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Posted 7/21/2000
Kenner & Niederhoffer
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Wall Street
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Meet the Willie Mays of finance
Renowned MIT professor Andrew Lo has trained his technical analysis skills onto the market. Among his findings? Markets are not random, and those hot tech stocks might really be worth their prices.
By Laurel Kenner and Victor Niederhoffer
Bears have been known to pretend to flee from their human pursuers, and then to hide and kill from ambush when least expected. As one of Louis L'Amour's heroes might say, at the point most likely for an ambush, be careful. Right before and after these points, be doubly careful.
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The ambush today sent Standard & Poor's 500 futures down 27 points, the largest end of week drop since Jan. 28, a particularly discouraging move since it followed a rally yesterday that nobody was expecting. The Nasdaq 100 ($NDX.X) retreat to 3,908, down about 3% on the week, was also unfortunate, but must be considered in the context of the previous week's 5.5% gain. Under the circumstances, the small decline of 110 points in the Dow, leaving it down only 0.7% on the week, must be viewed as a relatively good performance.
Kenner & Niederhoffer
Victor Niederhoffer has traded stocks, currencies and futures worldwide for the past 40 years; he is the author of "The Education of a Speculator." Laurel Kenner is a trader and former Bloomberg markets editor. In a special series of weekend columns for MoneyCentral, they'll assess the past week's Wall Street performance and next week's prospects. Let us know what you think in the Start Investing Community.
Thursday's rally was caused by seemingly bullish remarks by Doc Greenspan, chairman of the Federal Reserve; his words sent bonds soaring more than 1.75 points, the largest rise since Oct. 14, 1998, when the Long-Term Capital Management hedge fund bailout was finalized amid massive injections of dollars into the monetary system, via interest-rate cuts, by the Fed.
The good news is that the ecology of the market is vastly improved by the week's developments. Stocks love to rise after huge reductions in long-term interest rates, and the close in the bond future at 98.75 gives it a yield of just 5.79%, the lowest level since April 10. The odds are about 20 to one that stocks will be higher in 30 days from their closing levels today.
And the very fact that the ambush occurred is good news. The level of complacency will be much lower going into the end of the month, and fears of the two previous summer declines will creep into the collective consciousness. Activity at the bearish cults will pick up and much will be made of the seeming weakness of stocks in the face of good news.
How marvelous. The market loves nothing better than to climb a wall of worry, and we're just as bullish this week as we were bearish last week.
Read Briefing.com's weekly market recap on MSN MoneyCentral's Investor.
A new look at technical analysis
In every field there is a Mozart; a genius with grace, technical mastery and natural simplicity -- a Magic Johnson in basketball, a Willie Mays in baseball, a Margot Fonteyn in dance, a James Levine in conducting. We were very fortunate recently to meet Andy Lo, who brings similar luster to quantitative and computational finance.
We caught up with Andy at 50 Memorial Drive in Cambridge, Mass., home of MIT's department of economics and Sloan School of Management. To enter the building's vast lobby is to sense the ghosts of past Nobel Prize winners as well as the presence of living luminaries -- Bob Solow, Lester Thurow, Paul Samuelson, Franco Modigliani, Paul Krugman. And then there are those in line to receive the honor in the future. We will not jinx his chances by adding our own vote as most likely to visit the Swedish king.
Already, Andy has a collection of high-powered honors that includes the 1999 Graham and Dodd Award from the Financial Analysts Journal, the 1998 Paul A. Samuelson Award and research grants from the most prestigious government and commercial institutions.
His modesty can be seen in his response to Vic's request for the list of his awards. "In contrast to the days when you started out in academic finance, I've had the luxury of beginning my career just as the field really started to become popular, and we now have enough awards in this profession that everyone can go home a winner!"
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His upstairs office is engulfed with hundreds of books on statistics, economics and finance -- a small part of his collection.
His family moved to New York when he was five, and Andy spent pleasant summers on the streets in Queens learning to play "lightning chess" (10 seconds a move) and how to light and throw an M-80 without losing fingers. He attended high school at Bronx Science, and college at The Wharton School of the University of Pennsylvania. One of his college jobs, which he calls "a geek's version of the perfect summer vacation," was at Rockefeller University's experimental physics department. He made photo-detectors, programmed Monte Carlo simulations of alpha-particle decay and learned to use a lathe, a drill press, and design printed circuit boards. "That was a very intoxicating combination of theory and practice," he told us. "Developing statistical models and implementing them is simply the most recent expression of my desire to build things that work."
