other very closely. As mentioned earlier, the value-
splits and stock dividends. Under this method, I weighted DJIA was significantly depressed after
changed the divisor only when individual component August 1987 by the dismal performance of IBM.
stocks were added and deleted from the DJIA. In The constant-divisor index and equal-weighted
those months of the test period, I computed a new average calculated from geometric returns, which are
divisor so that the value of constant-divisor DJIA depicted in Graph 6, are better than the current DJIA,
before the substitution equaled the value of the in- because they are free from the potentially distorting
dex after the substitution. biases associated with the present method of cal-
The initial divisor used in my constant-divisor culating the index. The geometric, equal-weighted
DJIA calculations was 1.465, the actual DJIA divi- DJIA would serve as a better benchmark for evaluat-
sor in existence at the end of June 1979. This figure ing portfolio performance, while the constant-divi-
was changed to 1.511 beginning with my August sor DJIA would function as a better indicator of gen-
1982 calculation to reflect the substitution of Amer- era1 movements within the blue-chip sector of the

Graph 3
ACTUAL DJIA VS. EQUAL-WT.(GEOM.) DJIA

Juna 1979 through Dacsmbrr 1989
2.800
2.700
2.600
2.500
2.400
2.300
ii 2.200
e 2.100
2.000
“D$
5, 1.900
c cl 1 .a00
%H
”2 z 1.700
A.5 Jz 1.600
i 1.500
2I” 1.400
1.300
1.200
1.100
1 .ooo
0.700
1980 1981 1982 i 983 1984 1985 1986 1987 1988 1969
El Actual DJIA t Equd-Wt.(Gaom
Graph 4
ACTUAL DJIA VS. CONSTANT-DIV SOR DJIA

Juna 1979 through Dwambar 1989
2.800 ,
2.700 -
2.600 -
2.500 -
2.400 -
2.300 -
g 2.200 -
e 2.100 -
2.000-
44
g, 1.900 -
pi 1.000 -
00OJ 1.700-
x 1 .600
&
i .500
2
f
1980 1981 i 982 1983 1984 1985 1986 1987 1988 1989
cl Actual DJIA + Cord.-Dlvlsor DJIA

Graph 5
EQUAL-WT.(ARITH.) VS. VALUE-WT. DJIA

Juna 1979 through Dacmmbw 1989
0 Equal-Wt.(Arlth.) t Valua-Walghtad
Graph 6
EQUAL-WT.(GEOM.) VS. CONS.-DIVISOR DJIA

June 1979 through Dacamber 1989
2.600
2.700
2.600
2.500
2.400
2.300
2.200
2.100
2.000
1.900
1 A00
1.700
1.600
1 so0
1.400
1.300
1.200
1.100
1 .ooo
0.900
0.800
0.700
1980 1981 1982 1963 1984 1965 1986 1987 1988 1989
0 Equal-Wt.(Gaom.) + Conat.-Dlvlsor MIA

