2

The Behavior of Stock-Price Relatives-A Markovian Analysis
Author(s): Bruce D. Fielitz and T. N. Bhargava

Source: Operations Research, Vol. 21, No. 6 (Nov. - Dec., 1973), pp. 1183-1199
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The Behavior of Stock-Price Relatives-
A Markovian Analysis
Bruce D. Fielitz
Georgia State University, Atlanta, Georgia
T. N. Bhargava
Kent State University, Kent, Ohio
(Received June 7, 1972)
This paper presents a method of Markovian analysis of changes in the natural

logarithms of stock prices over time. It examines 200 stocks from the New
York Stock Exchange for the period December 23, 1963, to November 29, 1968,
and defines a set of three states (up, down, small change) for the process in
terms of the mean absolute deviation of changes in the natural logarithms of
prices. This definition of the set of states allows both the magnitude and
the direction of change to be incorporated in the analysis. Standard statisti-
cal tests for stationarity and dependence in vector and individual-process
Markov-chain models are employed for both fixed- and variable-time data
(the latter refers to highs for a day or week interval). In addition, a method for
testing the homogeneity of the vector Markov chain is given. Empirical results
for the vector-process model suggest that price movements appear to be de-
scribed by a first- or higher-order nonstationary Markov chain. Tests also
indicate that the vector-process Markov chain is heterogeneous. Empirical
results for the individual-process Markov-chain model suggest that an indi-
vidual stock has a short-term memory with respect to daily price relatives, i.e.,
the process is first- or higher-order. However, the corresponding process
lacks stationarity. No dependency appears to exist for a weekly time lag.
N UMEROUS empirical studies have appeared in recent years concerning the

behavior of stock market prices (see; for example, COOTNER,1j5 FAMA,[781
HAGIN,I'1l LEVY,I'1l and NIEDERHOFFER AND OSBORNE,[21I to cite only a very few).
While a few writers believe that certain price trends and patterns exist to enable
the investor to make better predictions of the expected values of future stock-
market price changes, the majority of these studies conclude that past price data
alone cannot form the basis for predicting the expected values of price movements
in the stock market.
The purpose of this paper is to reinvestigate in terms of a simple Markov chain
the question of dependency among the price movements of common stocks. The
findings show that the stock market does have a short-term memory in that price
behavior is dependent on immediately preceding daily price changes. But, at the
same time, this dependency has nonstationary transition probabilities, and thus
even the steady-state-transition matrix cannot be formed.
The procedure employed here is to consider the behavior of changes in the
natural logarithms of prices of stocks, both for the market as a whole in terms of a
vector Markov chain, and for a single stock in terms of its particular Markov chain.
1183
1184 Bruce D. Fielitz and T. N. Bhargava
Further, both the fixed- and variable-time models represented by closing- and high-
price data, respectively, are studied. (The designation of high-price data as vari-
able-time and closing price data as fixed-time is somewhat arbitrary, but is based on
the observation that high-price data are more variable in their occurrence point in
time than are closing-price data.)
The choice of changes in the natural logarithms of prices has several advantages.
First, it is well known that studying first differences in a time series often removes
the secular trend present in the original series. Such is the case with stock market
prices (see, FIELITZ110I). More precisely, studying first differences in a time series
removes a constant P = (l/T) E Pt from the series. The mean first difference
AP [1 (-1 ] t-ll (Pt+,-Pt)
is the slope of a line from P1 to PT. By studying APt -AP, one removes the slope
of the line from P1 to PT, which is the slope of a least-squares trend-line fit to the
undifferenced data Pt. The same statements apply to analyzing lnPt instead of Pt.
But what is removed in this case is slightly different. By studying Aln Pt-AlnP,
a geometric rather than an arithmetic mean is removed. The slope of the least-
squares trend-line fit is a power law Pta (a not required to be an integer),
or a straight line on a semilog plot.
Second, MOORE[191 has shown that the variability of simple price changes for a
given stock is an increasing function of the price level of the stock. Taking the
first difference of the natural logarithms of prices seems to eliminate this tendency.
Actually, as OSBORNE["22 has shown, this process slightly overcompensates for the
price-level effect. The variance cInP = (Aln Pt)2- (Aln P)2 is somewhat smaller
for high-priced as compared to low-priced stocks. Thus, using lnPt+i-lnPt instead
of Pt+,-Pt tends to make stock-price differences homogeneous (more precisely,
homoscedastic), but does not do so entirely.
Third, for price changes less than plus or minus 15 percent, the changes in the
natural logarithms of prices are very close to percentage change and sometimes
studying percentage changes is desirable.
Let Pt denote the price of the sth stock at time t; and let X8e denote the change
in the natural logarithms of the prices of stock s, measured between time t and time
t-o1; i.e., Xt=lnP8t-lnP8,,_I, with s=1, 2, *, S. and t=1, 2, * , T in the total
time interval [0, T]. (The random variable of interest in this paper will always be
changes in the natural logarithms of prices.) Consideration is given to the single-
dimensional or individual process { Xt, t 1, 2, --, TI of a stock s. Also, the
collective or vector process {IXt, t= 1, 2, * *, T} is examined, where Xt= (X1t, X2t,
* , Xst) is an S-dimensional vector with the components representing changes in
the natural logarithms of the prices of stock 1, stock 2, *- , stock S.
With regard to these processes, some preliminaries are now presented to permit
drawing a statistical inference in a random process, in particular, for a sim-
ple Markov chain. Let {XI} = {Xt, t = 1, 2, *, TI be a process that evolves in
time. One can either take X8, for Xt, or Xt for Xt, as the case may be, and apply
the appropriate methods to the individual or vector process. The set of possible
values (v =1, 2, * * *, V) of the events of the process is called the state space of the
chain, with the individual elements v called the states of the chain. The process
{XtI is said to be a Markov chain of order one if P[Xt=vtj (X0=vo) A (XI= vI)
A ... A (Xt-1 = Vt-1)]-P (Xt = vtXtI = vti). The first-order transition probabili-
The Behavior of Stock-Price Relatives 11 85
ties for a Markov chain, denoted by Pij (t), are the conditional
one-step transition from, say, state v = i at time t-1 to state v
specifically, Pi j(t)=P (Xt =vtjXt-l = vt-l) = P (Xt =j|Xt-l = i);
A Markov chain is said to have stationary transition probabilities if the probabilities
Pij (t) do not depend on t; ij, =1, 2, ***, V. The probabilities from a first-order
Markov chain form a V X V matrix, known as the first-order transition matrix of the
process. Finally, the vector process {Xt = {Xt, t= 1, 2, -, TI is said to be
homogeneous if the probabilities Pij (t), for each i and j, are the same for all the
S-component Markov chains of the vector process; that is, Pij(l) (t) =Pij(2) (t)=
* * Pijes) (t); i~j= 1, 2, .. * > V; s= 1) 2, .. * * S.
In this paper, the model considered is that of a first-order Markov chain. A
the particular Markov chain studied here has a finite number of states and a finite
number of equidistant points at which observations are made. In our analysis, use
is made of standard methods, as developed by ANDERSON AND GOODMAN [J and ap-
plied by BHARGAVA,13] for drawing statistical inferences in time. Statistical tests
are performed for the following hypotheses, both for fixed- and variable-time data:
(1) the transition probabilities, for the vector Markov chain, are homogeneous, (2)
in a Markov chain the transition probabilities are stationary, and (3) the observa-
tions at successive points in time are independent against the alternative hypothesis
that the observations are from a first- or higher-order Markov chain.
1. THE MARKOVIAN MODEL
FOR THE PURPOSE of analyzing stock prices as a Markov chain, a set of values in
which the process takes place must be defined. This can be done by simply taking
two states, viz., up and down. DRYDEN161 and YING1231 consider a third state, viz.,
no change. Also, Niederhoffer and Osborne[211 utilize seven states to study transac-
tions data. Our study considers a three-state process-up, down, and no change-
but the method used to define the states is different from those of other authors and
indeed, has some advantages.
States of the Process
In defining the states of the process, the work of Niederhoffer and Osborne [21 h
particular relevance for this study. In their paper both the directions and magni-
tudes of security price changes are incorporated directly into the analysis. This ap-
proach is significant. Niederhoffer and Osborne suggest that, while dependency
may not be exhibited in simple directional models, dependency may well exist in
more complicated models requiring the integration of both magnitude and direction
of change. The work in this paper tends to reinforce this position, namely, that
models attempting to discover dependent patterns in security price changes should
be established on the basis of both magnitude and direction of change.
Let t XI represent the process of changes in the natural logarithms of prices over
time, t =1, 2, * * *, T. MANDELBROT, [17,181 and Famal7] have indicated that the non-
Gaussian family of stable Paretian distributions may give the best fit for the proba-
1 186 Bruce D. Fielitz and T. N. Bhargava
bility distribution of X,. In such cases X, is typically ch

