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The Speculator
Avoid the pits by following the
pendulum
NBA teams ride the shooter with the hot hand, and baseball
players live and die with hitting streaks. But streaking stocks
don't hold near the potential as those swinging back and forth, we
find.
By Victor
Niederhoffer and Laurel Kenner
”It is no great wonder if in the long process
of time, while fortune takes her course, hither and thither…numerous
coincidences should spontaneously occur.”
--
Plutarch
Streaks in stocks, sports, casinos and war
promise great riches. Sometimes the hand is hot and sometimes it’s
not. Biotech stocks now have a cold hand. Eight months ago, they
sizzled. The flow of battle between the bulls and bears is
constantly shifting like runs of the dice -- but it’s quantifiable,
as we’ll explain in a moment.
Hot hands are
most evident in basketball. Take the NBA playoffs game Saturday
between the New Jersey Nets and Boston Celtics. The Nets were ahead
by 74-53 at the end of the third quarter. Amazingly, the Celtics
went on to win the game 94-90. “It was the greatest comeback that
I’ve ever been a part of,” said Celtics coach Jim O’Brien.
At the end of the third quarter, Paul Pierce of the Celtics
had scored just 9 points. Inspired by rousing comments from teammate
Antoine Walker, Pierce scored 19 in the fourth quarter, outscoring
the entire Nets team in that period. The speech, the crowd’s cheers
and reinforcement from his own success placed him in “the
zone.”
On the battlefield, generals call this momentum. The
epic stories of Homer are filled with it. In “The Iliad,” first the
Greeks are massacred by the Trojans. Next, the tide shifts as
Diomedes gets in the zone. Shortly, after two more shifts, the
Trojan Hector storms the Greek ramparts only to be beaten back by
Patrocles in the armor of the great warrior Achilles. After
Patrocles is killed by Hector, the tide shifts again, with the
Greeks ready to call it quits. Achilles agrees to enter the fray
again, putting aside his dispute over insider trading with
Agamemnon, and the tide of battle shifts for the last time. No
wonder that Ares, the Greek god of war, is also the Hellenic god of
momentum.
Cool to the hot-hand
notion
But are these examples of hot hands real, or do
they just seem that way because of the vagaries of memory? Closer to
home, does persistence, reversal or randomness exist in individual
stocks?
Most researchers who have studied hot hands conclude
the concept is a myth. The expert in this field is Cornell
University psychology professor Thomas Gilovich. In a series of
studies, he looked at records of shots from the floor by the
Philadelphia 76ers, foul shots by the Boston Celtics, three-point
shots in the All-Star contest and a shooting experiment with the
Cornell college team. In each case, he concluded that “detailed
analyses provided no evidence for a positive correlation between the
outcomes of successive shots.”
After sinking a few in a row,
a player may think he’s in the zone. But in actuality, the numbers
show that the chance of hitting the next shot tends to decrease
slightly from the average level of some 50%.
One of the
criticisms of these basketball studies is that they attempt to
measure individual hot hands in team sports where there is
significant interaction. Studies of hot hands in the Professional
Bowling Association tour found some short-term persistence in
individual scores. However, attempts to find streaks in baseball
show no such streakiness. An excellent book that reports tests for
streakiness of batters and teams in baseball is “Curve Ball” by Jim
Albert and Jay Bennett. They found that in one year, only six of 30
teams showed streakiness, a result consistent with chance. “So
really there is no strong support in this 1998 season for teams
displaying streakiness,” they concluded.
Our favorite study
was Pomona College economics professor Gary Smith’s look at
horseshoe pitchers’ hot hands. He found that the number of double
ringers pitched showed strong persistence. After two doubles in a
row, the players in world championships pitch doubles 60% of the
time. After two non-doubles in a row, they pitch double ringers only
47% of the time. He disagrees with Gilovich's basketball data and
says his analysis of horseshoe pitching indicates that players do
have modest hot and cold spells.
Amos Tversky, the father of
research in cognitive biases, collaborated on many studies with
Gilovich. The psychologist has extended this work in numerous
directions, including the stock market. He said that he lost more
friends from his studies than he could count. We have found a
similar reaction when we write our articles debunking such myths as
the momentum of market indexes. “Get out of here. That’s why you
went broke. You belong in jail” is just one of the mild responses
from the dozens we elicit with tests of beliefs that are generally
accepted as true.
Yes, a 3-for-3 shooter or batter feels
that he has a better chance of hitting the next time up. Yes, when
stocks go up three weeks in a row, everyone’s bullish, and when they
go down three weeks in a row, everyone is bearish. The problem is
that card players and dice players feel this, too. After filling in
a few flushes, you are “in the zone.”
The market's momentum pendulum
Most
people would agree that cards and dice don’t have memory. The
question is, do stocks have memories?