r
stock market. During the test period, the geometric, nents of the downward-bias theory is the fact that the DJIA divisor
is seldom adjusted for stock dividends of less than 10 percent.
equal-weighted index exceeded the constant-divisor These critics therefore maintain that the divisor is higher and
DJIA in 99 of the 126 months (78.6 percent of the the DJIA is lower than they otherwise would be ifthe divisor were
test months). Nevertheless, the geometric, equal- adjusted for all stock dividends.
weighted index finished 1989 at 2707.39, less than 17. Rudd, 58.
the constant-divisor DJIA of 2710.97. 18. Milne, 86.
Graph 7, which portrays the actual DJIA to- 19. On August 31, 1982, American Express was substituted for
Manville Corporation. AT&l’was broken-up on February 16,1984,
gether with the geometric, equal-weighted and con- and one can think of the new AT&I’ as being substituted for the
stant-divisor indices, illustrates that the empirical old AT&T. On October 31, 1985, McDonald’s and Philip Morris
differences among these alternatives was very small were added to the DJIA, and American Brands and General Foods
were deleted. Finally, on March 13,1987, Boeing and Coca-Cola
during the test period. It therefore may be difficult were substituted for Into, Ltd. and Owens-Illinois Glass.
to convince people of the need to change the present 20. Milne, 86.
method used in calculating the DJIA. The calcula- 21. Ibid.
tions show, however, that there is potential for great-
er distortions in the future. BIBLIOGRAPHY
With this consideration in mind, I recommend Butler, Jr., Hartman L., and Allen, J. Devon. “The Dow Jones
Industrial Average Re-Reexamined!’ Financial Analysts Jour-
changing to a constant-divisor DJIA. Such an aver- nal 35 (November-December 1979), 23-30.
age had been used prior to October 1928, and one Butler, Jr., Hartman L., and Decker, Martin G. “A Security Check
therefore could argue that the original DJIA was on the Dow Jones Industrial Average.” Financial Analysts
being reinstated. A constant-divisor index would Journal 9 (February 19531, 3745.
eliminate the theoretical biases associated with the Butler, Jr., Hartman L., and DeMong, Richard F. “The Chang-
ing Dow Jones Industrial Average.” Financial Analysts Jour-
manner in which the current DJIA adjusts for stock nal 42 (July-August 1986), 59-62.
splits and stock dividends. It would be a major Carter, E. Eugene, and Cohen, Kalman J. “Bias in the DJL4
improvement. Caused by Stock Splits? Financial Analysts Journal 22
(November-December 19661, 90-94.
Daily Stack Price Record, New York Stack Exchange. New York:
FOOTNOTES Standard & Poor’s Corporation, April 1979-December 1989.
Milne, Robert D. “The Dow Jones Industrial Average Re-exam-
1. Hartman L. Butler, Jr. and Devon J. Allen, “The Dow Jones
ined!’ Financial Analysts Journal 22 (November-December
Industrial Average I&-Reexamined,” Financial Analysts Journal
1966), 83-88.
35 (November-December 1979), 23.
Reilly, Frank K. Investment Analysis and Portfolio Management.
2. Robert D. Milne, “The Dow Jones Industrial Average Re-exam-
2nd ed. New York: CBS College Publishing, 1985.
ined,” Financial Analysts Journal 22 (November-December 1966),
83. Rudd, Andrew T. “The Revised Dow Jones Industrial Average:
New Wine in Old Bottles?’ Financial Analysts Journal 35
3. Ibid.
(November-December 1979), 57-63.
4. Ibid.
Schellbach, Lewis L. “When Did the DJIA Top 1200?” Financial
5. E. Eugene Carter and Kalman J. Cohen, “Bias in the DJIA Analysts Journal 23 (May-June 1967), 71-73.
Caused by Stock Splits,” Financial Analysts Journal 22 (Novem-
Shaw, Robert B. “The Dow Jones Industrials vs. the Dow Jones
ber-December 1966), 90.
Industrial Average” Financial Analysts Journal 11 (November
6. Mime, 84. 19551, 37-40.
7. When Hamilton expanded the DJIA to include thirty stocks
and changed its method of calculation, the divisor was set at 16.67
so as to equate the value of the index to what it had been just
before the change. The current DJIA divisor, which reflects all
of the stock splits, major stock dividends, and component changes
that have occurred since October 1928, is 0.555.
8. F’rank K. Reilly, Znuestment Analysis and PorybZia Management, Associate with the Environmental Services Specialized
2nd ed. (New York: CBS College Publishing, 1985), 121. Finance Unit at the Bank of Boston.
9. Hartman L. Butler, Jr. and Richard F. DeMong, “The Chang-
ing Dow Jones Industrial Average,” Financial Analysts Journal
42 (July-August 19861, 59.
10. Milne, 86.
11. Robert B. Shaw, “The Dow Jones Industrials vs. the Dow Jones
Industrial Average,” Financial Analysts Journal 11 (November
19551, 37.
12. Andrew T Rudd, “The Revised Dow Jones Industrial Average:
New Wine in Old Bottles?,” Financial Analysts Journal 35
(November-December 1979), 63.
13. Carter and Cohen, 90.
14. Ibid., 91.
15. Ibid., 94.
16. Another minor argument sometimes put forward by propo