mean value and infinite second- and higher-order moments. If their analysis is cor-
rect, it means that the variance is infinite, and is not a suitable measure of disper-
sion. However, for a measure of dispersion one can use the mean absolute devia-
tion (referred to hereafter as MAD).
Simply, the three states can be defined by:
X,=up (denoted by v= 1) if the observed x,>x++k(MAD),
X,=no change (denoted by v=2) if the observed Xt is Xt-k(MAD)<xtt+
k(MAD),
X,= down (denoted by v=3) if the observed x,<-t-k((MAD),
where t is the observed mean, MAD is given by t=, fxt-ittj/T, and k is an ap-
propriate constant.
If k is chosen to make the three states approximately equiprobable (and thus ob-
tain maximum entropy), we find, upon ex post facto examination of the sample
data, that k should be taken equal to 0.5. Clearly, one can obtain a larger set of
states in a manner similar to that given above, and other appropriate methods of
choosing k can also be used. This method enables us to consider both magnitude
and direction of change at the same time. Accordingly, it provides more flexibility
than the simpler models employed in the past. If, for example, a stock-market fol-
lower wishes to study more than three types of price change, this method permits
him to define as many types of change as desired. Moreover, selecting different
values of k permits performance standards to be altered appreciably. Thus, if a
researcher is interested in studying only very large changes in stock prices, the value
of k can be increased so that only large changes (both positive and negative) can be
studied. Correspondingly, if one wishes to study only minor price fluctuations, the
value of k can be reduced.
Vector and Individual-Process Markov Chains
Once the states are defined, an empirical representation for the vector process
and each individual process can be considered by the formation of a series of mat-
rices of transition observations. Tests for stationarity and independence are im-
mediately applicable, as well as a test for homogeneity in the case of the vector
process.
Before considering the empirical representations of the vector and individual
processes, some comments are in order regarding the meaning of the terms homoge-
neous, stationary, and independent as used in this paper, in contrast to the conven-
tional meaning of these words. (The authors are grateful to M. F. M. Osborne for
this clarification.)
Define p-dependent or p-independent, where p is short for 'in the probability
sense.' The term p-dependent, or p-independent, is a relation between at least two
attributes a and b (which may or may not be described by numerical variables of a
population). These attributes can be defined ad libitum, and increased or de-
creased in number as occasion demands or ingenuity can provide. Examples are
price, change in price, time t or era c, stock label s, time difference (any interval),
time separation of time intervals (one unit for a simple Markov process), etc. The
objective is to try to pick variables (attributes or 'coordinates') to describe a popula-

