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THE APPLICATION OF NEURAL NETWORKS TO U.S. EQUITY PRICING AND CLASSIFICATION

by

S. Kris Kaufman, President Douglas Frick, Vice President Alex Kaufman, Research Associate Parallax Financial Research, Inc.

2004

White Paper for Parallax Financial Research, Inc. products:

Price Wizard TM

Dynamic Price Wizard

ValueNet TM

Beta Predictor™

Wizard Explorer TM

Inc. products: Price Wizard T M Dynamic Price Wizard ™ ValueNet T M Beta Predictor™ Wizard

Abstract

Neural network modeling technology has been applied to the problem of determining the fair market price for a company based on all significant stores of value as reported through required SEC filings and current economic conditions. No attempt was made to use analyst estimates or other future looking assumptions. Significant biases due to trend persistence, price, economic conditions, and company size were reduced using proprietary splitting and sampling techniques. Sector and industry biases were eliminated by producing one network for each of 16 economic sectors, each of which included binary flags to signify industry membership. Data used for this work came from Zacks databases of US corporate data between 1990 and 2001. After a preparation step which separated the data samples into training and test sets, and applied some outlier elimination filters, the NGO product by BioComp was used to train the networks. Training for most sectors resulted in R squared numbers above 0.8 as follows:

Sector

2

R

Samples

Consumer Staples

.88

16,413

Consumer Discretionary

.79

12,943

Retail/Wholesale

.75

21,511

Medical

.77

14,321

Auto/Tires/Trucks

.90

3,891

Basic Materials

.86

13,893

Industrial Products

.87

16,935

Construction

.89

8,619

Multi-Sector Conglomerates

.93

4,795

Computer And Technology

.63

27,991

Aerospace

.88

3,387

Oils/Energy

.82

11,035

Finance

.91

32,000

Utilities

.96

15,567

Transportation

.88

6,451

Business Services

.75

4,065

The final neural models return an estimated price. There are numerous applications for these price estimates such as pricing IPO’s, portfolio selection, macro modeling of sectors and industries, stock market index pricing, asset allocation, and construction of enhanced indices. The asset allocation application required an additional network be built to classify “value” and “growth” stocks. Another stock screening application required that the recent rates of change of valuation and price be combined with our estimated price in a dynamic neural network model. Beta is an often used management variable, and we wished to estimate beta to the S&P 500 as well as beta to an industry average. A beta predictor neural net was constructed for this purpose. Test results show that our methodologies significantly improve the stock screening process at all levels.

TABLE OF CONTENTS

List of Figures

ii

List of Tables

iv

Acknowledgements v

Glossary

vi

Introduction

1

Chapter I: Building an Equity Pricing Model (Price Wizard TM )

4

The Search for Value 4

Data Preparation

7

Neural Network Background

12

Neural Net Training Results

17

Value/Growth Classification Network (ValueNet TM ) 26

Predicting Beta to the S&P500 and Industry Indices (Beta Predictor™) 27 Adding Rate-of-Change to Price Wizard (F% or Dynamic Price Wizard™).28

30

Model Processing & Delivery 30

Interactive Price Calculator (Wizard Explorer TM ) 32

Chapter II: Model Delivery & Visualization

TradeStation TM Historical Graphing

35

TradeStation TM Aggregate Portfolio Graphing

37

EXCEL TM Database and Summary Spreadsheets 44

Chapter III: Historical Testing Methods

48

Survivorship and In-Sample Considerations

48

Chapter IV: Applications 60

Stock Selection Screening

40

CSFB Holt versus Parallax Equity Pricing Model

40

Aggregate Valuation Statistics 40

Aggregate Portfolio Valuation

40

Sector and Industry Valuation

40

Index/ETF Valuation

40

Enhanced Index Applications

40

Long/Short Applications

40

Asset Allocation Applications 40 Chapter V: Client Performance Examples 60

The Influence of Price Trend Persistence 63

Equity Screening Example 1 (Marque Millennium)

63

Equity Screening Example 2 (Corporate Consulting)

63

Glossary

73

Bibliography

75

Index

78

Appendix A: Parallax Financial Research 77 Appendix B: Zacks Historical Data 78

LIST OF FIGURES

Number

Page

1.

Zacks Current Database

5

2.

Three Layer Neural Network

12

3.

Neural Network Activation Functions

14

4.

Network Training for the Finance Sector

16

5.

Predicted Price vs. Actual for the Test Data

17

6.

Predicted Price vs. Actual for the Training Data

17

7.

Consumer Staples Network Training Results

18

8.

Utilities Network Training Results

18

9.

Retail/Wholesale Network Training Results

19

10.

Finance Network Training Results

19

11.

Medical Network Training Results

20

12.

Oil/Energy Network Training Results

20

13.

Neural Response Surface

21

14.

Training Statistics for Best Value/Growth Network

26

15.

Neural Response Curve for Value/Growth Network

27

16.

Price Calculator Data Retrieval

32

17.

Price Calculator Data Editing and Recalculation

33

18.

TradeStation Display of Estimated Prices

34

19.

CSCO Estimated Prices shows Bubble Formation

35

20.

June 1996 Relative Valuation Histogram

36

21.

March 2001 Relative Valuation Histogram

37

22.

Percentage of Undervalued Stocks in the Banking Sector

39

23.

Percentage of Undervalued Stocks in the Retail Sector

40

24.

Percentage of Undervalued Stocks in the Oil/Energy Sector

41

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ii

25.

Percentage of Undervalued Stocks in the Nasdaq 100

42

26. Percentage of Undervalued Stocks by Sector

43

27. Percentage of Undervalued Stocks by Market Cap Band

44

28. Percentage of Undervalued Stocks by Industry

45

29. Percentage of Undervalued Stocks by Asset Class

46

iii
iii

LIST OF TABLES

Number

Page

1. List of Fundamental Factors used to Estimate Price

5

2. Top Price Factors for Consumer Discretionary Stocks

22

3. Neural Network Training Results

23

4. TradeStation Inputs for Indicator PFR_Wizard

35

5. Monthly EXCEL Spreadsheet of Estimated Equity Prices

43

6. Monthly EXCEL Spreadsheet with the Statistical Valuation Summary

44

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iv

ACKNOWLEDGMENTS

Work on this product began in 1990 and has gone through three major revisions over the intervening 14 years. The author wishes to express sincere appreciation to Edward Raha, Doug Frick, Phillip Zachary, Gary Gould, John Rickmeier, Bill Meckel, Ken Garvey, Diana Kaufman, and Alex Kaufman for their support and assistance in the development of these products and related applications. This work was partially supported by contracts with Bankers Trust, Daiwa Securities, Managed Quantitative Advisors, and Marque Millennium Capital Management

v
v

GLOSSARY

Neural Network. A mathematical modeling technique which has the capacity to learn by example. It is also referred to as a “non-parametric” modeling technique.

ETF. Exchange traded funds are portfolios of stocks that have similar characteristics and are available for trading as a single entity.

IPO. Initial public offering of a stock.

EXCEL. Microsoft Office spreadsheet software program

TradeStation.

TradeStation Securities

Stock

charting

and

back

testing

software

program

from

Sector. One of 16 divisions of the US economy by corporate characteristics

SEC. The Securities and Exchange Commission.

NGO. Neurogenetic optimizer software produced by Dr. Carl Cook of BioComp Systems (www.biocompsystems.com)

Dr. Carl Cook of BioComp Systems ( www.biocompsystems.com ) Zacks Investment Research is a Chicago based

Zacks Investment Research is a Chicago based firm with over 24 years of experience in providing institutional and individual investors with the analytical tools and financial information necessary to the success of their investment process (www.zacks.com )

Russell 3000. The Russell 3000® Index offers investors access to the broad U.S. equity universe representing approximately 98% of the U.S. market. The Russell 3000 is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected (www.russell.com/US/Indexes/US/3000.asp).

