--- "A Smarter Computer to Pick Stocks," NY Times, Nov
24 ---
[Excerpt]
Studies estimate that a third of all stock trades in the
United States were driven by automatic algorithms last year,
contributing to an explosion in stock market activity.
Between 1995 and 2005, the average daily volume of shares
traded on the New York Stock Exchange increased to 1.6
billion from 346 million.
But in recent years, as algorithms and traditional
quantitative techniques have multiplied, their successes
have slowed.
"Now it's an arms race," said Andrew Lo, director of the
Massachusetts Institute of Technology's Laboratory for
Financial Engineering. "Everyone is building more
sophisticated algorithms, and the more competition exists,
the smaller the profits."
---
For full article, see
http://www.nytimes.com/2006/11/24/business/24trading.html ,
free online for a few more days.
Jose, I think folks should take the above as an opinion
only. For one thing, Ben Graham, the so-called father of
value investing, does not recommend relying on future
earnings. Such calculations of the future demand too many
assumptions.
My sense is that the algorithms about which the article
talks seem to use a mix of conventional wisdom for choosing
stocks; some "technical" analysis; and information of all
flavors and varying specificity, depending on the industry
and stock, concerning economic conditions.
Ben Graham has a funny line about "technical analysis" and
how there's nothing technical about such methodologies. I
agree with him (big deal; little Elle agrees with the old
sage, I know), hence my quotation marks, as well as my
'raised eyebrow' at what some of these algorithms claim to
do.
What is the cointegrating vector -- what equilibrium relationship does
your model assume?
> For a value investor, the estimation of
> future earnings is the most important variable to pick -or not- a
> stock, since discounted future earnings gives the intrinsic value of
> the stock, which is compared to market value.
It is discounted DIVIDENDS, not EARNINGS, that equal the fair value of
the stock.
As you may appreciate, I picked my stocks by using something more than
just a stock screener...
With respect to the technicalities of the estimation of an error
correction model -unit roots, the cointegrating vector, etc...- they
are a bit too sophisticated for this forum. I have a paper on the
Spanish housing market which uses the same analysis and methodology
used for stocks, you may see it here:
http://www.um.es/analisiseco/documentos/Jose-Bailen.pdf
<jose....@gmail.com> wrote
I believe that premise, that most mispricing should be temporary. Though
a few anomalies (such as the returns of value stocks) test that assumption.
But WRT program trading - my understanding is that a lot of that
activity isn't the type of trading you might be thinking of. I think a
substantial portion of the volume is more mundane arbitrage trading,
including ETF arbitrage. For example if an S&P 500 ETF is priced a bit
too high relative to the value of its component securities, even after
factoring in transaction costs, you short the ETF and purchase the
basket of securities, producing a risk-free profit. There are similar
trades for other products and derivatives. If computers weren't working
these trades ETFs would face the pricing problems of closed-end funds.
The growth in ETFs means ETF-arbitrage program trading should steadily
increase, and those profits are always going to be there for the firms
with the resources to quickly identify and trade around them. I imagine
too many firms may get into it for it to be profitable enough, but that
should self-correct.
-Tad
Jose, good for you for developing a model like that, and very
interesting paper on housing (which could be a thread in itself...did
you model the US market as well?). [RE: the equity model - My personal
belief is that earnings predictions even a couple years out are
difficult/impossible to make any better than the market does. The best
we can do is watch for overreactions to earnings misses or other bad
news, and adopt a longer-term attitude than the typical institutional
investor.]
I think you & Beliavsky can find a common ground this way...if you want
to value a stock, and aren't assuming infinite life, a dividend-discount
model should include a "residual value" or "liquidation value" or
"buyout value" term at the end of your stream of projected dividends.
And of course, you'd need to look to earnings relative to dividends paid
to estimate retained earnings and the value of the enterprise at that
end point. I don't see this as strictly a theoretical exercise because
"going private" with fat cash flow & a solid balance sheet, or being
acquired, is an common exit for businesses that produce the strong cash
flow that could be, but isn't necessarily, used for dividends.
This wraps into the other Elle thread, on the importance of dividends in
choosing an investment. I think for a lot of reasons, you can't focus on
dividends when selecting stocks, because there are too many things that
get in the way between earnings and dividend policy. Unless you look at
total return you're ignoring external factors that might be affecting
dividend policy (eg for a REIT, tax constraints; for a stock,
acquisition plans).
-Tad
> What is the cointegrating vector -- what equilibrium
> relationship does your model assume?
As they say down South -- Say what again?
This is why I am a Random Walk, Efficient Market, John Bogle, Index Fund
kinda investor. ;-)
But that doesn't mean I don't enjoy reading posts from those of you more
academically and mathematically inclined. The group never ceases to be a
learning experience for me.
The error correction model provides both the long term equilibrium and
the short term dynamics. For the model's forecast, you need to make
some assumption on the evolution of the exogenous variables. Once you
make these assumptions, you obtain a forecast of the endogenous
variable -in this case, earnings- and therefore you obtain the
intrinsic value of the company, and compare it with its actual market
value.