tion that are as p-independent as possible.
The choices can be tested (by chi-square, regression, or correlation) to see if
they are in fact p-independent or not. p-independence is usually (it does not have
to be) tested two variables at a time, but even this two-at-a-time kind of testing is
not unique. One still has to specify which and whether the remaining variables are
fixed, or projected (summed over). This is true whether one is using chi-square, or
correlation coefficients, of which there are many kinds when one has more than two
variables. Note that for three variables one can have p-independence of any two
taken two at a time, and yet not for all three (FELLER, [9] p. 127). With four vari-
ables, it is still more complicated.
For most (not all, as was discussed earlier) of the s and Pt, p-dependence has
been eliminated by (a) using Aln Pz, and (b) replacing Aln P, by the three states
defined above. This reduces the problem to four variables: i, j, t (or era c), and s.
Alternatively, this can be considered as three variables if i and j are lumped into a
single nine-valued variable. The question now is: What pairs and under what
conditions (which of the remaining ones fixed or summed) are p-independent? (See
KENDALL AND STUART1141, vol. II, p. 582.)
As will become apparent shortly, the particular definition of homogeneous used
in this paper is p-independence of s and c, for both i and j held fixed. This is a
reasonable choice, since we are interested in Markov processes. However, the
reader should note that this pair (s, c) can be tested for p-independence with exactly
the same data in ways other than the method given here.
The particular definition of stationarity is p-independence of t and j, with i fixed
and s summed over. The same remarks given above apply. Note that one of the
remaining variables is summed over here, whereas in the previous case they are both
held fixed.
The 'independence,' or order-of-the-chain test, is a test of p-independence of
i and j, with s and t summed over.
The need for this explanation regarding the specialized nature of the terms
homogeneous, stationary, and independent as used in this paper should become
apparent shortly. With this clarification, we can now proceed with the discussion
of the formation of transition matrices.
For the vector-process Markov chain, let M (t) denote the empirical transition
matrix for the process { Xt, t = 1, 2, *- , T }, where t -1 and t correspond to a specific
first-order conditional relationship in the total time interval [0, T]. The objective
is to summarize, in a series of transition matrices, the performance of all stocks for
each particular first-order relation in [0, T]. To form M (t), for each stock S the
observed value xs(t1,) of the random variable X,(t1), is noted for i= 1, 2, , V,
as is the observed value xt of X8 for j= 1, 2, * * *, V. These values are then classi-
fied in the appropriate cell of the transition matrix, depending on the position (row)
that x,(t1-) occupied, and the value that xst takes. The same procedure is repeated
for each s =1, 2, . . ., S in the sample, until all S stocks are exhausted and the
frequency count of stocks performing according to the definition of the transitions
to the various states is recorded in the appropriate cell of the matrix. Anderson
and Goodman"13 then show that, for each cell in the matrix, the transition probabili-
ties can be calculated from the recorded transition frequencies. This same proce-
dure is repeated for the first-order relation (t, t + 1 ) and

tion matrices is formed, with the number of transition matrices corresponding to the
number of subintervals of T being investigated, i.e., (t-1, t), (t, t?1), (t?l,
t+2), * . ..
For the individual Markov process let M8(t) denote the empirical transition
matrix for the process {X8t, t = 1, 2, * *, T}, where t- 1 and t again correspond to
some first-order differencing interval in the total time period [0, T]. For each s,
the first-order conditional changes in the natural logarithms of stock prices may be
classified into a series of transition matrices by a relatively simple process. First,
divide the total time interval [0, T] into C equal subintervals. Then, count, as
above, over each c = 1, 2, *, C subinterval in [0, T], the appropriate conditional
changes [X~t= x.t=jlX,(t-)=x(t-)=i], where s is fixed, t=1, 2, *, and i,j=
1, 2, * * *, V. Thus for each subinterval c = 1, 2, * *, C, the transition frequencies
are assigned to the appropriate cells in the matrices and transition probabilities are
computed.
Test and Homogeneity for the Vector Process
If the vector Markov process is homogeneous, then I Xt, t = 1, 2, * -, T )

to an individual process, and {Xt, t=1, 2, .*, T}, s=1, 2, , S., can be con-
sidered as Markov chains with the same parameter values of the transition probabili-
ties. If {Xt} is not homogeneous, then {Xst} must be studied separately as in-
dividual processes for each s = 1, 2, * * *, S in order to make specific statements about
changes in the natural logarithms of prices for the S different stocks.
For simplicity, in some past empirical work done with Markov chains, researchers
have investigated collective processes, implicitly assuming the homogeneity of the
vector process (see, for example, Niederhoffer and Osborne 21). But when con-
sidering Markovian analysis in regard to the behavior of daily and weekly stock-
market prices, one might suspect in the light of diversity of stocks and stock-price
behavior that this homogeneity assumption may not be taken for granted in any
consideration of the collective movements involved in the vector process {Xt}.
This important point will be discussed further in the implications and conclusions
section of the paper, after the empirical results are presented. (The argument
against homogeneity has also been advanced in other applications of Markov theory
to practical problems, for instance, consumer behavior models in marketing. See,
for example, MORRISON[20]*)
To determine whether or not the vector Markov process { Xt, t = 1, 2, **, T)
is homogeneous, a simple test can be devised using some of the methods given in
CHAKRAVARTI, et. al. t4l The total time interval is divided into C equal subintervals
and for each fixed i, j a frequency matrix with elements f8, is formed, where fsc equals
the number of transitions of stock s from state i to state j during the cth time inter
val for s= 1, 2, *, S and c= 1, 2, , C. Then we compute the statistic:
ZEstates observedvd -fealculated /fcalculated]
= E8,C [f8c- (2Ecf8c '8f8c)/ (Z8,Cf8c)] [(Z8,f8c)/ (f f8 * Ecf8c)].

