Computers & Operations Research 27 (2000) 1111}1129

Predictable variation and pro"table trading of US equities:

a trading simulation using neural networks
Luvai Motiwalla *, Mahmoud Wahab

Department of Manuf. and MIS, University of Massachussetts, Lowell, One University Avenue, Lowell, MA 01854, USA

Department of Economics and Finance, University of Hartford, 200 Bloomxeld Avenue, West Hartford, CT 06117, USA

Abstract

A switching rule conditioned on out-of-sample one-step-ahead predictions of returns is used to establish

investment positions in either stocks or Treasury bills. The economic signi"cance of any discernible patterns
of predictability is assessed by incorporating transaction costs in the simulated trading strategies. We "nd
that ANN models produce switching signals that could have been exploited by investors in an out-of-sample
context to achieve superior cumulative and risk-adjusted returns when compared to either regression or
a simple buy-and-hold strategy in the market indices. The robustness of these results across a large number of
stock market indices is encouraging.

Scope and purpose

A large body of evidence has accumulated suggesting that stock returns are predictable by means of
publicly available information on a number of "nancial and macroeconomic variables with an important
business cycle component. Previous research has, for the most part, relied on standard statistical techniques
(e.g., regression analysis) with unduly restrictive assumptions presumed to hold in the underlying data-
generating process. This paper reexamines the evidence regarding predictable variation in US stock returns
using both arti"cial neural network (ANN) and regression, and compares simulated trading results obtained
from ANN models with those obtained from regression.  2000 Elsevier Science Ltd. All rights reserved.

Keywords: Neural networks; Investment management; Predictability; Regression

1. Introduction

Developments in the "eld of arti"cial intelligence (AI), expert systems, fuzzy control, and neural
networks have proven useful for "nancial modeling and forecasting. The two basic AI modeling

* Corresponding author. Tel.: #1-978-934-2754; fax: #1-978-934-4034.

E-mail addresses: luvai}motiwalla@uml.edu (L. Motiwalla), wahab@uhavax.hartford.edu (M. Wahab)

0305-0548/00/$ - see front matter  2000 Elsevier Science Ltd. All rights reserved.
PII: S 0 3 0 5 - 0 5 4 8 ( 9 9 ) 0 0 1 4 8 - 3
1112 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

techniques that can be used to support investment decisions are expert systems, which apply
human logic, and arti"cial neural networks (ANN) which mathematically replicate the neural
connections of the human brain [1]. The novelty about neural networks lies in their ability to
model non-linear processes from historical data, with few (if any) a priori assumptions about the
nature of the data generating process. This is particularly helpful in the area of investment
management, where much is assumed and little is known about the nature of the processes driving
changes in asset prices [2].
Investment applications of ANN have utilized machine learning for time-series forecasting,
pattern recognition and data reorganization to produce recommendations that are valuable for
decision making. Applications of ANN to "nancial and investment decision making problems have
been fairly successful [2]. For example, successful applications of neural networks have been
reported in bond rating studies [3], in corporate solvency classi"cations [4], bankruptcy predic-
tions [5], in addition to a wide variety of other applications in the area of investment management
including predicting stock market returns [2,6], and stock selection [7]. In all of these studies,
performance improvements in terms of forecast e$ciency (reliability) range from 5}50% * repres-
enting reductions in forecast error variance when compared to linear parametric approaches such
as regression-based models [8].
The present paper adds to the growing literature on applications of ANN in the Investment
Management area by taking it a step forward. Speci"cally, we are interested not only in modeling
the return behavior of popular US stock market indices using both linear predictability models
such as regression and non-linear models such as ANN, but also, and more importantly, we are
interested in assessing the economic signi"cance of any discernible patterns of predictability in
stock returns as captured by both ANN and regression through the use of simulated trading
strategies while incorporating transaction costs into the trading exercise. Thus our experiment is
a side-by-side comparison of two competing methods: ANN and regression. In either case, the
performance benchmark we use is one of always being in the market (a passive buy-and-hold
strategy). While previous studies may have compared ANN and regression in terms of forecast
e$ciency using error metric such as root-mean-square error, a comparative analysis of forecasting
errors will tell us little about the pro"t-making potential of either forecasting methodology.
Instead, we need to link these forecast to actual decisions and then calculate the resulting pro"ts or
losses for either methodology.
The out-of-sample performance of both ANN and regression is compared along two dimensions:
the "rst concerns directional accuracy, while the second concerns the resultant investment perfor-
mance predicated on the switching signals generated by each technique. Rather than assume
that investors knew that a speci"c forecasting model (with speci"c variables) was going to
perform well, we make the weaker assumption that investors eatablish a base set of potential
forecasting variables thought a priori to have been relevant to forecasting stock returns and, at
each point in time, search for reasonable model speci"cations using both ANN and regression
capable of predicting stock returns across this set. Essentially, this procedure assumes that
investors use only historical information to select a model, and then use the chosen model to make
one-month-ahead predictions of stock returns. The recursive forecasts are employed in a portfolio
switching strategy according to which stocks are bought/held or sold/avoided the following month
depending on whether the predictions generated by each technique call for an up-market or
a down-market.
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1113

