Posted
3/20/2003
The Speculator
Put ivory-tower
theory to a real-world test
Every year, a parade of academics floats any number
of theories about potentially profitable market quirks. We've come up with a
new rating system to help you analyze those big ideas.
By Victor
Niederhoffer and Laurel Kenner
"All theory is gray, but green
is the golden tree of life."
-- Johann Wolfgang von Goethe, "Faust: A Tragedy"
Ph.Ds
customarily wear a large hood on top of the cap and gown in academic
ceremonies. In times past the hood served not only to protect against rain and
cold but also as a bag to beg for alms.
This
is consistent with the view of academics as impractical, absent-minded and
incapable of making a buck in the real world, and for many years financial
academics were true to the stereotype. They loudly proclaimed the market to be
completely efficient in translating information into prices, a theory summed up
by the one about the professor and the student: “Look,” exclaims the student,
as they walk along the road. “Someone dropped a $100 bill!” “Nonsense,” the
professor replies without bothering to look. “If there were a $100 bill,
someone would have picked it up.”
Today,
thousands of professors and advanced students are engaged in a gold rush for
anomalies -- chinks in the market’s efficiency -- that might yield the odd $100
note. Most investors are too busy to do more than keep a weather eye on their
portfolios, let alone review masses of academic literature. Therefore, we have
developed a ratings system along the lines of Michelin and Zagat to help
distinguish the good from the bad. We publish our first two SpecDuo Ratings
today.
We
have to admit searching long and hard to find an anomaly study that was truly
useful, one we could honor with a perfect SpecDuo rating. Just before we went
to press, we found the perfect academic paper: “The Equity Share in New Issues
and Aggregate Stock Returns,” by Malcolm Baker and Jeffrey Wurgler, in the
October 2000 edition of the Journal of Finance. In brief, they found that when
equity issuance relative to debt was in the bottom quarter of all years they
studied, the average return of the market the next year was 14%. When the
equity issuance-to-debt ratio is in the top quarter, the returns next year were
-6%. They attribute this to the issuing companies’ sense of whether their
stocks are too high or too low. (Their data end in 1997, but issuing
percentages during the last two years have been in the lowest quartile and are
thus highly bullish.)
We
also reviewed a study of whether certain days of the week are more profitable
than others for trading. Our rating, together with a full explanation of the
SpecDuo Rating system, appears below.
Animus toward the anomalous
An
anomaly is a deviation or departure from the normal order (the phrase “abnormal
return” appears frequently in these studies). In finance, an anomaly can
sometimes produce returns that deviate significantly from those of the market
as a whole -- in other words, returns that cannot be explained by the
efficient-market hypothesis.
The
literature on anomalies is voluminous and multifaceted. The 20 or so financial
and accounting journals usually contain at least three or four articles on the
subject. The educational Web site Investor Home (see link at left under Related
Web Sites) devotes a section to anomalies, listing subjects, articles and noted
professors in the field. The anomalies that are the subject of these studies
can be categorized into:
Incentives for academics
Good
work in the anomalies field can produce not only tenure and corporate
sponsorship of the professor’s chair, but financial backing for the ideas. Some
professors even put on the “red hood,” straddling the campus and the world of
money management, or leave the ivory tower entirely to found their own hedge
fund.
Eugene
Fama, one of Vic's teachers at the University of Chicago, directs research at
the Dimension series of mutual funds. Richard Roll, one of the most respected
professors in finance, is a partner in the multibillion-dollar firm Roll and
Ross Asset Management. Our good friend Dr. Andy Lo of the Massachusetts
Institute of Technology is spearheading a major effort to find profitable
anomalies in stock prices. This is consistent with the view of academics as
impractical, absent-minded and incapable of making a buck in the real world,
and for many years financial academics were true to the stereotype. They loudly
proclaimed the market to be completely efficient in translating information
into prices, a theory summed up by the one about the professor and the student:
“Look,” exclaims the student, as they walk along the road. “Someone dropped a
$100 bill!” “Nonsense,” the professor replies without bothering to look. “If
there were a $100 bill, someone would have picked it up.”