Under the hypothesis of homogeneity, each statistic U0j has an asymptotic
square distribution with (C-1 ) (S-1 ) degrees of freedom.
Test for Stationarity of the Process
For testing the hypothesis of stationarity in a first-order Markov chain, the null
hypothesis is Ho: pij(t)=pij for all i, j=1, 2, * *, V; t=1, 2, * , T. The chi-
square test of stationarity in contingency tables consists of calculating for each
row i of the transition matrix the sum
u, = Estates [(fobserved-fcalculated )2/fcalculated]
= ZEt'j ( fj(1Efj(1 ji 0
= Et j~ ~-[tfti~~~~~~t)/j~~
E (tfj /fij tfi]j fij (t(t)][jfjt)
)] 2/ (2)
I{[tfii(ol/j Etftij(t)[Eiftij(0)]
where fj (t) denotes the observed number of transitions from state i at time t- 1
to state j at time t.
The assumption is made that E jfij (t) are nonrandom for ij= 1, 2, ,V;
t= 1, 2, ..., T. Under the null hypothesis, each Ui2 has an asymptotic chi-square
distribution with (V-1 ) (T-1 ) degrees of freedom. Also, Uj2, for i= 1, 2, V,
are asymptotically independent, so that the sum
U2= 3 i A U2 (3)
has an asymptotic chi-square distribution with V (V-1 ) (T-1 ) degrees of freedom.
In the empirical analysis that follows, the stationarity test is applied using equa-
tions (2) and (3) first to the collective or vector process, where the transition
matrices reflect aggregated transitions across all securities, and then to each of the
individual processes, where the transition frequencies are unique to each security.
Test for the Order of the Chain
For testing the null hypothesis that the Markov process is independent in time
against the alternative hypothesis that it is dependent, i.e., first-order, the following
statistic is computed:
U2 = Zstates [ (fobserved -fcalculated )2/fcalculated]
= ij ({Ztfij(t)-[Zj Etfti(t)EZ Etfti(t)]/

[Et Ej Etfti(t)]121 (4)
[Ej )7tfti(t),t 'Etftij(t)][Ei Efj Etf
The statistic U2 has an asymptotic chi-square distribution with (V- 1)2 degrees of
freedom.
In the empirical analysis the order test is applied first to the collective or vector
process, and then to the individual processes.
2. THE EMPIRICAL EXAMINATION
THE DATA USED in this study consist of the daily high and closing prices f
200 stocks traded on the New York Stock Exchange for the period December 23,
1963, through November 29, 1968. The only restriction made in selecting the stocks
is that price data must have been available for the entire period covered, i.e., the
company must have been in existence since December 23, 1963, and price quota-
tions for the stock must have been available since then.
The sample studied here (which represents 16.3 percent of the total number of
stocks listed on the New York Stock Exchange in 1964) appears to be very repre-
sentative of the performance of the total number of securities listed on the New
York Stock Exchange. For example, FISHER AND LORIE[11] find that an equal
dollar investment in all the stocks listed on the New York Stock Exchange from
12/63 through 12/65 yields an annual compound rate of return of 23.4 percent.
Computation of a similar rate of return for the same period for the stocks used in
this study yields an annual compound rate of return of 24.5 percent. The two
numbers are very close, especially since the 23.4 percent figure is net of buying com-
mission charges, while the 24.5 percent figure is gross of buying and selling com-
missions.
In addition, FRIEND, BLUME, AND CROCKETT[12] find an equal dollar investment
in all the stocks listed on the New York Stock Exchange for the period April, 1964,
through June, 1968, produces an annual rate of return of 17.8 percent. An equal
dollar investment in all 200 stocks examined in this paper for the same period pro-
duces an annual rate of return of 19.9 percent. Once again, the numbers are very
close, especially since the 17.8 percent figure appears to be net of buying and selling
commissions, while the 19.9 percent figure is gross of commissions.
The data are adjusted for the usual bases-splits, stock dividends, and cash
dividends. The daily closing prices and the closing prices on Mondays (for weekly
comparisons) are used for the two fixed-time models for time lags of one and five
days, respectively. Similarly, daily high prices and high prices on Mondays are
used for variable-time models for time lags of one and five days. The choice of
Monday prices for studying the behavior of the weekly time lag is arbitrary, but is
prompted in part by our belief that weekly openings (Mondays) reflect the dy-
namics of weekly stock-price movements as well as any other day.
Three states are considered for both the fixed- and variable-time models and for
both the time lags, where k, the dispersion parameter associated with MAD, is taken
to be 0.5. With these definitions of the states, the empirical process is completely
described, appropriate transition matrices are obtained, and statistical tests may
be performed.
Vector Process
A total of 1289 daily changes in the natural logarithms of prices is contained on

the data file for each stock. These daily changes are divided into 8 subgroups in
time, each consisting of 161 observations. The last observation is omitted. Thus,
referring to the notation used earlier, we obtain C = 8, S = 200, V = 3. Each U0
(i, j= 1, 2, 3) has large degrees of freedom, i.e., 1, 393, enabling us to use the normal
approximation to the chi-square distribution. Table I presents the U2 and asso-
ciated z values and the statistical decision, significant or not significant, reached
both for the daily closing and daily high prices.
The high incidence of significant observations in Table I suggests that the hy-
The Behavior of Stock-Price Relatives 1191
pothesis of homogeneity cannot be accepted. Interestingly, one may note that, for
the entire stock market, the probabilities of remaining in the same state from day to
day, or for experiencing a large gain or loss, seem to vary from stock to stock causing
the nonhomogeneity. The probabilities for a relatively small upward or downward
shift remain the same for all the stocks.
In the same way as developed above, tests for homogeneity of the vector process
are made for the five-day (weekly) time lag. In this case the number of weekly
price changes is 257, divided into 8 subgroups in time, each consisting of 32 observa-
tions. As before, the last price change is omitted. Table II shows that the weekly
TABLE I
TESTS OF HOMOGENEITY IN VECTOR-PROCESS MARK OV-CHAIN MODELS
(Changes in the natural logarithms of daily closing arnd high prices.(a))
Daily closing Daily high
(i, j) U2 z value(6) Decision(b) U2 z value(c) Decision(')
1, 1 2350.24 15.79 Sig. (***) 2872.82 23.03 Sig. (***)

1, 2 1041.96 -7.12 Not sig. 1126.25 -5.31 Not sig.
1, 3 1677.36 5.15 Sig. (***) 1789.22 7.05 Sig. (***)
2, 1 1027.86 -7.43 Not sig. 1107.32 -5.71 Not sig.

2, 2 5195.88 49.17 Sig. (***) 5686.04 53.87 Sig. (***)
2, 3 998.60 -8.08 Not sig. 1108.74 -5.68 Not sig.
3, 1 1727.54 6.01 Sig. (***) 1973.18 10.05 Sig. (***)

3, 2 1021.52 -7.57 Not sig. 1112.50 -5.60 Not sig.
3, 3 2485.12 17.73 Sig. (***) 2589.12 19.19 Sig. (***)
(a) The test procedure used is that of equation (1).