Graph 7
ACTUAL, EQUAL-WT.(GEO.), & CON-DIV DJIA

Juna 1979 thr&h D.c;mbw 1989
2.600 ,
2.700 -
2.600 -
2.500 -
2.400 -
2.300 -
ii 2.200 -
2.100 -
x-J
F 2.000 -
1.900 -
g0: 0 1 A00 -
8 5 1.700 -
GO s 1 .600
_*t.
1 so0
f
s 1 .400
E
.300
.200
.lOO
0.700
1980 1981 1982 1963 1964 1985 1986 1987 1966 1969
0 Actual DJIA + Eq.-Wt.(Gao.) V COllSt.-DlV.
Appendix A
Equal. Equal-
VdUP Weighted WeIghted COMstpnt
AdUd Weighted (Arith.) Geom.) Llkisc.r
DJIA DJIA DJIA DJIA DJIA
841.98 84198 841.98 811.98 841.98

e46.42 834.90 85451 654.51 846.50
007.63 858.16 895.26 894.98 687.37
818.58 848.86 889.30 889.09 876.33
815.70 801.48 816.66 816.06 815.27
82235 807.51 820.55 820.64 822.18
838.74 802 78 841.64 642.04 836.14
675.35 645.67 889 20 892.51 876.19
663.14 838.11 871.96 a30.86 862.80
785.75 767.67 793.39 790.53 765.64
817.06 796.18 625.44 622.70 816.55
85085 818.51 855.72 653.66 850.68
867.92 83823 874.68 870.11 067.49
935.32 892.26 950.96 941.13 93447
932.59 897.07 949.34 939.60 932.68
932.42 366.77 946.76 937.22 932.25
924.49 899.07 640.40 935.48 924.83
99334 965 95 996.10 1005.16 993.09
663.99 93566 973.75 973.95 663.62
947.27 936.73 663.67 958.00 647.53
974.58 950.97 989.47 986.57 974.66
949.43 1044.82 1029.86 1002.05
99775 94727 103266 1019.92 996.e-t
991.75 941.67 1021.05 1001.15 986.86
976.88 933.3-l mo5.35 989.83 974.57
952.34 930.47 980.19 967.96 954.69
681.47 879.43 901.37 895.33 ea.73
849.98 860.98 859.71 653.36 653.75
852.55 872.52 660.30 861.83 851.00
888.98 903.79 897.21 899.50 894.80
875.00 897.86 677.02 880.46 877.39
87110 915 16 867.10 862.33 667.58
824.39 865.92 818.50 814.91 82227
822.77 em.33 817.30 817.69 622.27
e-48.36 890.25 841.28 646.41 646.67
819 54 87115 80122 814.18 819.28
811.93 858.36 795.45 802.34 81041
808.60 864.10 762.26 790.13 803.33
901.31 954.36 882.17 891.05 895.93