I/B/E/S. Institutional Brokers Estimate System. A system that gathers and compiles the different estimates made by stock analysts on the future earnings for the majority of U.S. publicly traded companies (www.firstcall.com)

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INTRODUCTION

“Intrinsic value is the investment concept on which our views of security analysis are founded. Without some defined standards of value for judging whether securities are over- or under-priced in the marketplace, the analyst is a potential victim of the tides of pessimism and euphoria which sweep the security markets.”

“Intrinsic

value is therefore dynamic in that it is a moving target

which can be expected to move forward but in a much less volatile manner than typical cyclical or other gyrations of market price. Thus, if intrinsic value is accurately estimated, price will fluctuate about it.” Graham and Dodd, Security Analysis (pg. 41 and 43, Fifth Ed.)

The price of a stock is an opinion, or more correctly, the sum total of thousands

of opinions which are expressed through buy and sell decisions every day in the

marketplace. These opinions are based on published corporate and economic

fundamentals, as well as imprecise factors such as future estimates, recent trends,

news, and lawsuits. They are also subject to irrational investment behavior,

rumors, individual biases, and to some extent random fluctuations. Since price is

dependent on so many factors, it is natural to try and separate out the effect of

the most intrinsic components first. In fact, our goal was to find a mathematical

way of pricing a stock that may not have been priced by the marketplace. As they

say though, if the problem were that easy, it would have been solved already.

Even the intrinsic components of a stock price depend on many interrelated

factors, and just as identical real estate varies in price by location, the same

corporate earnings numbers will result in different valuations within different

sectors or in different economic conditions. Our model had to be based on

known fundamentals and economic conditions, compensate (normalize) for

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sector and industry, and properly weight the many stores of value that give a company an intrinsic worth.

Mathematical models are normally built by making a-priori assumptions about the

functional form of the solution. These are called parametric models, and are solved by regression methods to determine a number of coefficients. This is fine

if you know that the solution must be a straight line or some other simple, well-

known function. But in the real world, relationships are not necessarily simple, and we don’t always know the form of the solution. Inputs and outputs could even be related in a non-linear fashion. If you don’t have to guess the functional form of the answer, you have a big advantage. We chose to use neural network modeling for this reason.

A neural network is a mathematical modeling tool which has the capacity to learn

by example. This is an extraordinarily useful ability, especially in financial modeling, where the inputs & outputs are usually well documented, and there are countless examples. Networks are “trained” by being presented with thousands of facts, each fact consisting of inputs and corresponding outputs. Through a unique feedback process, the network learns how those inputs are related to the outputs, and develops a general model to describe the relationship.

In our case, fundamentals were fed in, and the corresponding stock price was used as the output. Again, if this problem were so easy…. There were significant sources of bias and data error which had to be dealt with, and some of our techniques are so innovative that they must remain proprietary. Data preparation steps were critical to the success of the model, and will be discussed in as much depth as possible.

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2

Once trained, the model knows how to form a price opinion that should be close

to a reasonable consensus opinion based solely on economic and fundamental

report data. We expect that when the model price is lower than the actual price, then there is probably a degree of optimism that things will be far better in the future. On the flip side, if actual price is lower than the model, then there may be significant pessimism. Whatever the cause of the discrepancy, it is the analyst’s job to try and understand why it exists.

A successful model will have many applications depending on the kind of client

being served. Our prices could be used to evaluate portfolios of all sorts, from

individual to professional funds. Model prices could even be used to assess the economy based on broad collections of stocks. For clients that need investment products, our model would be useful at all levels. The prices could be used to rank stocks from under-valued purchase candidates to over-valued sell or short sale candidates.

prices could be used to rank stocks from under-valued purchase candidates to over-valued sell or short
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Chapter

1

BUILDING AN EQUITY PRICING MODEL

The Search for Value

The search for corporate value is complex. Do earnings alone determine a fair price? How about cash flow, book value, sales, or dividends? How important are interest rates, debt, or the industry in which the company operates? These are all good questions, and the answer is that they all matter. The complexity of judging how much to weight each factor, and how the factors change relative to each other is hopelessly complex. Add to that the challenge of remaining unbiased by the times in which we live. It was rare, for example, to find an analyst who was willing to say that tech stocks were overvalued in 1999. Instead, many chose to adjust their models to reflect an irrational reality. So Parallax has chosen mathematical modeling for its ability to provide consistent results to an unmanageably complex problem.

Our goal was to build a computer model with no assumptions about the relationship between price and fundamental factors. We wanted the model to learn from example and be able to generalize what it had learned to any other set of corporate data. More specifically, our equity-pricing model used neural

network technology to learn how a stock’s fundamental balance sheet data had been translated to a market price in the past, within the context of its industry group and economic sector. Then, going forward in time, the trained model simultaneously evaluates all these factors as they change month to month, in order to produce an estimated stock price.

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4

To accomplish this ambitious goal we needed to include the factors that have been cited by the financial community as key to stock valuation. This also included such economic numbers as PPI, CPI, GDP growth and interest rates. The data we chose for this project came from Zacks corporation’s DBDQ, DBCM, and ECON databases, and are listed below along with a screenshot of the DBCM database reference guide from which all of the values and their explanation were gleaned:

which all of the values and their explanation were gleaned : Figure 1 – Database Items

Figure 1 – Database Items reference page for the Zacks DBCM current database. The table below was compiled from this document.

Inputs

Input Description

stale

This is an integer value representing the number of months old the data is

roi

Return on Invested capital. Calc: (Income before extras & discontinued operations)/(Long-term debt, convertible debt + non-current capital leases + mortgages + book value preferred stock + common equity)

sales_q

Sales quarterly per share

inc_bnri12

Twelve month Income before non-recurring items per share

book/share

Book value of common equity per share

5
5

trend_bvsg

Trend book value per share growth rate calculated from beta of an exponential regression on the last 20 quarters’ of fiscal book value per share

cash/share

Cash flow per common share. Calc: CASH FLOW/ SHARES OUT

op_margin

(Income before extraordinary items and discontinued operations for the previous 12 month period/Sales for the previous 12 month period) X 100

net_margin

(Net income for the previous 12 month period/Sales for the previous 12 month period) X 100

pretax_mrg

Trailing four quarter pretax profit margin. Calc: (PRETAX INC/SALES) x 100

curr_ratio

Current Ratio: Current Assets/Current liabilities

payout_rat

Dividend payout ratio. Calc: INDICATED ANNUAL DIVIDEND/ACT EPS 12

inventory

Inventory value per share

tot_c_asst

Total current assets per share

tot_c_liab

Total current liabilities per share

beta

Stock return volatility relative to the S&P 500 over the last 60 months (includes dividends)

roe_12m

Return on Equity; 12-month EPS/Book Value per Share

roa_12m

Return on Assets; 12-month EPS/Total Assets per Share

div_yield%

Dividend yield, based on IND AN DIV and PRICE

ttl_lt_dbt

Total Long-term debt quarterly; Debt due more than one year from balance sheet date; long-term debt, convertible debt, non-current capital leases and mortgages

act_eps_q

Diluted quarterly actual EPS before non-recurring items.

act_eps_12

Diluted quarterly actual earnings per share before non- recurring items

sales_12mo

Sales during the last 12 months

12msls/-4q

Last 12 months of sales divided by the last 12 month sales 4 quarters ago

12meps/-4q

Last 12 months of earnings divided by the last 12 month earnings 4 quarters ago

quick_rati

Quick Ratio – Most Recent (Current Assets- Inventory)/Current Liabilities

gdp_growth

Real Gross Domestic Product divided by GDP one quarter ago

Ppi_fin_gds

Producer price Index – Finished Goods Seasonally Adjusted Index

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6

Cpi

Consumer Price Index – All Urban Consumers – Not Seasonally Adjusted

TBond Yield

Yield on Long-term Treasury Bonds

TBill Discount

Discount rate on new issues of 91-day Treasury bills

Prime_Rate

Average prime rate charged by banks

Industry

Zacks industry classification

Table 1. List of all fundamental factors used to estimate stock price via neural network.