To figure that out, we
decided to focus on something seemingly humdrum. During the first
three weeks of May, Johnson & Johnson (JNJ,
news,
msgs)
showed three consecutive weekly declines. Some people are going to
think that Johnson & Johnson is likely to go back to average and
rise the next week. Others are going to think it is streaky and
ready to go into the cellar. The first bias is called the “gambler’s
bias,” or the law of small numbers. The second bias is called the
“representation,” or “hot hands” bias.
To test these two
perceptions, we chose the current 10 largest Nasdaq stocks and the
10 largest S&P 500 stocks by market capitalization. We studied
weekly prices from May 1997 to the present. Since
Intel (INTC,
news,
msgs)
and Microsoft (MSFT,
news,
msgs)
were common to both lists, we were left with 18 companies. To
simplify our tests and maintain a reasonable homogeneity in the
results, we calculated the signs of the moves in each of the first
three weeks for each stock. There were eight possibilities in all.
Then we looked at the results that occurred in the remaining week of
the month for each stock. The averages and numbers of observation
appear in the table below.
Streaking stocks
| Moves in the last week of the month
compared with previous weeks, 1997-2002 |
| Week 1 |
Week 2 |
Week #3 |
# Observations |
Average move Week 4 |
| Up |
Up |
Up |
156 |
+1.6% |
| Up |
Up |
Down |
165 |
+0.6% |
| Up |
Down |
Up |
188 |
+0.6% |
| Up |
Down |
Down |
125 |
+1.3% |
| Down |
Up |
Up |
108 |
-1.3% |
| Down |
Up |
Down |
91 |
+2.8% |
| Down |
Down |
Up |
114 |
-1.4% |
| Down |
Down |
Down |
100 |
-0.8% | |
Those
stocks in the lead triumph and prosper in the last week, while those
that are near the bottom meet disaster in the final week. When a
stock is up three weeks in a row, it adds an average 1.6% in the
final week. When a stock is down three weeks in a row, it falls an
average 0.8%. Even worse, those that fall the first two weeks and
then rise have dropped 1.4% by the end of the month. Most striking
of all are the reversals in fortune of the group that reversed like
a pendulum during the first 3 weeks. Stocks that were down the
first, up the second, and down the third tend to go up 2.8% in the
final week.
There are eight different groups of stocks that
we can classify based on their persistence and reversibility in the
first three weeks. Within each group and within the sample of 1,047
company-weeks, there is much variation in the performance. The
average variation in the performance of an individual company during
the final week is 10%. Chance doubtless contributes in large measure
to the results.
Yet putting it all together, after some
simulation and calculations, we conclude that the superior
performance of 2.8% in the final week for the group of companies
that registered decline-rise-decline during the first three weeks is
unlikely to have occurred by chance. Let’s call it a 1-in-20 shot.
The tendency for momentum to continue in the final week for
the companies that registered three consecutive rises or three
consecutive declines is suggestive but not conclusive of some true
differences. Let’s call it a 1-in-10 shot.
Whipped with fear,
we note that several stocks fell into the bearish groups as of May
24. These included the pharmaceutical companies
Amgen (AMGN,
news,
msgs),
Immunex (IMNX,
news,
msgs)
and Johnson and Johnson. Also, in bearish categories were tech
stocks Dell Computer (DELL,
news,
msgs),
IBM (IBM,
news,
msgs),
Maxim Integrated Products (MXIM,
news,
msgs)
and Qualcomm (QCOM,
news,
msgs).
No stocks fell into the two relatively bullish groups. It is too
early to see whether these stocks meet their predicted fate.
Take heart from our studies that swings in fortune of stocks
are a pendulum. The slow during the first part of the monthly race
lose at the end. The swift at the beginning of the race go on to
win. Those that zigzag down-up-down tend to prosper.
June 21
will be the next day the classes are formed. We will acquaint you
with the members at that time in this column.
Final Note
Our previous reports have
focused on the superior performance of companies that announce
buybacks. They have been showing a hot hand of 30 percentage
points-per-year superior performance to average stocks during the
past two years. Our preference is to buy these regardless of how
many shares they buy back and how great the buyback shares relative
to those outstanding. Since our last report May 16, two new
companies have announced buybacks,
ThermoElectron (TMO,
news,
msgs)
and Unum Provident (UNM,
news,
msgs).
We will be buying these stocks for our own account to add to the 21
others that have announced. This is consistent with our view that
stocks this year will end up with a positive return.
Kindly
feel free to give us your suggestions and augmentations for our work
at The
Speculator, or request a spreadsheet of the above results.
At the time of publication, Victor Niederhoffer and
Laurel Kenner owned shares in the following stocks listed in this
article: Johnson & Johnson and IBM.
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