Timing the Stock Market

Richard E. Neapolitan
Professor and Chair of Computer Science
Northeastern Illinois University

Slides available at:

http://www.neiu.edu/~reneapol/renpag1.htm
 Stock Market Review

• Corporations sell shares of the company

to the public.
• These shares are called the stock in
company.
• Each share of stock represents one vote
on matters of corporate governance.
Stocks are traded on a stock exchange such
as the NYSE.
Stocks go up and down in value throughout
the day, week, month, etc.
Why Do Stock Values Change?

• Growth prospects of the company change.

• Macro-economic variables change.
– Inflation
– Jobs (Non-farm payroll)
• Momentum?
 Stock Indices
• A stockmarket index is an indicator that
keeps track of the performance of some
subset of stocks.
• Dow Jones Industrial Average
– 30 blue chip companies
– Currently around 12000
• S&P 500
– 500 large U.S. companies
– Currently around 1400
Like stocks, indices go up and down.
 Common maxim:
• Own stocks (Dow) if you have a long-term
time horizon.
• The stock market has averaged 10%
yearly over the past 100 years.
• So if you own stocks, in the long run you
will average 10% on your investment.
• Instead of the 5% or so a CD or the bank
will pay.
Dow over past 107 years:
What will market do in next 20 years?
• Harvard Economist John Chapman noted
the following:
• Price/Earnings (PE) Ratios are way out of
wack compared to historical norms.
• Previously PE ratios have always returned
to norms by prices going down.
Invest in Dow now:
None of this matters if we can ‘time’
the stock market.

• Buy low
• Sell high
During the 1990’s exuberant day
traders made big bucks timing the
market.
During the early part of this
century day traders lost big bucks
timing the market.
Day Trading
In the short term (several years)
the daily values of the market seem
to follow a random walk.

• A number of researchers have shown this.

• I ran my own ‘runs’ test indicating it.
A random walk is the result of a sequence of coin tosses.
Go up one unit after a heads.
Go down one unit after a tails.
Eight random walks:
 Fooled by Randomness
• Book by Nassim Nicholas Taleb.
• He argues people constantly delude themselves
because they do not understand probability and
are programmed to find reasons where none
exist.
• People end up believing in magic.
– Astrology
– Hot dice or coins
– Hot stock markets
 However,
• As noted earlier, the market’s value is related to
macroeconomic variables.
• Perhaps we can predict the market’s
performance for the coming month from
information about these variables today.
• We want to predict the market’s return at end of
the month from information at beginning of the
month.
• The fact that the market’s return follows a random
walk does not pre-empt that we could do this.
• Suppose I toss a coin at the beginning of each
month, and the market goes up or down each
month based on the outcome of the toss.

• The market’s return would follow a random walk

even though we could predict it.
 Factor Models

Factor models give the value of a stock at

the end of a month as a function of the
values of macroeconomic variables at the
end of the month.
 Edwin Burmeister’s factors:
• f1: Business Cycle
– Monthly change in a business index
• f2: Inflation
– Monthly change in investment
• f3: Investor Confidence
– Monthly change in difference between returns
on risky corporate bonds and gvmt. bonds
• f4: Time Horizon
– Monthly change in difference between returns
on 20-year gvmt. bonds and 30-day T-bills
• f5: Market Timing
 We then have:

ri(t) = ři(t) + bi1f1(t) + bi2f2(t) + bi3f3(t)

+ bi4f4(t) + bi5fk(t) + εi(t)

ri(t) is the monthly return of asset i at the end

of month t.
ři(t) is the expected return of asset i at the
end of month t.
bik is the risk exposure of asset i to factor k.
• Burmeister has shown that his factor model is
accurate.
• This shows that the market’s performance is
indeed related to macroeconomic factors.
• However, it does not help with timing the market
since all values are at month’s end.
• We want the return at the end of the month in
terms of macroeconomic variable information at
the beginning of the month.
 Market Timing with Tony Volpon

• Tony Volpon is an ex-mutual fund manager, who

now spends his days, relaxing on the beach in
Brazil, trying to figure out how to time the market.
• He identified around 30 variables as possibly
having predictive value for the S&P 500 return.
 Tony’s Variables
• SPFret(t) (This is what we want to predict.)

