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The market is like a beautiful woman of the fatale variety who always amazes with her virtuosity and newness. Never the same. Both must be quantified and used to advantage.

Phil McDonnell adds:

Phil McDA couple of years ago vic initiated a discussion of Information Theory and how it might apply to markets. One particular aspect of information theory deals with how codes can be represented. For example the letter A could be 65, B is 66 and so on. To interpret the market's signal one can classify market moves into categories. An up move would be a 1 and a down move a zero. This would be a simple two letter alphabet. For a four letter alphabet of market moves we could take large moves of more than +.5%, small moves up, small moves down and large down moves of more than -.5%. For larger market alphabets we could break the moves down into more bins with finer granularity.

In doing the study I looked at various alphabets from 4 to 16 characters (bins). In each case the results showed a significant predictive ability when one computed the information content of the resulting bins. On thing I noticed at the time was that the larger magnitude bins (both up and down) carried greater information value.

Another observation was that characters which were 'missing' or in relatively low frequency tended to be more likely to appear. This latter phenomenon is very much consistent with the Chair's femme fatale metaphor. The market tends to surprise us with what we have not seen in a while. Come to think of it, it has been a long time since we saw positive drift in the market.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008


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