Appendix A (continued)
EL@- Equal.
Vdllb Wtiphted Weighted COMt.UUt.
Weighted Wdb.) Nseom.) Divisor
JmA DJL4 DJIA DJIA
696.25 954.15 871.01 678.OQ 890.39
931 12 1081.71 956 12 965 88 981.88
1039.28 1103.28 993.12 1004.45 1022.50
1046.54 1130.44 1015.38 1022.02 1032.88
1015.10 1198.41 1058.92 1060.42 1061.55
1112.18 1208.05 1099.69 1105.39 1096.82
1130.03 1220.81 1125.64 1131.90 1119.15
1226.20 1340.58 1241.10 1245 12 1210.79
1199.98 1285.31 1238.57 1239.06 1181.94
1221.96 1320.33 1248.74 1246.48 1202.49
1199 22 1315.38 1238.82 l!u3.15 1119 a3
1216.16 1339.65 1260.46 1283.41 1201.52
1233.13 1353.90 1278.71 1281.95 1214.28
1225.20 1351.98 1271.97 1281.01 1204.00
1216.02 1368.14 1344.81 1336.66 1253.39
1253.84 1380.28 1311.72 13cul.11 1238.42
1220.58 1341.90 1292.89 1214.53 1205.41
1154.83 1280.97 1201.90 1185.01 1124.32
1164.89 1233.60 1210.59 1192.31 1134.01
1170.15 1320.12 1233.11 1203.21 1158.93
1104 85 1245.12 1151.58 1128.15 1038.30
1132.40 1284.21 1164.35 1153.18 1122.92
1115.28 1280.98 1155.93 1128 13 1104.93
1224.38 1388.64 1299.43 1257.99 1218.75
1208.11 1398.85 1282.02 1243.15 1207.14
1201.38 1394 41 1280.14 1228.14 1209.99
1188.94 1385 31 1252.81 1211.12 1189.83
1211.57 1394.39 123474 1241.25 1210 31
1286.11 1495.82 1380.28 1330.29 1234.61
1234.01 1488.83 1382.83 1331.82 1239.75
1288.73 1455.44 138423 1315.03 1271.17
1258.08 1445.01 1355.72 1310.19 1280.29
1315.4, 1505.23 1423.45 1318.11 1313.03
1335.48 1506.07 1441.20 1395.02 1338.22
1341.45 1485.90 140621 1347.02
1334.01 1481.87 1448.01 1392.18 1330.32
1328.83 1455 23 1423.43 1319.98 1315.14
1374 31 1529.21 1441.39 1403.17 1361.89
1412.13 1819.58 1552.98 1502.06 148289
1548.81 1720.48 1822.88 1510.40 1533.94
1887.84 1650.48 159920 1550.29
1109 06 178&OQ 1738.51 1137.98 1895.27
1818.81 1859 18 16aO.83 1322.31 1182.35
1783.98 1345.84 1813.14 1153.39 1719.11
1818.11 189l.eQ 1883.16 1828.35 1796.78
1892.72 1895.31 1874.50 1829.52 181370
1775.31 1165.00 1717.35 1894 19 1712.29
1898.34 1892.11 1681.62 1820.42 1332.34
1181.58 1778.91 1182.55 1102.74 1891.98
1311.11 1931.03 1881.81 1812.95 1799.88
1914.23 1992.08 1811.12 1337.80 1841.74
1a95.95 1848.92 1345.98 1812.01 1832.78
2158.04 2019.28 2119.90 2073.39 2091.32
2223.99 2115.41 2198.83 2145.74 2183.07
2304.69 2217.14 2211.82 2222.82 2230.19
2283.36 2232.88 2291.50 2238.40 2203.48
2291.51 2248.74 2318.13 2266.88 2213.92
2413.53 2353.08 2435.36 2319.41 2343.43
2512.07 2416.24 2616.93 2570.05 2490.40
2662.95 2581.68 2864.72 2819.99 2588.81
2596.28 2492.51 2819.63 2560.65 254419
1993.53 1978.72 1915.49 1935.31 1967.80
1833.55 1784.44 1918.88 1189.29 1798.97
1938.83 1870.00 1950.39 1930.51 1388.18
1958.22 19oc.12 2007.24 1987.55 1911.30
2071.82 1981.19 2159.43 2113.12 2013.98
198808 1888.55 2ow.90 2046.03 1923.57
2032.33 1918.83 2127.51 2090.58 1981.02
2031.12 1921.22 2124.20 2060.43 1981.58
2141.71 2021.87 2252.63 2209.18 2064.55
2126.73 2017.30 2238.93 2205.26 205801
2031.85 1913.88 2144.20 2089.02 1965.30
2112.91 1974.84 2221.66 2152.18 2085.12
2143.85 2011.82 2282.14 2196.28 2088.43
2114.51 1989.21 2221.88 2153.83 2051.40
2189.51 2029.40 2284.38 2213.44 2095.84
2342.32 2188.32 2446.48 2396.49 2215.52
27.58.39 2095.53 2313.88 2323.29 2198.25
2293.82 2110.08 7.40684 2383.30 2232.59
2418.80 2201.52 2512.33 2449.28 2351.06
248015 2249.70 2555.19 2487.45 2408.62
2440.06 222115 2511.11 2438.58 2318.35
2880.66 2407.20 2133.15 2850.23 2805.01
2737.21 2428.66 2796.32 2108.99 2659 54
2692.82 2413.81 2141.48 2871.58 2830.34
2645.08 2392.36 2669.21 2595.06 2808.54
2106.21 2440.28 2127.57 2854 74 2810.05
2153.20 2418.34 2163.31 2101.39 2710.97