We selected this list for a few reasons besides the obvious connection to valuation. First, these items had the highest historical availability for US stocks in the Zacks databases, and the more samples the better. Some of the items are primary and some are expressed as formulas. There are certainly items that are dependent on each other, and even a few that are redundant. We found that neural net training is less likely to become biased if the inputs are chosen in this manner.

At the end of training we can look at what the neural net learned about the relative importance of factors in general, and a bit about how price varies with each factor. It is essential that what the network learns also makes sense. Price should be positively correlated with earnings, cash flow, and book value for instance. Choosing a good set of inputs is important, but data quality and preparation is critical. In the next section we will discuss how training and testing data were prepared.

Data Preparation

The most significant source of bias is due to sector and industry norms. Different types of companies show their worth in different ways. For example, we can’t hope to evaluate utility and tech stocks with the same model, since their business structures are just too different. For this reason we split the data up by

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Zacks economic sector. Twelve years of monthly data samples for 2,547 stocks, were physically divided into sixteen EXCEL spreadsheet files by sector (223,000 facts in all). The Zacks sectors are as follows:

(223,000 facts in all). The Zacks sectors are as follows: Then, within each sector file, columns

Then, within each sector file, columns were inserted and filled with a one or zero binary flag to signify industry membership. In the end, the full impact of sector and industry membership was preserved and this source of bias removed. The following is the complete list of all industry classifications placed within their respective sectors:

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8
9
9
9
10
10

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The trickiest bias to remove was price. Stocks priced less than $1 are simply not valued in quite the same way as those at $100, and what about Berkshire Hathaway which is priced in the tens of thousands of dollars. The proprietary trick we developed to eliminate price bias also had the side benefit of stopping economic bias. Data errors and extreme outliers had to be eliminated also. We used a multiple pass Gaussian filter for this step. Lastly, cycles of optimism and pessimism are also a source of bias. We were careful to balance price trend persistence over the twelve year period in order to deal with this problem.

We were careful to balance price trend persistence over the twelve year period in order to

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Neural Network Background

The NeuroGenetic Optimizer (NGO) software by BioComp Systems, facilitates the creation of artificial neural networks by employing genetic algorithms in order to modify neural net structure. The term neural network could refer to the real life networking of neurons in various biological organisms, but it is used here (and in most cases) to reference the concept of an artificial neural network, which is a model created inside the computer that mimics the most fundamental functions in a biological neural network.

In real world neural networks, it is believed that “learning” takes place when the strength of an axon connection is increased by virtue of its usage. For instance, when a small child is learning how to define a tree, he could be shown a pine tree, and the connections supporting a tree as a tall, green, spiky, thing with brown bark are reinforced and strengthened. As the concept of “tree” evolves, green will be given more weight, and spiky will be given less weight, because, while most trees he is shown are still green, they do not all have spikes (i.e. – a maple tree). This is a real-world example of a neural network, in order for the boy to accurately predict what is and is not considered a “tree”; he must have seen enough examples of different kinds of trees. This way, he can determine the connection between the various characteristics of the tree (independent variables) and whether or not it is a tree (classification output).

This real-world example might be solved with a “classification” neural network. For the young boy’s learning, he had to classify objects as ‘tree’ or ‘not tree’ by looking at the variables that are important. He knew which variables were

important by experience and training with many different sorts of trees. If he had only seen pine trees all his life, and classified them as ‘tree’, then he would not be

sorts of trees. If he had only seen pine trees all his life, and classified them

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able to accept that a palm tree is also a ‘tree’. For this project, the computer was simply asked to learn how corporate fundamentals contribute to stock price, which is a “function approximation” problem.

The NeuroGenetic Optimizer allows the user to train a number of different application types: function approximation, diagnosis, clustering, time series prediction, and classification. Classification neural networks look at examples with multiple outputs or categories, and correlate that to the input data provided. Once a classification net has been properly trained, it will be able to look at a set of data and determine what category it falls into. Neural networks are powerful tools, but nobody has placed biological neurons inside the computer, and they are certainly not comparable to human consciousness, so how exactly is this machine learning achieved?

In order to understand neural networks it is important to understand the ‘hidden layer’ of nodes in between the input and output layers. Input nodes could be compared to the neurons in the eyes, and output nodes could be the neurons leading to the vocal chords where an answer or result is spoken aloud. The hidden layer simulates the set of neurons in between, where both learning and problem solving occur. All the input nodes send information to all the hidden nodes, and all the hidden nodes send data to all the output nodes. Here is a simplified diagram of just such a basic three-layer neural network:

send data to all the output nodes. Here is a simplified diagram of just such a

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Figure 2. Picture provided from Louis Francis’ article “The Basics of Neural Networks Demystified” in

Figure 2. Picture provided from Louis Francis’ article “The Basics of Neural Networks Demystified” in Contingencies magazine, <www.contingencies.org/novdec01/workshop.pdf>

In the diagram, the term “feedforward” simply references the direction of data

flow from input layer to hidden layer to output layer. A quote from the magazine

article from which this diagram was taken goes a long way to summarize the

“learning” that goes on in the hidden layer:

Neural networks “learn” by adjusting the strength of the signal coming from nodes in the previous layer connecting to it. As the neural network better learns how to predict the target value from the input pattern, each of the connections between the input neurons and the hidden or intermediate neurons and between the intermediate neurons and the output neurons increases or decreases in strength… A function called a threshold or activation function modifies the signal coming into the hidden layer nodes… Currently, activation functions are typically sigmoid in shape and can take on any value between 0 and 1 or between -1 and 1, depending on the particular function chosen. The modified signal is then output to the output layer nodes, which also apply activation functions. Thus, the information about the pattern being learned is encoded in the signals carried to and from the nodes. These signals map a relationship between the input nodes (the data) and the output nodes (the dependent variable(s)). (3)

Just as with our analogy of the young boy and the trees, the neural network takes

each independent variable (input) and weights them according to their

importance in discerning the dependent variable(s) (output). The activation

functions that are triggered in each hidden node of the neural network record the

variable(s) (output). The activation functions that are triggered in each hidden node of the neural network

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signal strength and thereby encode the patterns correlating input and output data. In summary, this program “evolves” to a point where it can continually solve similar problems over and over again. These tools are extraordinarily useful, because they can “learn” about how to solve a problem that may be non-linear, such as stock market price estimation.

The trained network is the answer to the problem. If one were to distill the neural network down to a corresponding equation it probably would be pages in length and be too confusing to comprehend. The weights and activation functions of the hidden layer can be viewed by the user, since they are written into the file, but only when each of the weights and interconnections are taken together in their entirety can the pattern be discerned by the neural network. Understanding how and why the chosen variables, the activation functions, and the connection weights interact to produce the correct answer is next to impossible for a human being to discern by simply looking at the net. Neural networks are often referred to as “black box” modeling, because the correlation that’s determined is not easily discernible, but the trained neural network will allow the user to look at “response curves.” These response curves show a graphed correlation between data variables used for input, and allow the user to judge whether or not the neural network has learned about the independent input variables adequately. There will be an elaboration on response curves in the results section.

The last bit of information that is important to know concerns the activation functions. The NGO utilizes three different types of activation functions, which are the functions in the hidden layer that specify the relationship between inputs and outputs. The different types of functions used by the NGO are as follows:

specify the relationship between inputs and outputs. The different types of functions used by the NGO

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1. “Lo”– Logistic Sigmoid

1. “Lo”– Logistic Sigmoid 2. “T” – Hyperbolic Tangent 3. “Li” – Linear

2. “T” – Hyperbolic Tangent

1. “Lo”– Logistic Sigmoid 2. “T” – Hyperbolic Tangent 3. “Li” – Linear

3. “Li” – Linear

1. “Lo”– Logistic Sigmoid 2. “T” – Hyperbolic Tangent 3. “Li” – Linear

Figure 3. Three types of neural network activation functions used by NGO.

