Stock Trading Evolution

wrote

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?

It is discounted DIVIDENDS, not EARNINGS, that equal the fair value of the stock.

Backtest it, tell the group why Hendry is not filthy rich at this point, and report back. ;-)

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

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.

An error-correction model is a dynamic model in which the movement of the variables in any periods is related to the previous period's gap from long-run equilibrium. What you do is, first, estimate the long term equilibrium relation between the variables (in this case, earnings of a given company -endogenous variable- and the exogenous variables: company's industry sales, relative price of the good sold by the company/industry; and salaries, and interest rates (which explains most of the cost of goods sold by the company). These exogenous variables

-which are non-stationary, i.e, they have a trend to increase (or decrease) over time- need to be cointegrated with the price of the stocks, i.e, a linear correlation of earnings and -say- salaries paid by the industry needs to be stationary. Intuitively, they should move in the same direction over the long term.

The error correcti> > > I use an econometric package and an error correction model