(b) Significance probabilities are indicated as follows: *=0.05 to 0.01; **=0.01 to 0.0
***=less than 0.001.
(c) Since the chi-square distribution is asymptotically normal for more than 30 degre
freedom, the normal distribution may be used. In this case the degrees of freedom are 1393,
i.e., (8-1) (200-1). Therefore, in addition to the U2 value, the z value from the normal distribu-
tion is calculated by the formula z=-\/2U2--\/2d-1, where U2 is the chi-square value, an
d is the degrees of freedom. The magnitudes of the U2 values and associated z values for the
significant cases in the table are such that the significance probabilities are very small, as indi-
cated in footnote (b).
vector process cannot be assumed to be homogeneous. The situation here is even

more engaging than given in Table I in the sense that the stocks have different
transition probabilities only for the cases in which they repeat the most recent dir ec-
tion and magnitude of weekly price movements. Correspondingly, the stocks seem-
ingly exhibit identical transition probabilities for the cases where direction and mag-
nitude of price movements are not repetitive.
For the three-state process, the results in Tables I and II suggest that individual
stocks do not have identical probabilities for holding price levels, or for making sub-
stantial price movements. Moreover, each stock seems to have the same probabili-
ties for modest upward or downward movement, indicating at least some con-
formity of price behavior.
Because of heterogeneity, as indicated in the previous section, the vector-process
Markov chain should not be used to analyze the daily and weekly price movements
of securities. If one assumes that the vector process is homogeneous, tests for sta-
tionarity and dependence are possible. Obviously, such exercises are meaningless
if the vector process is heterogeneous, as is the case for the daily and weekly vector
processes described here. However, to provide complete analysis of the vector
process and to provide some important information that will be referred to in the
conclusion section of this paper, Table III shows the results of tests for stationarity
and dependence; it shows that in all cases the vector process could be described by a
nonstationary first- or higher-order Markov chain if homogeneity is assumed. The
TABLE II
TE-STS OF HOMOGENEITY IN VEiCTOR-PROCE1'SS MARKOV-CHAIN MODELS
[Changes in the natural logarithms of weekly (Monday) closing and high prices.(a)]
Weekly (Monday) closing Weekly (Monday) high
(, ) U2 z value(c) Decision(b) U2 z value(c) Decision(b)
1, 1 1504.26 2.08 Sig. (*) 1593.30 3.68 Sig. (***

1, 2 980.36 -8.49 Not sig. 903.98 -10.25 Not sig.
1, 3 1034.67 -7.28 Not sig. 996.81 -8.12 Not sig.
2, 1 919.78 -9.88 Not sig. 921.06 -9.85 Not sig.

2, 2 2268.01 14.58 Sig. (***) 2357.78 15.90 Sig. (***)
2, 3 949.17 -9.20 Not sig. 927.08 -9.71 Not sig.
3, 1 972.85 -8.66 Not sig. 1009.80 -7.83 Not sig.

3, 2 968.00 -8.77 Not sig. 1021.52 -7.57 Not sig.
3, 3 1728.72 6.03 Sig. (***) 1688.97 5.35 Sig. (***)
(a) The test procedure used is that of equation (1).

(b) Significance probabilities are indicated as follows: *=0.05 to 0.01; **=0.01 to 0.0
***=less than 0.001.
(c) Since the chi-square distribution is asymptotically normal for more than 30 degrees of
freedom, the normal distribution may be used. In this case the degrees of freedom are 1393,
i.e., (8-1) (200-1). Therefore, in addition to the U2 value, the z value from the normal dis-
tribution is calculated by the formula z=\/2U2--\/2d-1, where U2 is the chi-squar
and d is the degrees of freedom. The magnitude of the U2 values and associated z values for
the significant cases in the table (except for the weekly closing 1, 1 value) are such that the
significance probabilities are very small, as indicated in footnote (b).
magnitude of the U2 values in the tests for order indicate strong first-order de-
pendency relations. Also, the z values in the stationarity tests show that a large
amount of nonstationarity is present.
Individual Process
The results of stationarity and independence tests for the individual-process

Markov-chain model, shown in Table IV, indicate little difference in the outcome of
tests of fixed- and variable-time individual-process Markov-chain models. How-
ever, considerable difference exists between the results for daily and weekly price
changes.
Specifically, the findings show that the stock market has a short-term memory
in the sense of being dependent on immediately preceding daily price changes.
However Table IV shows further that the dependency in daily stock-price changes
does not carry over to weekly changes. When the lag is increased from one to five
days by taking Monday closing- and high-price changes, the process becomes inde-
pendent in time.
TABLE III
TESTS OF STATIONARITY AND ORDER IN V1EcTOR-PROCE'SS MARKOV-CHAIN MODELS(a)

PART I: Changes in the natural logarithms of daily and weekly closing prices
Stationarity tests Order test(d)
Lag U2 z value(c) Decision(b U2 Decision(b)

(in dayz)
1 51,845.22 197.64 Nonstationary (***) 1,336.75 1st or higher order (***)

5 9,625.78 83.33 Nonstationary ***) 214.31 lst or higher order(***)
PART II: Changes in the natural logarithms of daily and weekly high prices
Stationarity tests Order test(d)
Lag U2 ? Decision(b) 2 Decision(b)

(in days) (at 5% level) (at 5% level)
1 28,593.97 183.72 Nonstationary (***) 2,717.69 1st or higher order (***)