APPENDIX B
Portion of Test Period Compound

in which Company Was Annual Price
Company Included in the DJIA Appreciation
Allied Signal (Formerly Whole Period 3.87%
Allied Chemical)
Aluminum Company of America Whole Period 10.74%
American Express E/31/82 to 12/‘29/89 16.25%
AT&T (Before break-up) 6/29/79 to 2/16/84 2.02%
AT8lr (After break-up) 2/16/84 to 12&J/89 18.41%
Bethlehem Steel Whole Period -1.31%
Boeing 3113187 to 12/29/89 21.02%
Chevron Corporation Whole Period 10.28%
lIFormerly Standard Oil
of California)
Coca-Cola 3113187 to 12/29/89 19.34%
DuPont Whole Period 10.97%
Eastman Kodak Whole Period 4.70%
EXX0n Whole Period 13.31%
General Electric Whole Period 16.92%
General Motors Whole Period 3.42%
Goody&W Whole Period 10.08%
IBM whole Period 2.40%
International Paper Whole Paper 9.25%
McDonald’s Corporation 10131185 to 12/29/89 22.46%
Merck & Ca Whole Period 20.18%
Minnesota Mining & Whole Period 10.40%
Manufacturing Ca
Navistar (Formerly Whole Period -19.79%
International Harvester)
Philip Morris 10/31/85 to 12/29/89 43.77%
Primerica (Formerly whole Period 3.68%
American Can)
Procter & Gamble Whole Period 13.14%
Sears Roebuck Whole Period 6.72%
Texaco Whole Period 7.47%
Union Carbide whole Period 6.22%
USX Corporation (Formerly Whole Period 4.90%
us Steel)
United Technologies Whole Period 10.75%
Westinghouse Electric Whole Period 21.14%
Woolworth Corporation Whole Period 16.16%
American Bran&s 6/29/79 to 10/31/85 10.89%
General Foods w29f-79 to 10/31/85 23.32%
Into, Ltd. 6/29/79 to 3113187 -3.69%
Manville Corporation 8l29/79 to 8131182 -40.53%
(Formerly Johns Manville)
Owens-Illinois Glass 6/29/79 to 3113187 26.89%

r
NOTES
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SPRING 1991

A PUBLICATION OF THE MARKET TECHNICIANS ASSOCIATION

Issue 37 spring 1991

John R. McGinley Michael J. Moody

Charles D. Kirkpatrick II David Upshaw, C.F.A.

Frederick Dickson Anthony W. Tabell

Richard Orr, Ph.D. Henry 0. Pruden, Ph.D.

MTA JOURNAL / SPRING 1991 1

ELIGIBILITY: REGULAR MEMBERSHIP is available to those “whose professional efforts are

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2 MTA JOURNAL / SPRING 1991

MTA Editorial Policy

The MARKETTECHNICIANSASSOCIATIONJOURNAL~~ publishedbythe Market Technicians Associ-

Style For The MTA Journal

MTA JOURNAL /SPRING 1991 3

President Vice-President/Long Range Vice-President/Seminar

*Membership Vice Chairpersons

4 MTA JOURNAL / SPRING 1991

Moving Share Repurchase

Stock Market Price Behavior:

MTA JOURNAL I SPRING 1991 5

6 MTA JOURNAL / SPRING 1991

MTA JOURNAL/SPRING 1991 7

8 MTA JOURNAL / SPRING 1991

Overview of the price/earnings ratio. In particular, I began to

MTA JOURNAL /SPRING 1991 9

10 MTA JOURNAL / SPRING 1991

cremental expected return. By measuring return us- a -0.01 - UNPROFITABLE

MTA JOURNAL / SPRING 1991 11

12 MTA JOURNAL / SPRING 1991

Overview thesized that changes in odd-lot trading reflect

MTA JOURNAL / SPRING 1991 13

LIQUID ASSET RATIO VS S&P 500

S&P 500 LIQUID ASSET RATIO

0 llllllll”llllll~llllillllllllllllllillllllllillllllllilillllllllllllllillllllliilllllllllll~l’llll”l’lllllllll II 1”,I,,,:,“’ “I ,,,

- LIQ ASSET + S&P 500

14 MTA JOURNAL/SPRING 1991

% CHANGE IN CASH VS % CHANGE S&P 500

-25% -20% -15% -10% -5% 0% 5% 10% 15%

MTA JOURNAL /SPRING 1991 15

16 MTA JOURNAL / SPRING 1991

RAW ASSET FIGURES VS RAW S&P 500

MTA JOURNAL / SPRING 1991 17

18 MTA JOURNAL / SPRING 1991

MTA JOURNAL/SPRING 1991 19

20 MTA JOURNAL /SPRING 1991

NON-CUMULATIVE AVERAGE EXCESS RETURNS

-1 20 41 62 83 104 125 146 167 188 209 2x)

Day Relative to Announcement

CUMULATIVE AVERAGE EXCESS RETURNS

._-._ _.__._._ - ._ - .-.-.-.. ~