These functions adjust during training so that the neural net as a whole can simulate the learning process. Depending on the problem being solved, different combinations of these activation functions will be employed, and the sum of the dynamics of these functions will produce the trained network.

functions will be employed, and the sum of the dynamics of these functions w ill produce

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Neural Net Training Results

Recall from the data preparation discussion that we prepared training and test data containing thousands of facts for all sixteen sectors being considered. Each fact contained a monthly snapshot of our fundamental inputs and the corresponding month-end price as output. The facts were run through NGO directly from EXCEL on a modest 1GHz Pentium IV PC with 512M Ram. It typically took several hours to complete the training and evaluation of each sector net.

A successfully trained network will understand how to interpret new information. In all neural net training runs, some data is held back for testing and additional validation. If the net has not learned anything, and merely memorized its training data, then it will score well when presented with the training data, but poorly when presented with new fresh data. A successfully trained net performs virtually the same on both sets.

The network was presented with test facts to gauge its progress after every training loop. The error criterion chosen for training was r-squared. Low r- squared numbers close to zero signify a poor training result, while high r-squared numbers close to one signify good results. Poor results are also confirmed when the training set has a high r-squared and the test set a low one. This signifies memorization occurred instead of true learning. We were hoping for r-squared results that were consistent and in excess of 0.8. An r-squared of 1.0 means that the predicted stock prices exactly matched the actual prices. We know this is not possible simply because of random noise and other effects that we did not model.

the actual prices. We know this is not possible simply because of random noise and other

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The picture shown below is an actual screenshot of the training run for the Finance sector network. Notice the training and test r-squared results were almost identical at 0.88.

and test r-squared results were almost identical at 0.88. Figure 4. This is a screenshot taken

Figure 4. This is a screenshot taken during training of the finance sector network. Notice how similar the r-squared figure is between the test and training sets.

of the finance sector network. Notice how similar the r-squared figure is be tween the test

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Figure 5. Predicted price for the test set fits the actual results very well. This
Figure 5. Predicted price for the test set fits the actual results very well. This

Figure 5. Predicted price for the test set fits the actual results very well. This indicates the network has learned how to estimate price.

Figures 5 and 6 are actual screenshots of “Predicted vs. Actual” prices from the Finance sector training run. Notice that the quality of fit on the training set is almost identical to the fit on the test set. This indicates that our network is learning instead of memorizing.

set is almost identical to the fit on the test set. This indicates that our network
set is almost identical to the fit on the test set. This indicates that our network

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Figure 6. Predicted price fits the actual training prices, which indicates that the fundamental factors relate strongly to market price.

the fundamental factors relate strongly to market price. Figure 7. This picture shows the predicted vers

Figure 7. This picture shows the predicted versus actual prices we found from the Consumer Staples network training (r-squared = 0.8866):

the Consumer Staples network training (r-squared = 0.8866): Figure 8. This figure shows the network training

Figure 8. This figure shows the network training results for the Utilities sector (r-squared=0.9594).

= 0.8866): Figure 8. This figure shows the network training results for the Ut ilities sector

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Figure 9. Network training results for the Retail/Wholesale sector (r-squared=0.7529) Figure 10. Network training results

Figure 9. Network training results for the Retail/Wholesale sector (r-squared=0.7529)

results for the Retail/Wholesale sector (r-squared=0.7529) Figure 10. Network training results for the Finance sector

Figure 10. Network training results for the Finance sector (r-squared=0.9077)

sector (r-squared=0.7529) Figure 10. Network training results for the Finance sector (r-squared=0.9077) 21

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Figure 11. Network training results for the Medical sector (r-squared=0.7657) Figure 12. Network training results

Figure 11. Network training results for the Medical sector (r-squared=0.7657)

training results for the Medical sector (r-squared=0.7657) Figure 12. Network training results for the 22

Figure

12.

Network

training

results

for

the

sector (r-squared=0.7657) Figure 12. Network training results for the 22 Retail/Wholesale sector (r-squared=0.7529)

22

Retail/Wholesale

sector

(r-squared=0.7529)

A response curve, or “neural response surface”, provides information about how two or more variables relate to one another in the prediction of a particular output. These response curves are generated by isolating one or two of the inputs and changing them over a particular range of values in order to see what relationship the net perceives between the variables and the output. All other inputs are left at average values. At this point a graph is produced so the relationship can be visualized. This tool can be used to show whether or not the connections that the neural network has made between input and output variables make sense.

has made between input and output variables make sense. Figure 13. Does the result make sense?

Figure 13. Does the result make sense? A neural response surface shows the relationship between some inputs and an output.

One such relationship that can be easily verified with response curves is that price should increase as book value and earnings rise. The figure above shows that the network has learned this lesson from all the examples it was fed.

and earnings rise. The figure above shows that the network has learned this lesson from all

23

Another way to analyze the neural net training results is by a sensitivity analysis. This test determines which of the inputs have the most influence on the output, and if they are positively or negatively correlated. Here are the top factors for the Consumer Discretionary sector network:

Causal Variable (Input) Direction ----------------------------- ----------

Pct.Effect Cum.Effect ----------

----------

act_eps_12

Positive

9.07%

9.07%

inc_bnri12

Positive

6.98%

16.05%

book/share

Positive

5.35%

21.40%

payout_ratio

Positive

4.41%

25.80%

Table 2. Top factors effecting price for Consumer Discretionary sector stocks

If a net didn’t train well, it could mean that a few bad facts made the process difficult. It could also mean that the problem has no solution. Our results were excellent in terms of high r-squared numbers, the equivalence of training and test r-squared, and most importantly, the response curves made economic sense. Price did in fact correlate positively with earnings, cash flow, book value, etc.

Sector

R^2

Samples

Trendline

Consumer Staples

.88

16,413

A=0.97P+6.70

Consumer Discretionary

.79

12,943

A=0.98P – 0.68

Retail/Wholesale

.75

21,511

A=0.92P+4.16

Medical

.77

14,321

A=0.97P+0.39

Auto/Tires/Trucks

.90

3,891

A=0.99P+0.95

Basic Materials

.86

13,893

A=0.98P+2.34

Industrial Products

.87

16,935

A=1.00P – 1.09

Construction

.89

8,619

A=0.98P+1.70

Multi-Sector Conglomerates

.93

4,795

A=0.99P+1.08

1.09 Construction .89 8,619 A=0.98P+1.70 Multi-Sector Conglomerates .93 4,795 A=0.99P+1.08 24

24

Computer And Technology

.63

27,991

A=0.97P+0.11

Aerospace

.88

3,387

A=1.00P+0.70

Oils/Energy

.82

11,035

A=0.96P+9.47

Finance

.91

32,000

A=0.99P - 0.22

Utilities

.96

15,567

A=0.99P+0.17

Transportation

.88

6,451

A=0.96P+2.66

Business Services

.75

4,065

A=0.92P+4.66

Table 3. The figure shows the sector r-squared error, number of samples, and best regression trendline found during neural net modeling

The table above contains the r-squared results for all sample facts used during training and testing. It also includes the formula for a best fit regression trendline through the results graph. If the fundamental model could completely explain price, the trendline formula would simply be A (actual price) = P (predicted price). Our results are very close to this result. Slopes were slightly less than 1.0 and most intercepts slightly more than 0, which could be interpreted as slight tendency for predicted to be less than actual price at the lower price end. This effect is canceled by the method we use for constructing a final estimate, since we sample the model numerous times across the whole price spectrum

The sector networks were successfully trained and are now ready to accept fresh corporate data and produce price estimates. No further training is needed, although we expect to retrain every 5 years in order to benefit from the additional data. In later chapters we will explore the monthly processing, distribution, visualization, investment uses, and historical test results for this pricing tool we call Price Wizard TM

visualization, investment uses, and historical test results for this pricing tool we call Price Wizard T

25

Value/Growth Classification Network

Before examining the test results for our equity pricing model, we found the need for one more piece of information. The world of equity management is subject to numerous product divisions based on broad classifications of stocks as “value” or “growth”. We needed to build a neural network that would be able to look at a company’s fundamental data and determine whether it should be classified as a value stock or a growth stock, or maybe somewhere in between. Value stocks are thought to be safer, growing slowly, but having solid intrinsic value and often paying dividends to compensate investors for the slower growth. Growth stocks often do not pay dividends, may have little intrinsic value, but have been growing very fast. It is useful to have a consistent method of classifying stocks as value or growth since it enables us to build asset allocation tools and better evaluate client portfolios.