5 9,770.62 84.37 Nonstationary (***) 210.85 lst or higher order(***)
(a) The test procedures used involve equations (2) and (3) for the stationarity test, and
equation (4) for the order test. Since the vector-process model is being investigated, the
transition matrices are comprised of aggregated transitions over all securities and are defined
in accordance with the discussion in Section 1, subheading Vector and Individual-Process
Markov Chains.
(b) Significance probabilities are as follows: *-0.05 to 0.01; **=0.01 to 0.001; ***=less
than 0.001.
(c) Since the chi-square distribution is asymptotically normal for more than 30 degrees of
freedom, the normal distribution may be used. In this case the degrees of freedom are 7734
for the daily lag, i.e., (3) (3-1) (1289-1), and 1536 for the weekly lag, i.e., (3) (3-1) (257-1).
Therefore, in addition to the U2 value, the z value from the normal distribution is calculated
by the formula z V2U2-V/2d-1, where U2 is the chi-square value, and d is the degrees of
freedom. The magnitudes of the U2 values and the associated z values for the outcomes in the
table are such that the significance probabilities are very small, as indicated in footnote (b).
(d) Degrees of freedom: (V-1)'= (3-1)2 = 4.
3. IMPLICATIONS, CONCLUSIONS, AND COMPARISONS WITH PREVIOUS RESULTS
Vector Process
Because of the heterogeneity of the individual processes comprising the daily

and weekly vector processes, a three-state (up, down, no change) vector Markov
chain should not be used to describe the dynamics of daily or weekly price behavior
on the New York Stock Exchange. The empirical results reported here have shown
that this conclusion holds whether time lags of one or five days are considered, and
holds whether closing or high prices are considered.
TABLE IV
TESTS OF ORDER AND STATIONARITY IN INDIVIDUAL-PROCESS
MARKOV-CHAIN MoDELs(')
PART I: Fixed-time individual-process Markov-chain Models
(Daily and weekly closing-price changes)(b)
Lag Proportion of Proportion of Proportion of processes

(in days) processes first or processes stationary and first
higher order stationary or higher order
1 0.710 0.415 0.270

5 0.140 0.880 0.120
PART II: Variable-time individual-process Markov-chain models

(Daily and weekly high-price changes)(b)
Lag Proportion of Proportion of Proportion of processes

(in days) processes
higherfirst or processes
order stationarystationary
or higherand first
order
1 0.875 0.345 0.275

5 0.150 0.900 0.115
(a) The test procedures used involve equations (2) and (3) for the stationarity
tests, and equation (4) for the order test. Since the individual-process model is being
investigated, the transition matrices are unique to each security, and are defined in
accordance with the discussion in Section 1, subheading Vector and Individual-Process
Markov Chains.
(b) The results reported in this table reflect tests of significance at the 0.05 level.
Since it is not practical to report the results of all the individual tests (1600 at each
significance level), only a summary of the results is presented in this table. The
phrase "proportion of processes . . ." means fraction of the 200 stocks.
Table V shows that all the significant z values in the homogeneity test of daily
vector-process models discussed earlier in Table I lie along the diagonals. One pos-
sible explanation for this occurrence is that different companies are affected at differ-
ent times by new information that could produce significant differences in the runs
and in the large reversal patterns among daily stock prices (large meaning a change
to a nonadjacent state). For example, some companies might experience price runs
as a result of favorable (unfavorable) earnings reports, dividend policies, and in-
dustry news, while at the same time other companies would not be similarly affected
by this information and their daily price-change behavior would then be different.
On the other hand, some companies may experience large reversal patterns because
TABLE V
SUMMARY OF Z VALUES IN HOMOGENEITY TEST OF DAILY VECTOR-PROCESS
MARKOV-CHAIN MODELS
i
i 1 2 3
1 Sig. Not sig. Sig.

2 Not sig. Sig. Not sig.
3 Sig. Not sig. Sig.
of the uncertainty relative to new information, while at the same time other com-
panies would not be similarly affected. Moreover, because new information be-
comes available at various times, heterogeneous behavior among stocks is further
compounded. While the price behavior of some groups might be affected by today's
news, tomorrow's news could conceivably affect a different group of stocks.
The results of the homogeneity tests given in this paper are consistent with the
analysis of market and industry forces affecting stock-price changes made by
KING.1151 Also, it should be noted that Famal8l offers an explanation similar to the
heterogeneity reasoning given above. His argument is based on the initial over-
and under-adjustment of prices to new information.
Similar findings are obtained when the results of the homogeneity test in vector
Markov chains defined from weekly closing- and high-price relatives are considered.
However, in these cases, the significant z values lie only along the main diagonal, as
shown in Table VI.
The same general explanation as given above is applicable here, except that no
question of divergent patterns exists for large reversals. Evidently, the larger
TABLE VI
SUMMARY OF Z VALUES IN HOMOGENEITY TEST OF WEEKLY VECTOR-PROCESS
MARKOV-CHAIN MODELS
i 1 2 3
1 Sig. Not sig. Not sig.

