To print article, click
Print on your browser's File menu.
Go back
Go back
Posted 1/31/2002
Details
 |
Related Site
Get "Bargaining for Advantage: Negotiation Strategies for Reasonable People," by Richard Shell on Amazon.com.
Recent Articles
• Companies that speak softly carry big profits , 1/24/02
• 'We're No. 1' usually means 'not much longer', 1/17/02
• Watch the money on the sidelines, 1/10/02
more...
|
The Speculator
Come-from-behind winners lose in the end
When similarly priced stocks cross paths, who wins? We tap bargaining theory to try to find out, and we learn the lower-priced stock usually pulls ahead -- but only briefly.
By Victor Niederhoffer and Laurel Kenner
Picture yourself at a crowded intersection without proper traffic lights. All the drivers are as different as human diversity itself in their destinations, distances traveled and need to get where they want to go. Yet somehow, spontaneously, they navigate the intersection with a minimum of accidents. Each driver goes through a similar process: He slows down, establishes eye contact, bargains as to who goes first and then waits or moves.
| New
stock picks from market professionals every day on CNBC. |
Is this not what happens to stocks every day of the year? They approach each other at different rates of change, from different distances from their highs, with differing needs for capital. And yet somehow they keep us buying and selling, often with an imprecation or two at their rudeness, but still most of us stay alive.
At the beginning of the year, many of the 30 Dow stocks started out nose-to-nose at intersections. Take J.P.Morgan (JPM, news, msgs), American Express (AXP, news, msgs) and Alcoa (AA, news, msgs), all within $1 of the intersection of 36th Street, or $36. Are there any general principles that can be applied to figure out which stocks are going to win, which to buy and sell? And can those principles be applied to all bargains?
This is a key query to which all students of the Kennerhoffer School of Bargaining might well want to know the answer. Granted it's good to buy on the cheap, and to buy when the other side needs to sell. But what are the rules of the game? After many calculations with the Speculators' proverbial pencil and paper -- and yes, we admit it, a few computers as well -- we quantified the situation.
Pairing off the players
Here are the pairings of all the Dow stocks that were trading within $1 of each other at year-end 2001.
| Higher-priced stock | Price | Lower-priced stock | Price |
| Walt Disney (DIS, news, msgs) | 20.72 | Hewlett-Packard (HWP, news, msgs) | 20.54 |
| Exxon (XOM, news, msgs) | 39.30 | Boeing (BA, news, msgs) | 38.78 |
| SBC Communications (SBC, news, msgs) | 39.17 | Boeing (BA, news, msgs) | 38.78 |
| Exxon (XOM, news, msgs) | 39.30 | SBC Communications (SBC, news, msgs) | 39.17 |
| American Express (AXP, news, msgs) | 35.69 | Alcoa (AA, news, msgs) | 35.55 |
| J.P. Morgan (JPM, news, msgs) | 36.35 | American Express (AXP, news, msgs) | 35.69 |
| Johnson & Johnson (JNJ, news, msgs) | 59.10 | Merck (MRK, news, msgs) | 58.80 |
| Home Depot (HD, news, msgs) | 51.01 | Citigroup (C, news, msgs) | 50.48 |
We matched up similar closely priced pairs of stocks at the end of each year starting with 1996. We then found which ones crossed in January and came up with 56 pairs. When they crossed, the company that started out ahead tended to underperform in the first week -- but after 30 trading days stood 4 percentage points higher. The company that started out behind rose 2.7 percentage points after 30 trading days -- a difference of some 1.3 percentage points in favor of the company coming from the north. The table illustrates:
Performance of Dow stocks crossing in January (1996-2001)
| Direction they came from | % Chg After 1 day | % Chg After 5 trading days | % Chg After 30 trading days | % Chg After 60 trading days |
| Ahead | 0.3 | -0.3 | 4 | 3.1 |
| Behind | 0.5 | 1.5 | 2.7 | 0.8 |
| Difference | -0.2 | -1.8 | 1.3 | 2.3 |
Taking account of the uncertainty of the individual differences, which was some four times as great as the difference in the means, we can say that the observed differences have about a 1-in-20 shot of occurring through chance variations alone. Not enough to bet the ranch on, but certainly enough to consider coming to the bargaining table.