Training data was taken from the Russell 3000 value and growth indices and the fundamental data from Zacks. Data preparation was the same as for the price network except that all sixteen sector training files were combined into one, with Industry membership replaced by Sector membership. The Russell method includes I/B/E/S earnings estimates in their formula, which Parallax found to be misleading in past studies. We expect that by leaving expectations out of our training, that the classification system produced may even outperform the Russell technique.

expectations out of our training, that the classification system produced may even outperform the Russell technique.

26

Figure 14 – Training statistics for the best Value/Growth neural network found The best network

Figure 14 – Training statistics for the best Value/Growth neural network found

The best network used 16 of the possible 42 inputs for value vs. growth

prediction as follows:

1. book value of common equity per share,

2. trend book value per share growth rate,

3. cash flow per common share,

4. operating margin,

5. pretax margin,

6. inventory value,

7. total current assets per share,

8. total current liabilities per share,

9. beta,

10. return on assets,

11. dividend yield,

12. 12 month sales divided by 12 month sales 4 quarters back,

13. presence in Sector 1 (Consumer Staples),

14. presence in Sector 3 (Retail/Wholesale),

15. presence in Sector 6 (Basic Materials), and

16. presence in Sector 10 (Computers and Technology).

15. presence in Sector 6 (Basic Materials), and 16. presence in Sector 10 (Computers and Technology).

27

Results show that our model was able to match 92% of the Russell classifications without the IBES estimates, which is sufficient for our purposes. Response curves again help us verify that the model makes sense. One such relationship that can be easily verified with a response curve is between book value per share, dividend yield per share, and the value stock designation. Generally when a company has high dividend yield and a high book value then it will be designated as a value stock. However, if the opposite is true, and both the dividend yield and book value are low, then it is more likely going to be listed as a growth stock. Here is a picture of the response surface that shows that the neural network learned to make that distinction.

that the neural network learned to make that distinction. Figure 15 – The response surface showing

Figure 15 – The response surface showing the relationship between dividend yield, book value per share, and the value stock designation.

surface showing the relationship between dividend yield, book value per share, and the value stock designation.

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A few other things can be inferred from the graph as well. For instance, when dividend yield is really high, an increase in the book value will have little effect on the stock being a value stock. If dividend yield is low however, book value has a large impact on the classification. In this way human beings can check the reasoning of the neural network and declare whether it is marred by confusion or has the same common sense perceptions about market variables as an analyst.

The end product of this training is our ability to assign a rank; we call it Value%, to every stock we process. A Value% of 0 means the stock is a growth stock; while a rank of 100 means it is a pure value selection. Value% in between 0 and 100 represents a stock with qualities of both classes.

means it is a pure value selection. Value% in between 0 and 100 represents a stock

29

Beta Predictor Network

Beta is a measure of a stock’s price volatility relative to a chosen benchmark index. It is often calculated in relation to the S&P 500 Index in order to judge whether a security is more or less volatile than the market. A stock with a beta of 1.00 will tend to move higher and lower in tandem with the S&P 500. Securities with a beta greater than 1.00 tend to be more volatile than the S&P 500, and those with betas below 1.00 tend to be less volatile than the underlying index. Securities with betas of zero generally move independently of the overall market. Just as price is dependent on fundamental factors, the volatility of price also is dependent upon fundamental factors. It isn’t hard to imagine that a company with high debt and poor earnings might be subject to bigger price swings than a company that is on a more solid financial footing. Our goal was to train a neural network to predict beta to the S&P 500 and beta to corresponding sector indices. Zacks provides us with a 60-month beta to the S&P 500 which includes dividends. We have added sector betas using Zacks sixteen sectors.

As in the pricing network, we used all the data items in Table 1 except beta, to train the sixteen sector nets. Response curves help us verify that the model makes sense. One such relationship that can be easily verified with a response curve is between current ratio and predicted beta. The current ratio is the ratio of current assets over current liabilities, which measures the company’s liquidity. The lower the current ratio, the less liquid and the higher we might expect beta to become. Here is a picture of the response surface that shows that the neural network learned to make that distinction.

Here is a picture of the respon se surface that show s that the neural network

30

Figure 15 – The response surface showing the relationship between current ratio and beta to

Figure 15 – The response surface showing the relationship between current ratio and beta to the s&p 500.

The next two pictures show the predicted versus actual betas for the consumer staples sector after training.

500. The next two pictures show the predicted versus actual betas for the consumer staples sector

31

32
32
32

32

The end product of this training is our ability to assign a predicted beta to the S&P 500 as well as a predicted beta to each corresponding sector. The following table lists the r-squared results from training each sector and the number of samples used for training. Note that as expected it is easier to predict betas to the sector than to the S&P 500:

 

S&P500

Sector

 

Sector

5YrBeta

2

R

1YrBeta

2

R

Samples

Consumer Staples

0.68

0.83

8645

Consumer Discretionary

0.71

0.63

6207

Retail/Wholesale

0.59

0.69

12159

Medical

0.56

0.86

7839

Auto/Tires/Trucks

0.83

0.98

2037

Basic Materials

0.50

0.75

6591

Industrial Products

0.68

0.76

7593

Construction

0.78

0.80

4535

Multi-Sector Conglomerates

0.79

0.85

2627

Computer And Technology

0.54

0.73

15170

Aerospace

0.67

0.81

2001

Oils/Energy

0.64

0.81

6249

Finance

0.61

0.72

18319

Utilities

0.50

0.66

7939

Transportation

0.68

0.78

3521

Business Services

0.38

0.74

1929

0.50 0.66 7939 Transportation 0.68 0.78 3521 Business Services 0.38 0.74 1929 33

33

Chapter

2

EQUITY PRICING MODEL DELIVERY & VISUALIZATION

Model Processing and Delivery

On the third Friday following the last trading day of the month, Zacks sends a custom report file to Parallax that contains the most recent fundamentals for about 8,600 stocks. We chose Zacks because from our experience they have the longest historical databases with the highest quality of any corporate data vendor (see Appendix B). Despite this, only about 3,600 stocks (Aug 2004 count) have all the data required for pricing. Some of the “dropout” is linked to new companies, since we need company records to go back at least 5 years. It seems though, that most of the dropout is due to incomplete SEC filings. We will come back to this topic later in the results section.

The pricing process for each stock is actually quite involved. Numerous price estimates are retrieved from the trained networks by repeatedly splitting the per share data, presenting the artificial data to the net, retrieving the price estimate, and then un-splitting the estimate. If the model is internally consistent and the stock is relatively easy to value, then the price estimates will all be about the same and independent of split factor. In practice, non-linearities and biases that remain in the model can cause scattered or even unstable estimates. We have even noticed cases of “dual” stable solutions that are widely separated in price. Our technique identifies these cases. The benefit of this type of error analysis is that it samples different regions of the valuation model for a single stock. A big error

this type of error analysis is that it samples different regions of the valuation model for

34

also may signal that the stock’s balance sheet is a bit atypical. Negative earnings, cash flow, ROE, etc. can cause low or unstable prices.