2 Not sig. Sig. Not sig.
3 Not sig. Not sig. Sig.
differencing interval of one week has a tendency to eliminate divergent, large re-
versal patterns but does not eliminate tendencies for runs.
Two slightly different explanations of the results in Tables V and VI have been
suggested by M. F. M. Osborne in a private communication. Imagine that one is
looking at semilog price charts of two securities, one a public utility stock, and the
other a 'science and electronics' stock. The former will have an excess (relative to
the latter) of small changes followed by small changes, the center cell, and the latter
an excess of large changes followed by large changes of the same or opposite sign.
These are the corner cells. Table V shows the details of how stocks are different;
they are different in their 'volatility.' Table VI adds details to the distinction on a
weekly basis; the distinction of big jumps is limited to successive big jumps of the
same sign.
It could also be that the differences and similarities shown in Tables V and VI
are attributable to the differences in the behavior of the specialist and/or the volume
of trading in two 'different' securities. This trading (small available volume) tends
to make for more big jumps; the same result (big jumps) can also occur if a specialist
is not willing to commit much capital in his attempts to smooth the market fluctua-
tions of a security, or if he quotes the widest allowed spreads.
One interesting phenomenon exists in interpreting the results suggested by
Tables I, II, V, and VI that the reader may wish to consider. The behavior of the
significance probabilities, which are with few exceptions less than 0.00001 or greater
than 0.99999, is rather peculiar. Evidently, the data are trying to suggest some-
thing that is not being asked of them. The implication of these results should be
obvious, but is not.
Conventional wisdom suggests that probabilities close to one mean the sampling
is not independent. To illustrate, suppose price changes are 99 percent determined
by the market factor and only 1 percent is due to factors peculiar to a given stock.
This will certainly drive some significance probabilities close to one if the 200 stocks
are considered as 200 independent variables, or 199 degrees of freedom.
But what about the probabilities close to zero? What may be occurring is that
when one finds a significant (small) probability, it is driven very small by the same
effect that causes large probabilities, i.e., dependent samples. Thus, these two
phenomena (probabilities very close to one or very close to zero) may have a com-
mon origin.
For the vector process Niederhoffer and Osborne[21M have shown that dependency
exists for much shorter time periods than those studied in this paper, i.e., between
transactions. On the basis of six stocks in a 22-day period in October, 1964,
Niederhoffer and Osborne 'predict' certain properties of the transition matrix be-
tween transactions (the ratio of continuations to reversals) for randomly chosen
single days in January for all stock transactions, for seven consecutive years. They
find reasonable agreement of predicted and observed values.
The Niederhoffer and Osborne dependency results for the transactions-interval
vector Markov process are consistent with the results shown in this paper for the
one- and five-day-interval vector Markov processes, provided homogeneity is as-
sumed (see Table III). However, the study by Niederhoffer and Osborne does not
consider the homogeneity problem examined in this paper. Further, Niederhoffer
and Osborne do not directly consider whether or not the transition probabilities from
transaction to transaction are stationary.
The results reported here indicate that, on the basis of daily and weekly data,
security price changes in the vector process are heterogeneous. Thus, as mentioned
earlier, considerations of stationarity and dependence are vaccous in the vector
model (defined from daily and weekly data) in the presence of heterogeneity.
But Niederhoffer and Osborne have investigated transactions data. Further,
they have consistently predicted the ratio of continuations to reversals for all stock
transactions. The implication is that the process they studied is stationary. How-
ever, we cannot determine whether or not the Niederhoffer and Osborne vector
process is homogeneous.
The question regarding homogeneity can be stated as follows: Is the underlying
process describing transaction price changes the same for all securities, or is the
underlying process describing each security's transaction movements unique to
that security? Our results for daily and weekly price movements show that the
underlying daily and weekly processes are different among securities. But the
transaction processes may well be the same among securities. For example, it is
quite possible that, because of the activities of the specialist, the processes describing
security transactions are identical across securities. If the transaction processes
are identical for all stocks, the Niederhoffer and Osborne results can be used to pre-
dict continuation-reversal ratios for securities. However, if the processes are in
fact different, then Niederhoffer and Osborne have investigated some type of 'aver-
age' process composed of an aggregation of different processes. But Markovian
theory, at least to our knowledge, is not applicable to 'mixtures' of different, un-

known processes.
Investigations of the vector process for shorter time lags by Niederhoffer and
Osborne have suggested that significant dependence exists between certain transac-
tion movements. The analysis in this paper is an intermediate step as far as time
lags are concerned in the investigation of Markovian dependency in security price
movements. We have studied daily and weekly price-change patterns, as opposed
to shorter transaction-time intervals, and as opposed to longer monthly or yearly
time intervals. We have shown that, for the vector process, the daily and weekly
price-change structures are not consistent with the Niederhoffer and Osborne trans-
action matrix simply extrapolated to the number of transactions in one day or in one
week. The transition is not homogeneous and not stationary for a daily or weekly
process. We have answered (empirically) some of the questions raised at the end of
the Niederhoffer and Osborne paper. The theoretical behavior of a Markov process
is known; i.e., the effect of the initial state (Aln P,) is eliminated after relatively few
transactions (see Feller 91, p. 384). Thus, to account for the dependencies shown in
Table III, something else is occurring for daily or weekly intervals that is not con-
tained in the Markov representation of price changes between transactions. Days
or weeks are long term relative to individual transactions. Therefore, relative to
transaction intervals, we have shown that prices have a 'long-term' structure differ-
ent from the transaction structure.
Individual Process
In investigating the dynamics of the stock market in terms of individual proc-

