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 WizardTM

Dynamic Price Wizard

ValueNetTM

Beta Predictor

Wizard ExplorerTM
 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 R2 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 IPOs, 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 WizardTM) ................................ 4
The Search for Value................................................................................................... 4
Data Preparation ......................................................................................................... 7
Neural Network Background ..................................................................................12
Neural Net Training Results ....................................................................................17
Value/Growth Classification Network (ValueNetTM).........................................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
Chapter II: Model Delivery & Visualization ................................................................30
Model Processing & Delivery..................................................................................30
Interactive Price Calculator (Wizard ExplorerTM) ................................................32
TradeStationTM Historical Graphing.......................................................................35
TradeStationTM Aggregate Portfolio Graphing .....................................................37
EXCELTM 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

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
 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

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
 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. Stock charting and back testing software program from

TradeStation Securities

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)

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)

vi
 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
1
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 dont always know the form of the solution. Inputs and outputs could
even be related in a non-linear fashion. If you dont 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.

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 analysts
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.

3
 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 stocks 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.
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 corporations 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:

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
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

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 cant 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
7
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:

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:

8
9
10
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.

11
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 boys 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
12
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:

13
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

14
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
thats 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:

15
 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.

16
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.

17
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.

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.

18
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.

19
Figure 6. Predicted price fits the actual training prices, which indicates that the fundamental
factors relate strongly to market price.

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

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

20
Figure 9. Network training results for the Retail/Wholesale sector (r-squared=0.7529)

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

21
 Figure 11. Network training results for the Medical sector (r-squared=0.7657)

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

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.

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 didnt 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

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 WizardTM

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 companys 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.

26
 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).

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.

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

28
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.

29
Beta Predictor Network

Beta is a measure of a stocks 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 isnt 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 companys 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.

30
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.

31
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 1YrBeta Samples
R2 R2
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

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

34
also may signal that the stocks 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 TradeStationTM charting program, so that all price
estimates can be displayed. This same database also powers our
interactive price calculator program called Wizard ExplorerTM

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

35
Interactive Price Calculator

The interactive price calculator software we call Wizard ExplorerTM, 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.

36
 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.

37
 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.

38
TradeStationTM 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.

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:

39
 INPUT DESCRIPTION DEFAULT
NAME
WizText Prints descriptive text if true TRUE
CoRepLine A dashed line is drawn if this is true TRUE
that leads to the quarter end date
upon which the valuation is made
DumpFile Dump valuation data to an ASCII FALSE
file if True (C:\IBM_Wiz.csv)
Split Wizard is published once a month, 1
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
DBS Reserved for testing other Wizard
databases
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.:

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

40
TradeStationTM 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.

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

41
By March 2001 however, only 25% of stocks were under-valued. What came
next was an enormous stock market drop.

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

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.

43
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.

44
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.

45
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.

46
Figure 25. The figure shows the percentage of stocks that make up QQQ (Nasdaq 100) that are
under their fair value.

47
EXCELTM 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:

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.

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.

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

49
 Figure 26.

Figure 27.

50
Figure 28.

Figure 29.

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.

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 didnt, or 44bp over the set of all
stocks, as shown in the graph below (from w1_2.xls):

53
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.

54
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.

55
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.

56
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).

57
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.

58
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.

59
Information Coefficient

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 its 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.

60
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.

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.

62
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:

63
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

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.

64
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:

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
65
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.

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).

66
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.

67
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 predictors excess gain profile
can be evaluated. The pictures below show the positively biased background gain
performance for randomly selected buys and sells:

68
69
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.

70
These two graphs show the percentage of winners, daily and weekly, for buys and
shorts, which exceed the background dartboard rate.

71
The next four graphs show the median and average percentage gain, daily and
weekly, for longs and shorts, which exceed the background dartboard rate.

72
73
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.

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

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

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