Today,
thousands of professors and advanced students are engaged in a gold rush for
anomalies -- chinks in the market’s efficiency -- that might yield the odd $100
note. Most investors are too busy to do more than keep a weather eye on their
portfolios, let alone review masses of academic literature. Therefore, we have
developed a ratings system along the lines of Michelin and Zagat to help
distinguish the good from the bad. We publish our first two SpecDuo Ratings
today.
We
have to admit searching long and hard to find an anomaly study that was truly
useful, one we could honor with a perfect SpecDuo rating. Just before we went
to press, we found the perfect academic paper: “The Equity Share in New Issues
and Aggregate Stock Returns,” by Malcolm Baker and Jeffrey Wurgler, in the
October 2000 edition of the Journal of Finance. In brief, they found that when
equity issuance relative to debt was in the bottom quarter of all years they
studied, the average return of the market the next year was 14%. When the equity
issuance-to-debt ratio is in the top quarter, the returns next year were -6%.
They attribute this to the issuing companies’ sense of whether their stocks are
too high or too low. (Their data end in 1997, but issuing percentages during
the last two years have been in the lowest quartile and are thus highly
bullish.)
We
also reviewed a study of whether certain days of the week are more profitable
than others for trading. Our rating, together with a full explanation of the
SpecDuo Rating system, appears below.
Animus toward the anomalous
An
anomaly is a deviation or departure from the normal order (the phrase “abnormal
return” appears frequently in these studies). In finance, an anomaly can
sometimes produce returns that deviate significantly from those of the market
as a whole -- in other words, returns that cannot be explained by the
efficient-market hypothesis.
The
literature on anomalies is voluminous and multifaceted. The 20 or so financial
and accounting journals usually contain at least three or four articles on the
subject. The educational Web site Investor Home (see link at left under Related
Web Sites) devotes a section to anomalies, listing subjects, articles and noted
professors in the field. The anomalies that are the subject of these studies
can be categorized into:
Incentives for academics
Good
work in the anomalies field can produce not only tenure and corporate
sponsorship of the professor’s chair, but financial backing for the ideas. Some
professors even put on the “red hood,” straddling the campus and the world of
money management, or leave the ivory tower entirely to found their own hedge
fund.
Eugene
Fama, one of Vic's teachers at the University of Chicago, directs research at
the Dimension series of mutual funds. Richard Roll, one of the most respected
professors in finance, is a partner in the multibillion-dollar firm Roll and
Ross Asset Management. Our good friend Dr. Andy Lo of the Massachusetts
Institute of Technology is spearheading a major effort to find profitable
anomalies in stock prices. Some academics leave the ivory tower completely; Jim
Simon, who chaired the State University of New York’s math department, departed
to found the successful Renaissance Technologies fund.
Regrettably,
academics often do studies retrospectively, indulge in data mining, throw out
results that don’t confirm their hypotheses and report results in a form that
can rarely be used. Many studies are based on data from the 1970s to the
mid-1990s, and the market’s recent devastating declines might well have changed
the results.
Moreover,
lots of smart people are always ready to jump on a winning idea, thereby
changing the odds of success. We might call the Heisenberg principle of
investing, after the 20th-century scientist who noted that the mere act of
observation changes an electron’s path.
Street smarts
Nowhere
does suspicion of the ivory tower linger more strongly than among non-academic
traders. Professors are fine with their complex theories and equations in the
safety of the classroom, they’ll tell you, but they just don’t have the street
smarts to survive in the market.
When
they do try out ideas in the real world, the results can be disastrous on a
biblical scale. This view was affirmed when the Nobel laureates Myron Scholes
and Robert Merton witnessed in 1998 a Fed-initiated rescue of their fund,
Long-Term Capital Management, at 5% of its former value. (Along these lines, we
will not refrain from noting that Vic himself earned a Ph.D. in statistics from
the same University of Chicago business school as Dr. Scholes, and that his
fund suffered a similar fate one year earlier than Long-Term Capital.)