We produce price estimates in this manner for all stocks with at least one stable solution. Monthly results are delivered to clients via three products:

1. A monthly database of estimated prices for each stock in an EXCEL spreadsheet format

2. A summary report in EXCEL format containing statistics on various collections of stocks. For example, we list the percentage of large cap stocks that are undervalued, and by what average and median amount.

3. A database file for the TradeStation TM charting program, so that all price estimates can be displayed. This same database also powers our interactive price calculator program called Wizard Explorer TM

Clients are notified monthly by email that these products are available for download. A message such as the following is sent from our operations center in Hawaii:

The August Wizard database is now available in:

ftp://ftp.pfr.com/users/dfrick/private/wiz_mwx/wizdb200408.exe

This is a self-extracting Zip archive that will put the database files into their proper location.

The Wizard spreadsheet and summary report are in:

ftp://ftp.pfr.com/users/dfrick/private/wiz_mwx/wizrep200408.zip

The Wizard spreadsheet and summary report are in: ftp://ftp.pfr.com/users/dfrick/private/wiz_mwx/wizrep200408.zip 35

35

Interactive Price Calculator

The interactive price calculator software we call Wizard Explorer TM , is the simplest way for a client to explore our neural network pricing model. When the calculator appears, enter the stock symbol, month, and year that you wish to examine in the top three boxes and then press the “Get Data” button. All of the fundamental factors will be read from our database and displayed in the edit windows.

The windows with a white background may be edited, including the pulldown list

of industry names. If for instance you want to see what Aetna is worth as an insurance company instead of a health care company, just change the industry before pressing the “Re-Calculate” button at the bottom. This button invokes our neural net model and causes the estimated price to be calculated. The price above this estimate is the month-end price from the prior month, so if you selected August 2004 at the top, the month-end price date would be July 31,

2004.

Sometimes fields display a “N/A” which means that no data was available from Zacks for this field. Just type in an estimate for the missing data and then re- calculate. If all the input data is present and the price estimate is listed as N/A, then you know that a stable solution could not be found. Our database goes back to 1990, but the displayed historical data is split corrected to September 2001 only. We have placed the appropriate split factor in an edit box on the lower right side for splits that have occurred since then.

placed the appropriate split factor in an edit box on the lower right side for splits

36

Enter symbol, month, year, and then press “Get Data” button to bring in fundamental data.
Enter symbol, month,
year, and then press
“Get Data” button to
bring in fundamental
data.

Figure 16. Neural network price calculator for “what-if” exploration. Enter stock information at the top and press “Get Data” to populate the fields below.

“what-if” exploration. Enter stock information at the top and press “Get Data” to populate the fields

37

Edit any of the fields with a white background and re-calculate the estimated price
Edit any of the fields with
a white background and
re-calculate the estimated
price

Figure 17. Edit any of the fields with a white background and recalculate. Compare the actual month end price with our estimated price.

of the fields with a white background and recalculate. Compare the actual month end price with

38

TradeStation TM Historical Graphing

The best way for clients to view our Price Wizard pricing model results is within

the TradeStation charting program from TradeStation Technologies. The graph

below shows our estimated stock valuations in purple for the stock IBM. The

solid purple line is the published record, while the dashed line refers back to the

company quarter from which the data was taken. Additional text is included

which describes the average valuation of the Industry and Sector. In the graph

below we show only valuations from 1998-2000. The text describes IBM on Dec

27, 2002. At that time we estimated it was worth $143.

Dec 27, 2002. At that time we estimated it was worth $143. Notice how over- valued
Notice how over- valued IBM became Price Wizard historical stock price estimates
Notice how over-
valued IBM
became
Price Wizard
historical stock
price estimates

Figure 18. TradeStation display of estimated prices from our neural net model

In TradeStation this feature is an indicator called PFR_Wizard and has the

following inputs:

from our neural net model In TradeStation this feature is an indicator called PFR_Wizard and has

39

INPUT

DESCRIPTION

DEFAULT

NAME

WizText

Prints descriptive text if true

TRUE

CoRepLine

A dashed line is drawn if this is true that leads to the quarter end date upon which the valuation is made

TRUE

DumpFile

Dump valuation data to an ASCII file if True (C:\IBM_Wiz.csv”)

FALSE

Split

Wizard is published once a month, and price is split corrected to the end of the month prior to the published date. If your stock split since publication, then you must change this factor. A 2:1 split requires Split=2.0

1

DBS

Reserved for testing other databases

“Wizard”

Table 4. TradeStation inputs for Parallax indicator PFR_Wizard.

The stock price bubble of the late nineties is best seen in the chart of Cisco Systems.:

late nineties is best seen in the chart of Cisco Systems.: Figure 19. Model prices of

Figure 19. Model prices of Cisco clearly showed the bubble forming

is best seen in the chart of Cisco Systems.: Figure 19. Model prices of Cisco clearly

40

TradeStation TM Aggregate Portfolio Graphing

All of the stocks we price each month are tagged with an industry, sector, market cap, and now a value/growth rank. We can calculate the percentage that they are away from the actual market price and plot histograms of relative valuation for many different collections of stocks. Statistics can be used on these distributions to characterize the collection. For instance, we may choose to look at the relative valuations of large cap finance stocks, or maybe small cap growth stocks. The figure below is a histogram of relative valuation from June of 1996. 55% of all the stocks we priced were under their estimated price at that time.

we priced were under their estimated price at that time. Figure 20. June 1996 relative valuation

Figure 20. June 1996 relative valuation histogram shows 55% of all stocks are undervalued.

price at that time. Figure 20. June 1996 relative valuation histog ram shows 55% of all

41

By March 2001 however, only 25% of stocks were under-valued. What came next was an enormous stock market drop.

What came next was an enormous stock market drop. Figure 21. March 2001 relative valuation histog

Figure 21. March 2001 relative valuation histogram shows 25% of all stocks are undervalued.

stock market drop. Figure 21. March 2001 relative valuation histog ram shows 25% of all stocks

42

The percentage of undervalued stocks is one useful statistic, another is the average amount of that relative valuation histogram, the median and standard deviation may also be important. We will come back to the question of which statistics work best in the testing chapter. As far as visualization is concerned, we have built several tools in TradeStation that plot “percent under-valued” graphs for stock collections by sector (PFR_WizardSector), industry (PFR_WizardIndustry), and any arbitrary list of stock symbols (PFR_WizardList). In the following figures, the size of the “percent undervalued” bar at the bottom of the chart represents the sampling error. Arrows mark extreme readings, which can be used to guide buy and sell decisions.

chart represents the sampling error. Arrows mark extreme readings, which can be used to guide bu

43

Figure 22. The figure shows the bank index and the percentage of stocks that were

Figure 22. The figure shows the bank index and the percentage of stocks that were undervalued in the bank industry over time. The size of the bar represents the sampling error. Arrows mark extreme readings, which can be used to guide buy and sell decisions.

bar represents the sampling error. Arrows mark extreme readings, which can be used to guide buy

44

Figure 23. The figure shows the retail index and the percentage of stocks that were

Figure 23. The figure shows the retail index and the percentage of stocks that were undervalued in that sector over time. The size of the bar represents the sampling error. Arrows mark extreme readings, which can be used to guide buy and sell decisions.

bar repr esents the sampling error. Arrows mark extreme readings, which can be used to guide

45

Figure 24. The figure shows the oil index and the percentage of stocks that were

Figure 24. The figure shows the oil index and the percentage of stocks that were undervalued in the oil sector over time. The size of the bar represents the sampling error. Arrows mark extreme readings, which can be used to guide buy and sell decisions.

bar represents the sampling error. Arrows mark extreme readings, which can be used to guide buy

46

Figure 25. The figure shows the percentage of stocks that make up QQQ (Nasdaq 100)

Figure 25. The figure shows the percentage of stocks that make up QQQ (Nasdaq 100) that are under their fair value.