esses, very little difference is found in the outcome of tests of fixed- and variable-
time models. However, considerable difference exists between the results for daily
and weekly price changes. The findings show that the stock market may be said to
have a short-term memory in the sense that price behavior is dependent on immedi-
ately preceding daily price changes. But, at the same time, this dependency has
nonstationary transition probabilities. Thus, not even the steady-state transition
matrix or characteristic vector can be estimated.
The dependence in daily stock price changes does not carry over to weekly
changes, and thus the question of predicting future (weekly) behavior does not
arise.
Nonstationarity
The nonstationary behavior of the Markov chains in describing both the vector
and individual processes defined from daily closing and high price changes is note-
worthy in that any dependence found is constantly changing in time. Indeed, the
nonstationary condition may account for the fact that to date efforts to formulate
models to predict stock-price movements on the basis of past daily and weekly price
data alone have generally been unsuccessful.
Thus far in the development of the mathematical theory of Markov chains, little
is known regarding the empirical analysis of nonstationary models (those with non-
stationary transition probabilities). This class of chains is so general that in most
cases they are of little predictive value. Even the two-state chain is extremely
complicated to analyze, and widely different types of behavior are possible, depend-
ing on the nature of the transition probabilities. Thus, finding some specific man-
ner in which the transition probabilities change is necessary before a detailed study
becomes possible. However, the possibility exists that the Markov formulation of
the individual process model developed here can be used for predictive purposes if
the nonstationarity present in the transition probabilities can be identified and cor-
rected. Efforts along this line, say, for example, by regression analysis, seem to be
fruitful areas for further research.
For time lags of one and five days, the results presented in this paper indicate
that meaningful statistical dependence of security price changes is hard to identify
in vector- and individual-process Markov-chain models. In the context of the
analysis employed here, meaningful statistical dependence connotes stationary de-
pendence in the case of the individual-process model, and stationary and homogene-
ous dependence in the case of the vector-process model. As has been discussed, un-
less a process is stationary, meaningful predictions of future price movements are
not possible even if significant dependence appears to exist.
We conclude with a consideration of the predictive capabilities of a Markov-
process representation of changes in price (or In Pa) when the condition of stationar-
ity (and homogeneity in the vector process) is satisfied. In a stationary Markov
process, tomorrow's expected price change given today's price change can be esti-
mated. However, not much about expected price changes more than one or two
steps away from a starting point can be suggested. After several steps, the memory
of the starting point is lost (Feller, [9] p. 384). All that remains is the steady-state
transition matrix and the characteristic vector, which give the probability of being
in a particular state independent of the starting state. Thus, the predicted price
change (expected value of Aln Pa) n steps away is a constant. This constant could
be zero, depending on the definition of the states, if n is appreciably greater than the
order of the process.
As discussed earlier, in this paper the expected Aln Pt is precisely the slope of the
line (or in the vector process the mean slope of lines of different stocks) from the
initial log price to the final log price of the data used to calculate the transition
matrix of log price changes. But it is exactly this slope (the .t value defined earlier)
that is accounted for by the definition of the Markov matrix given above. There-
fore, the predicted price change n steps away given by the Markovian model used
here (assuming stationarity and homogeneity) is E(Aln Pt)=Aln P=0, i.e., a
random walk of zero expected advance (relative to at).
ACKNOWLEDGMENTS
THE DATA USED in this paper were provided through the courtesy of ARNOLD
AMSTUTZ of M.I.T. and STEVE TAYLOR of Decision Technology, Inc. Also, the
Computer Center at Kent State University provided invaluable computational and
programming assistance. The authors wish to express special appreciation to
M. F. M. OSBORNE and to an unidentified referee for numerous helpful comments.
Finally, A. PARR of the University of Oklahoma contributed greatly to the improve-
ment of the manuscript.
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with Application to Group Dynamics," Ph.D. Dissertation, Michigan State University,
1962.
4. I. M. CHAKRAVARTI et al., Handbook of Methods of Applied Statistics, vols. I and II,
Wiley, New York, 1967.
5. PAUL H. COOTNER (ed.), The Random Character of Stock Market Prices, The M.I.T.
Press, Cambridge, Massachusetts, 1964.
6. M. DRYDEN, "Share Price Movements: A Markovian Approach," J. of Finance, 24,
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The Behavior of Stock-Price Relatives-A Markovian Analysis

Author(s): Bruce D. Fielitz and T. N. Bhargava

Georgia State University, Atlanta, Georgia

Kent State University, Kent, Ohio

(Received June 7, 1972)

This paper presents a method of Markovian analysis of changes in the natural

N UMEROUS empirical studies have appeared in recent years concerning the

1. THE MARKOVIAN MODEL

States of the Process

bility distribution of X,. In such cases X, is typically ch

Vector and Individual-Process Markov Chains

objective is to try to pick variables (attributes or 'coordinates') to describe a popula-

dure is repeated for the first-order relation (t, t + 1 ) and

Test and Homogeneity for the Vector Process

If the vector Markov process is homogeneous, then I Xt, t = 1, 2, * -, T )

ZEstates observedvd -fealculated /fcalculated]

= E8,C [f8c- (2Ecf8c '8f8c)/ (Z8,Cf8c)] [(Z8,f8c)/ (f f8 * Ecf8c)].

Test for Stationarity of the Process

u, = Estates [(fobserved-fcalculated )2/fcalculated]

Test for the Order of the Chain

U2 = Zstates [ (fobserved -fcalculated )2/fcalculated]

= ij ({Ztfij(t)-[Zj Etfti(t)EZ Etfti(t)]/

2. THE EMPIRICAL EXAMINATION

A total of 1289 daily changes in the natural logarithms of prices is contained on

Daily closing Daily high

(i, j) U2 z value(6) Decision(b) U2 z value(c) Decision(')

1, 1 2350.24 15.79 Sig. (***) 2872.82 23.03 Sig. (***)

2, 1 1027.86 -7.43 Not sig. 1107.32 -5.71 Not sig.

3, 1 1727.54 6.01 Sig. (***) 1973.18 10.05 Sig. (***)

(a) The test procedure used is that of equation (1).

vector process cannot be assumed to be homogeneous. The situation here is even

Weekly (Monday) closing Weekly (Monday) high

(, ) U2 z value(c) Decision(b) U2 z value(c) Decision(b)

1, 1 1504.26 2.08 Sig. (*) 1593.30 3.68 Sig. (***

2, 1 919.78 -9.88 Not sig. 921.06 -9.85 Not sig.

3, 1 972.85 -8.66 Not sig. 1009.80 -7.83 Not sig.

(a) The test procedure used is that of equation (1).

The results of stationarity and independence tests for the individual-process

TESTS OF STATIONARITY AND ORDER IN V1EcTOR-PROCE'SS MARKOV-CHAIN MODELS(a)

Stationarity tests Order test(d)

Lag U2 z value(c) Decision(b U2 Decision(b)

1 51,845.22 197.64 Nonstationary (***) 1,336.75 1st or higher order (***)

Stationarity tests Order test(d)

Lag U2 ? Decision(b) 2 Decision(b)

1 28,593.97 183.72 Nonstationary (***) 2,717.69 1st or higher order (***)

3. IMPLICATIONS, CONCLUSIONS, AND COMPARISONS WITH PREVIOUS RESULTS

Because of the heterogeneity of the individual processes comprising the daily

Lag Proportion of Proportion of Proportion of processes

1 0.710 0.415 0.270

PART II: Variable-time individual-process Markov-chain models

Lag Proportion of Proportion of Proportion of processes

1 0.875 0.345 0.275

1 Sig. Not sig. Sig.

1 Sig. Not sig. Not sig.

theory, at least to our knowledge, is not applicable to 'mixtures' of different, un-

In investigating the dynamics of the stock market in terms of individual proc-

1. T. W. ANDERSON AND L. A. GOODMAN, "Statistical Inference about Markov Chains,"

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1, 1 2350.24 15.79 Sig. () 2872.82 23.03 Sig. ()

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