Yet
academics have much to offer. They have access to massive computing power and
huge databases, and they are highly competent, trained in all forecasting and
analysis techniques. In previous columns, we’ve written about studies we think
have legs: anomalies based on accruals, insider trading, dividends, buybacks,
low prices and IPOs. Whatever you say about their street smarts, they are
definitely book smart -- and like you and me, they have every incentive to use
their considerable assets to come up with something useful and timeless.
Our
new SpecDuo Ratings system establishes a framework for weeding out the good from
the bad.
SpecDuo rating criteria
Here
are the important things to consider when reviewing a study, or evaluating a
media report on one:
For
example, many studies have concluded that initial public offerings
significantly underperform the market. The definitive paper on the long-term
underperformance of IPOs, “A Review of IPO Activity, Pricing and
Allocations," by Ivo Welch and Jay Ritter, enumerates the buy-and-hold
returns of 6,249 IPOs from 1980-2001. They conclude that these stocks
underperform the market on average by 23 percentage points over three years. In
general, their study is excellent, and their SpecDuo Rating can be found on our
Web site. Yet when we performed an update of all IPO s during the down market
of the last three years for our column two weeks ago, we found that they outperformed
the market by some 20 percentage points a year.
Seasonality and changing cycles
A
good part of the anomaly literature is devoted to studies of seasonality. A
basic problem with these studies is that merely picking a season to study involves
making guesses as to when and where the seasonality is. For example, is it in
January or December, on Monday or Friday, in the United States or the Ukraine?
(Yes, our Google search turned up a study of anomalies in the Ukraine.) Thus,
the very choice of a subject might involve random luck.
Another
aspect of seasonality studies that must be considered is whether the effects
noted are sufficient to cover transaction costs. A retrospective study showing
that you can make 2 cents more on Friday trades than Monday trades in your
typical $50 stock would not be sufficient in practice to leave anyone but the
broker and the market-maker richer.
Thus,
it’s essential to temper the conclusions of such studies with “out-of-sample
testing” -- in other words, with real trading.
With
that in mind, let’s consider a representative seasonality study, “The Day of
the Week Effect and Stock Market Volatility: Evidence From Developed
Countries,” by Halil Kiymaz and Hakan Berument, from the Summer 2001 edition of
the Journal of Economics and Finance. Their research examines whether returns
and variability differ on different days of the week in the five major
international markets from 1989 to October 1997. They conclude that day-of-week
anomalies exist for returns and volatility in all five countries.
For
example, they find that in the United States, stocks go down an average of
-0.08% on Monday, while rising on Fridays an average of 0.1%. But hold all
tickets -- 0.1% on a $50 stock is just 5 cents, hardly enough to cover transaction
costs even if the results hold up.
SpecDuo
Rating:
Practicality:
0
Transparency:
10
Testing:
10
Regime
shift possibility noted: 0
Spec
update
Fortunately,
the Spec Duo has the pencils and envelopes necessary to update the study. Here
is what we found for the daily changes and volatility for the S&P 500
Index ($INX) on the different days of the week
from the beginning of 1997 to March 15, 2003:
|
Returns and volatility by day of the week, in percent |
||||||||||||||||||
|
Regrettably,
the returns are so close to zero and the variabilities so close to equal that
the results are completely random. The day-of-week effect has been totally
useless to speculators over the last six years, despite what the literature
says.
Final note
We
wish to thank Mr. Adam Robinson for his research and editorial assistance on
this project. Before joining Vic's firm, Adam was the co-founder of the
Princeton Review. We have rated many additional anomalies papers. Our SpecDuo
Ratings, as well as reader comments on anomalies, are available on our Web site.
Please feel free to send us your own ratings on these and other academic papers