Figure 25. The figure shows the percentage of stocks that make up QQQ (Nasdaq 100) that

47

EXCEL TM Database and Summary Spreadsheets

The results of our stock pricing model are sent to clients each month in several forms, as was mentioned before. The following picture shows the EXCEL database format for the August 2004 report:

shows the EXCEL database format for the August 2004 report: Table 5. EXCEL spreadsheet containing estimate

Table 5. EXCEL spreadsheet containing estimated prices for all stocks with sufficient data.

The fields listed across the top include symbol, company name, sector name, industry name, market cap, month-end price from the prior month, estimated price (called “netprice”), and the percent change between the month-end price and our estimated price.

estimated price (called “netprice”), and the percent change between the month-end price and our estimated price.

48

Another EXCEL report contains statistics on various collections of stocks. The August 2004 report is shown below. At the top of this report is the statistical analysis of the stocks by common industry. For instance, in the apparel industry, there are 37 stocks, of which 16% are undervalued. The average price is 18% over the actual market price, and the median price is 20% over the market price. Not a very attractive industry. The report looks at sectors, market cap ranges, value versus growth, and industry breakdowns. The next two pages contain pictures created in EXCEL and derived from this August 2004 summary report.

in EXCEL and derived from this August 2004 summary report. Table 6. EXCEL spreadsheet containing valuation

Table 6. EXCEL spreadsheet containing valuation statistics by sector, industry, market cap, and value/growth rank.

Table 6. EXCEL spreadsheet containing valuation st atistics by sector, industry, market cap, and value/growth rank.

49

Figure 26.
Figure 26.
Figure 27.
Figure 27.
Figure 26. Figure 27. 50

50

Figure 28.
Figure 28.

Figure 29.

Figure 28. Figure 29 . 51
Figure 28. Figure 29 . 51

51

Chapter

3

HISTORICAL TESTING

Survivorship and In-Sample Considerations

Historical testing errors are often the undoing of great looking investment management systems. There are four main sources of these errors, all dangerous; curve fitting, clairvoyance, random data errors, and survivorship bias.

We have already discussed curve fitting, although it is called memorization in neural network lingo. It means that a neural net has not really learned anything about the facts presented, but because of the size of the network, it was able to just remember every fact. We have shown that this did not happen in our work. Both the training and test sets scored the same when processed by our networks. An additional memorization test requires we compare how well the networks performed in the “out-of-sample” period versus the “in-sample” period. Our out-of-sample period began in October 2001, so we will examine results before and after that date.

Clairvoyance in our case means that information used to construct historical price estimates was not available on or before the publishing date for those estimates. We have confidence that Zacks data is date consistent, since the databases we used had been carefully vetted over many years.

confidence that Zacks data is date consistent, since the databases we used had been carefully vetted

52

We do know, however, that occasionally corporate data is entered into these databases with a decimal place in the wrong spot. These random errors are worked out of a database over time, but would have been present in real time.

We do need to set some limits for our testing so that data errors are a bit more limited. Toward that end, we have chosen a set of all stocks, sampled monthly, which has a month-end price prior and subsequent to the published valuation report which were above $5.00 a share at the time. We assume that if a stock is found mid-month that it is bought at month end if it is still above $5.00. Further, we have restricted market capitalizations to be above 250 million as of the prior month-end. We are also requiring that the database list an earnings report date. In order to evaluate subsequent performance, we require at least one additional price point within the following 12 months. Performance for missing price periods is interpolated, but never extrapolated. Missing prices for the end of the evaluation period are simply the last known price carried forward. This set of filters produces 350,215 records spanning the date range from Oct-1989 through Aug-2004 (181 months). Out of these, a subset of 193,467 have been priced using our model.

The average 12 month performance of all stocks during the period was 9.23%. We were not able to price every stock because of missing data. The absence of data turns out to be a bit of an advantage however. The 12 month performance of stocks that had valuations was 9.67%, while the average was only 8.69% for the stocks that had none. This means that just having a valuation gives an advantage of 98 basis points over those that didn’t, or 44bp over the set of all stocks, as shown in the graph below (from w1_2.xls):

basis points over those that didn’t, or 44bp over the set of all stocks, as shown

53

Figure 30. This shows the average percentage gain for all stocks, all priced stocks, and

Figure 30. This shows the average percentage gain for all stocks, all priced stocks, and all unpriced stocks during our test period from Oct-1989 to August 2004 (250 million min market cap). Note there is a 44 basis point advantage at 12 months just because the company reported sufficient data to allow pricing.

The next pictures show the average 12 month performance of all priced stocks during the test period that were undervalued by different percentages at the time of hypothetical purchase. The first chart shows the straight average, while the second shows the excess performance above the average. Note that just being undervalued by any amount resulted in a performance gain of 400 basis points.

above the average. Note that just being undervalued by any amount re sulted in a performance

54

Figure 31. This shows the average percentage gain for all priced stocks that were undervalued

Figure 31. This shows the average percentage gain for all priced stocks that were undervalued by some percentage at the time of hypothetical purchase during our test period from Oct-1989 to August 2004 (250 million min market cap). Note there is a 400 basis point advantage at 12 months just by being undervalued by any amount.

min market cap). Note there is a 400 basis point advantage at 12 months just by

55

Figure 32. This shows the 12-month excess average percentage gain in basis points for all

Figure 32. This shows the 12-month excess average percentage gain in basis points for all priced stocks that were undervalued by different percentages at the time of hypothetical purchase during our test period from Oct-1989 to August 2004 (250 million min market cap). Note there appears to be an optimal 12-month performance of 600 basis points achieved by being undervalued by at least 20% at purchase.

to be an optimal 12-month performance of 600 basis points achieved by being undervalued by at

56

Figure 33. This shows the average percentage gain for all priced stocks that were either

Figure 33. This shows the average percentage gain for all priced stocks that were either over or undervalued by some percentage at the time of hypothetical purchase during our test period from Oct-1989 to August 2004 (250 million min market cap).

at the time of hypothetical purchase during our test period from Oct-1989 to August 2004 (250

57

Figure 34. This shows the average percentage gain for all priced stocks that were undervalued

Figure 34. This shows the average percentage gain for all priced stocks that were undervalued by some percentage at the time of hypothetical purchase during our test period from Oct-1989 to August 2004 (5 billion min market cap). Note there is a 325 basis point advantage at 12 months just by being undervalued by any amount. However, large cap stocks more than 40% undervalued performed worse than average at 12 months.

by any amount. However, large cap stocks more than 40% undervalued performed worse than average at

58

Figure 35. This shows the average excess percentage gain by year for all priced stocks

Figure 35. This shows the average excess percentage gain by year for all priced stocks that were undervalued by some percentage at the time of hypothetical purchase during our test period from Oct-1989 to August 2004. Note that during the bubble years of 1998 and 1999, undervalued stocks underperformed the index, while after the bubble in 2000, they soared.

years of 1998 and 1999, undervalued stocks underperformed the index, while after the bubble in 2000,

59

Information Coefficient

Information Coefficient Information Coefficient or IC is an accepted measure of skill for ranking stocks. IC

Information Coefficient or IC is an accepted measure of skill for ranking stocks. IC is calculated as follows: 1) Rank the stocks from best long ideas (forecasted highest return) to best short ideas (forecasted lowest return). 2) Rank the subsequent period actual returns, e.g. one month or 6 month from highest return to lowest return. 3) Calculate the correlation between those 2 series of numbers. The higher the IC, the better is the skill. A good IC is typically in the .05-.06 range, and above .07 is generally considered excellent. IC is a measure of the slope of the graph of forecasted returns compared with actual returns. The weakness of IC is that it’s a linear calculation. Therefore, you could have a high IC, but lower accuracy on the tails of the distribution – best long and short recommendations – or have a low IC, yet with excellent forecast ability on the tails.