"A Non-Random Walk Down Wall Street" by Andrew Lo.
At Harvard and MIT, he found that one problem with work in the field was that it didn't have a proper mix of those who ask the big questions and those who were trained in modern quantitative methods. He rectified that by co-authoring the 1996 book "The Econometrics of Financial Markets," and followed up with "A Non-Random Walk Down Wall Street" last year.
Andy was the first to refute the "random walk" hypothesis in a fashion that modern academics could find compelling. His victory wasn't easily won; although he ultimately succeeded, his quest was as difficult as Don Quixote's journey to uphold the honor of chivalry 500 years ago, and holds as many lessons for the current day.
His first battle came in the late 1980s when he discovered that weekly returns in indexes were highly correlated with each other -- a finding that challenged the academic orthodoxy at the time, which held that moves were completely random. One of the leading academics in the field publicly excoriated him, accusing him -- without evidence -- of mistakes in programming. In the best tradition of science since that time, Andy's work has been acclaimed, replicated and extended by numerous followers, while the naysayer's star has shriveled.
Andy's next step was to find why, since weekly moves in stock indexes tend to keep following the direction set in the previous week, that a similar positive relation doesn't show up in individual stocks. He found that while individual stocks don't show significant patterns from week to week, correlations between separate pairs of stock groups are quite high. For example, small-cap stocks tend to gain after large rises in large-cap stocks.
Things have changed since Andy did his work, though. Vic's tests on the weekly performance of index futures shows that they tend to change direction from week to week, and that this stems from negative correlations between individual stocks. For example, a 10-point weekly rise in Microsoft (MSFT, news, msgs) is likely to be followed by a 1.2 dollar drop in Dell Computer (DELL, news, msgs) the following week.
A third step in Andy's odyssey was to predict individual trades, and to prove that these regularities could be exploited in index arbitrage. In each of these areas, Andy pioneered new methods of statistical inference to tease out the full gamut of information from the data.
The final step was to employ the base he had developed in the previous areas to provide a framework for technical analysis itself. Andy's study of technical analysis, "Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation," is a paper that will change the foundations of the field when it's published.
He proposes new statistical techniques to define technical patterns, and then he applies scientific methods to determine their practical and statistical significance. His preliminary conclusion: "head and shoulders" patterns, and certain other patterns widely used in technical analysis, have some predictive significance, which is a quantum jump from any previously believed academic findings.
As he would be the first to admit, his work is still subject to extension and revision. We are not convinced that he has shown that any technical analysis patterns have validity. There were too many hypotheses tested, and not enough precision in the definitions of the beginning and ending of the patterns for our humble tastes. For example, the study assumes that the stock has met a bottom three days after the head-and-shoulders pattern ends. The trouble is that this assumption involves some armchair quarterbacking.
However, we agree with his conclusion that Nasdaq stocks are a much more fruitful area for the application of technical analysis methods than the more traditional New York Stock Exchange issues.
Andy is the kind of person who offhandedly remarks that he has recently written three patent applications and that his real specialty is not so much in math statistics, where he has laid the foundation of the field, but in English literature. "After reading ‘The Perfect Storm,' I thought immediately about writing the finance version: ‘The Perfect Crash.' If I had more time, I think I'd take a stab at it, describing the various events (or non-events) surrounding market crashes from 1929 to 1998, with plenty of interviews and charts to spice things up."
• Investors cap bullish week: Will Greenspan spoil it? , 7/14/00
• 8 new rules to help you ride the bull, 7/07/00
• After six market months, a climactic equilibrium, 6/30/00
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Unlike the vast majority of academic finance types, including his neighbors one mile west at Harvard, Andy is not bearish. He's too wise for that. He points out that investors have been exposed to unrelenting rises since 1980, helped by vast decreases in interest rates and rising institutional interest in stocks.
The net result is that the risk premium and the interest rate used to discount stocks to the present have decreased substantially, thus justifying current values. He believes that stocks will roll along over the next century as they have in the previous two, and that technology is on an inevitable march to improve human well-being. He invests by buying and holding index funds, because "I'm too busy teaching and doing research to pay enough attention to more active trading."
At the time of publication, the authors did not own any stocks mentioned in this article.
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