Here are the stocks that have crossed paths so far this year:
| Date | Intersection |
| Jan. 2 | Disney falls below Exxon |
| Jan. 2 | Home Depot falls below Citigroup |
| Jan. 2 | Johnson & Johnson falls below Merck |
| Jan. 4 | Exxon falls below Boeing |
| Jan. 7 | American Express falls below Alcoa |
| Jan. 8 | GE falls below Exxon |
| Jan. 16 | J.P. Morgan falls below American Express |
| Jan. 25 | J.P. Morgan falls below Alcoa |
The ones that are fresh enough to arouse our interest are J.P. Morgan versus Alcoa and American Express. We plan to buy some J.P. Morgan and sell the other two short in modest amounts to take advantage of our findings.
Why it works
As to why these pairs of stocks should behave in an apparently non-random way when they arrive at intersections, and why these results might have a raison d'etre that goes beyond the numerous possible comparisons in a study such as this -- we draw inspiration from bargaining theory.
During a negotiation, it is often a winning strategy for the stronger side to give a small concession at the beginning. The concession gives the other side a false confidence, increasing the stronger side's chances of ultimately winning. Recall that in the Civil War, the North began by losing one small battle after another only to regroup in impregnable strength a bit closer to home. We often see sports teams lose an early lead and then move on to a decisive victory after the other side lets down or runs out of energy. In a previous article on baseball comebacks, we observed this phenomenon from a different framework, and found that the team that makes a comeback tends to lose it all the next day.
The Speculators' decisions to trade or not always come after attempts to apply the scientific method to the gambits and ideas that the deep and harmonious principles of nature suggest, be they from the universal fields of physics, ecology or music. In this case, inspiration came from our continuing study of bargaining -- specifically, from a visit to Wharton in Philadelphia to interview professor Richard Shell, one of the foremost experts on negotiation.
One of Shell's many insights is that the process by which all bargains are struck is similar. The fleeting moment at a traffic intersection where two drivers must decide who goes first -- first, the stop for preparation; next, the exchange of information; third, the bargaining; and finally, the passing -- is one of his examples. The same basic steps can be seen in negotiations ranging from tribal disputes over land in Tanzania to high-stages merger deals in the U.S.
After meeting with Shell, it occurred to us that his intersection model was a beautiful metaphor for the stock market. The constant stopping and starting of cars, the feints, the bursts of speed, the near misses, and yet the supreme orderliness of it all, resembles nothing more than the similar process that stocks go through every day in crossing and recrossing the same price.
The purpose of the car crossings is easy to see; it's the attempt to reach a destination quickly and safely without an accident. The purpose for the market crossings is to facilitate the distribution of stocks to their most appropriate owners so that the wheels of commerce can continue. Stocks adopt many subtle dodges to induce the investor to buy them, and one way they accomplish their goal is by competing with other stocks. They start out above and often fall below, and almost every day are intersecting with rivals that they meet at the same price to induce trade. And, it seems, the ones that approach from below tend to win -- at least in the short term.
Final notes
We covered our longs in IBM (IBM, news, msgs) last Friday for a loss of some 3%. We licked our wounds and waited for the next large decline, which occurred Tuesday, Jan. 29, and bought some more that day at the close. We received more than 800 requests for our table of what happens after big one-day declines in IBM; we are now offering a workout of what happens to IBM after big declines over the previous two and three days. Write to us at dciocca@bloomberg.net....The Speculator recommended a hedged portfolio of biotech on Jan. 2. The hedge made about as much as the loss on the biotech stocks. We removed the hedge Jan. 30 and are now naked long the biotech portfolio. That is the only recommendation we have open, as the trades in IBM and J.P. Morgan that we are making are merely speculations which we find attractive ourselves but would not recommend at all to others, as there is too much uncertainty attached....We are grateful to Richard Shell for the helpful critique he made of our article and the time he devoted to educating us. We thank Shi Zang, our new research assistant, for his heroic work in calculating the performance of Dow stocks after intersections.
At the time of publication Victor Niederhoffer and Laurel Kenner owned IBM and were short American Express and Alcoa.
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.