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Posted 5/30/2002















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The Speculator

Recent articles:
• No greatness without great risk, 5/23/2002
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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.

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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.




MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.