[S&P(t+1) – S&P(t)] / S&P(t)

• SPret(t)
[S&P(t) – S&P(t-1)] / S&P(t-1)

• 10Tret(t) (change in 10 year treasury bonds)

[10T(t) – 10T(t-1)] / 10T(t)

 Tony’s Variables
• NFPret(t) (change in non-farm payroll)

[NFP(t) – NFP(t-1)] / NFP(t-1)

• Fedret(t) (change in federal funds)

[Fed(t) – Fed(t-1)] / Fed(t -1)

• Mact
A complex momentum indicator
 Tony’s Variables
3monthavg10T(t)

= [10T(t-3) + 10(t-2) + 10(t-1)] / 3

• 10Ttony(t)

[10T(t) –3monthavg10T(t)] / 3monthavg10T(t)

 Regression with Tony’s Variables
• We looked at about 220 months of data.
• Regression for SPFret in terms of the
other variables did not yield meaningful
results.
• Over-fitting.
• In similar cases the following has
sometimes worked:
– Discretizing the variables.
– Learning a Bayesian network from the data.
 Bayesian Networks
P(A = < 30) = .25
P(F = yes) = .00001 P(A = 30 to 50) = .40 P(S = male) = .5
P(F = no) = .99999 P(A = > 50) = .35 P(S = female) = .5

Fraud Age Sex

Gas Jewelry

P(G = yes | F = yes) = .2 P(J = yes | F = yes, A = a, S = s) = .05

P(G = no |F = yes) = .8 P(J = no | F = yes, A = a, S = s) = .95
P(G = yes | F = no) = .01 P(J = yes | F = no, A = < 30, S = male) = .0001
P(G = no |F = no) = .99 P(J = no | F = no, A = < 30, S = male) = .9999
P(J = yes | F = no, A = < 30, S = female) = .0005
P(J = no | F = no, A = < 30, S = female) = .9995
P(J = yes | F = no, A = 30 to 50, S = male) = .0004
P(J = no | F = no, A = 30 to 50, S = male) = .9996

P(J = yes | F = no, A = 30 to 50, S = female) = .002

P(J = no | F = no, A = 30 to 50, S = female) = .998
P(J = yes | F = no, A = > 50, S = male) = .0002
P(J = no | F = no, A = > 50, S = male) = .9998
P(J = yes | F = no, A = > 50, S = female) = .001
P(J = no | F = no, A = > 50, S = female) = .999
 Our Study (Tony and I)
• We discretized each variable into 3 ranges
so as to have the same number of data
items in each range.
– 0 (low)
– 1 (medium)
– 2 high)
• Example: SPFret (annualized)
– 0 : < - .075
– 1 : - .075 to .294
– 2 : > .294
We learned this Bayesian Network:
Mact NFPtony

SPFret

10Ttony
 P(SPFret)

Mact NFPtony 10Ttony =0 =1 =2

0 0 0 .27 .35 .43
0 0 1 .20 .35 .45
0 0 2 42 .33 .24
0 1 0 .17 .16 .66
0 1 1 .16 .22 .63
0 1 2 .39 .30 .31
0 2 0 .20 .26 .53
0 2 1 .32 .20 .48
0 2 2 .17 .21 .62
 P(SPFret)

Mact NFPtony 10Ttony =0 =1 =2

2 0 0 .45 .31 .23

2 0 1 .38 .33 .28
2 0 2 .49 .29 .22
2 1 0 .22 .41 .36
2 1 1 .21 .44 .34
2 1 2 .33 .54 .13
• These results make economic sense.
• We can use them to make buying rules:
• If Mact = 0 and NFPTony = 1 and 10Ttony = 0
go long.
• If Mact = 2 and NFPTony = 0 and 10Tony = 0
go short.
By analyzing many different
markets (foreign exchanges,
commodities, real estate, etc.),
we can always bet only on very
promising prospects.
 Cheap Plug:

My new book

Probabilistic Methods for

Financial and Marketing
informatics
Morgan Kaufmann

is now available.