– best long and short recommendations – or have a low IC, yet with excellent forecast

60

Figure 36. This shows the average percentage gain per month for all priced stocks, and

Figure 36. This shows the average percentage gain per month for all priced stocks, and undervalued stocks with varying predicted betas, during our test period from Oct-1989 to August 2004 (using a 5 billion minimum market cap). Note that having a predicted beta from 0.8 to 1.2 and being undervalued, performed better than stocks with predicted betas outside of this range.

beta from 0.8 to 1.2 and being undervalued, performed better than stocks with predicted betas outside

61

Predictor Statistical Testing Methods

Parallax has been producing neural-network based financial predictors since 1990 and so it is an integral part of our business to validate these predictors using reliable statistical methods. With each predictor, we need to answer the following set of questions:

1. What price behavior is being predicted?

2. What is the effective duration of the predictor?

3. How statistically significant is the predictor at each time step forward?

4. Is the predictor effective on all time scales?

5. Is the predictor effective on all financial series?

6. What combinations of predictors are the most effective?

The following section is an overview of a simple and reliable statistical method and an 8-year analysis of the Price Wizard predictor. In order to carry out this analysis, it is necessary to measure the price action during the time period immediately following each prediction event. We call this the “post-predictor” or “outrun” period.

time period immediately following each prediction event. We call this the “post-predictor” or “outrun” period. 62

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Post-Predictor Z Scores

We are interested in characterizing the post-predictor time period using a scale- independent method that allows comparisons between financial series. The “Z Score” is the most appropriate measure for this job. A Z-Score is the measure of how many standard deviations price has moved away from its price at the prediction event, assuming that the probability of either an up or down move is random at 50%.

By measuring local volatility at the prediction event, a normal probability distribution can be drawn going forward in time that acts as a roadmap for subsequent price moves. The map is centered at the closing price of the prediction event. Each day the map widens according to normal diffusion velocities, which are proportional to 1/Time, representing the region where the future price is most likely to be found. An example of such a probability map is shown below for the stock Home Depot on Feb 3, 2005:

most likely to be found. An example of such a probability map is shown below for
most likely to be found. An example of such a probability map is shown below for

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Viewed from the side at two time steps, diffusion acts to spread out the region where we might find the stock price as time elapses:

Diffusion causes expected prices to spread out over time
Diffusion causes
expected prices to
spread out over
time

At each time step, there is a larger standard deviation and the same mean. If we represent the actual price achieved at each step in terms of that standard deviation, we produce a series of Z-Scores. For example, if the price at a prediction event is $5, and then moves to $7 on day ten with a standard deviation of $1.60, then the Z-Score on day ten would be (7-5)/1.6 = 1.25. This means that price moved 1.25 standard deviations above the price at the prediction event. Since the standard deviation continues to increase, in order to maintain the same Z, price would have to increase by the same relative amount.

continues to increase, in order to maintain the same Z, price would have to increase by

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If all post-predictor prices for all financial series are converted to Z-Scores, and if

the predictors do not work, and if markets are random, then at every time

step, a histogram of all the Z-Scores would be expected to result in a

“standardized” normal distribution, with mean of zero and a standard deviation

of one N(0,1) as shown below:

zero and a standard deviation of one N(0,1) as shown below: We of course hope that

We of course hope that our predictors actually predict non-random price

behavior, so the degree of deviation from the normal curve is critical. We will use

a Chi-squared test to determine if the distributions are significantly different.

Are Financial Series Random?

We have assumed that price movement is best characterized by a random walk

model, but this might not be the case. There is gathering evidence for other

characteristic distributions such as a Biased Random Walk, Truncated Levy

Flights, or Cauchy distribution. Our solution is to produce a quantitative

background distribution based on randomly selected dates across our entire 3000

solution is to produce a quantitative background distribution based on randomly selected dates across our entire

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day test period, and for all of the 2500 stocks being considered. The figure below shows this background distribution of Z-scores corresponding to random prediction dates, and a normal distribution based on a random walk assumption plotted together. It is clear from this figure that a strict random walk assumption is inappropriate during our 8 year test period. Instead there appears to be a positive return bias.

period. Instead there appears to be a positive return bias. To illustrate this another way, we

To illustrate this another way, we could ask what percentage of buy predictions are winners (Z>0) if the timing is random, and plot this percentage each day following the randomly selected purchase dates. Normally this would be 50%, but since the background distributions is positively biased, the figure below shows the percent winners for randomly selected buys climbs steadily over time. The reverse is of course true for randomly selected sells (mirror image).

selected buys climbs steadily over time. The reverse is of course true for randomly selected sells

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On a weekly scale the effect is even more pronounced, as shown in the next

On a weekly scale the effect is even more pronounced, as shown in the next figure. I guess this could be called the dartboard effect, in that even a random selection of stocks during this period showed a 57% win rate at 30 weeks after purchase, and shorting was decidedly unprofitable.

stocks during this period showed a 57% win rate at 30 weeks after purchase, and shorting

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We will use these curves as benchmarks for our predictors over this test period and

We will use these curves as benchmarks for our predictors over this test period and stock set. In order to have a non-random buy predictor then, we need to see a win rate in excess of 57% at 30 weeks for example, and sells would need a win rate better than 43%.

So far we have examined the background distribution of Z-Scores and the percentage of winners. What we still need to know is how much gain is possible from randomly selected buys and sells, so that each predictor’s excess gain profile can be evaluated. The pictures below show the positively biased background gain performance for randomly selected buys and sells:

The pictures below show the positively biased background gain performance for randomly selected buys and sells:

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Price Wizard™ as a Predictor Price is often out of sync with value, being bid up or down based on future expectations and irrational trend persistence. The Price Wizard model discussed in this paper incorporates all major stores of corporate value, normalized simultaneously for sector, industry, and economic factors. It predicts what price should be, and if it works, then we should be able to detect a significant effect. The figure below shows the Z-Scores 30 weeks following a stock moving to undervalued from overvalued. Note the significant positive bias between the background distribution and the undervalued stock Z distribution. A Chi- squared test is designed for comparing distributions and a p<0.01 constitutes a rejection of our predictor distributions as random. In the case below, p=0, which confirms that these two distributions are indeed statistically different.

as random. In the case below, p=0, which confirms that these two distributions are indeed statistically
as random. In the case below, p=0, which confirms that these two distributions are indeed statistically

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These two graphs show the percentage of winners, daily and weekly, for buys and shorts, which exceed the background “dartboard” rate.

the percentage of winners, daily and weekly, for buys and shorts, which exceed the background “dartboard”
the percentage of winners, daily and weekly, for buys and shorts, which exceed the background “dartboard”
the percentage of winners, daily and weekly, for buys and shorts, which exceed the background “dartboard”

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The next four graphs show the median and average percentage gain, daily and weekly, for longs and shorts, which exceed the background “dartboard” rate.

and average percentage gain, daily and weekly, for longs and shorts, which exceed the background “dartboard”
and average percentage gain, daily and weekly, for longs and shorts, which exceed the background “dartboard”
and average percentage gain, daily and weekly, for longs and shorts, which exceed the background “dartboard”

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Dynamic Price Wizard™ (F% for short) as a Predictor

The knowledge of how much a stock is undervalued or overvalued is of primary

importance, but the rate of change in value and price during the preceding year is

also important. The Dynamic Price Wizard neural net (we call the indicator F%

for short) adds value by capturing these dynamics explicitly. The figure below

shows the Z-Scores 30 weeks following a stock moving to F% greater than a rank

of 90 out of 100. Note the significant positive bias between the background

distribution and the undervalued stock Z distribution.

distribution and the undervalued stock Z distribution. These two graphs show the percentage of winners, daily

These two graphs show the percentage of winners, daily and weekly, for buys and shorts, which exceed the background “dartboard” rate.

the percentage of winners, daily and weekly, for buys and shorts, which exceed the background “dartboard”

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The next two graphs show the median and average percentage gain weekly, for longs and

The next two graphs show the median and average percentage gain weekly, for longs and shorts, which exceed the background “dartboard” rate.

the median and average percentage gain weekly, for longs and shorts, which exceed the background “dartboard”

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