However, caution needs to be exercised when following this research strategy. In particular, it is
important that rules for predicting stock returns are formulated without the bene"t of hindsight.
Thus, a clear distinction has to be made between in-sample estimation and out-of-sample forecast-
ing for at least three reasons. First, using the entire sample of observations for purpose of trading is
inappropriate, as, in `real timea, no investor could have obtained parameter estimates based on the
entire sample. Second, an analysis of stock market predictability that focuses on a particular
forecasting model taken as known with certainty over the whole sample period can be criticized on
the basis of ignoring the problem of &model uncertainty' and the impact that this is likely to have on
investors trading strategies. When some forecasting model is used over the whole sample period, it
inevitably raises the possibility that the choice of the model could have been made with the bene"t
of hindsight [9]. Third, if a data set is used more than once for purposes of inference or model
selection then for validation of the chosen speci"cation, reliability of the results may be compro-
mised because of data snooping. Essentially, there is always the possibility that any satisfactory
results obtained may be due to chance rather than to any merit inherent in the model yielding those
results [10]. Our investment strategy takes these considerations into account as we employ
a recursive modeling strategy that assumes both: an unknown model speci"cation and unknown
parameters. Further, the model is developed using a subset of the data, and is tested and simulated
using a distinctly di!erent subset of the data. As pointed out in Sullivan et al. [10], new data is an
e!ective remedy against data snooping. Last but not least, we do not engage in wide-spread data
mining as we focus on the comparative performance of regression versus ANN in the context of
simply two trading rules, thereby reducing the chances of data snooping biases. Nevertheless,
caution is still warranted if the post-smaple data set is not su$ciently long since it is possible that
the results are an artifact of a particular sample period.
The trading exercise considers transaction costs since we are interested in shedding light on
whether or not the predictable components in stock returns are economically exploitable net of
these costs. We expect ANN models to perform better than linear regression models because ANN
models can choose the linear speci"cation as a special case.
With this in mind, we proceed as follows. Section 2 provides a background to the large and
growing literature that documents that stock market returns are predictable. Section 3 over-
views arti"cial neural networks (ANN) and their advantages over regression. Section 4 describes
the data, the ANN and regression modeling strategy, and the trading simulation exercise. Section
5 reports on trading results and their economic signi"cance. Section 6 concludes the paper with
a summary.

2. Background

A growing body of research supports the view that variations in security returns across time are
predictable. Fama and Schwert [11], Keim and Stambaugh [12], Campbell [13], Breen et al. [14],
Ferson [15], Fama and French [16,17] and Schwert [18] to name a few, provide evidence that
stock market returns are predictable by means of publicly available information such as time-series
data on "nancial and macroeconomic variables with an important business cycle component.
Variables identi"ed by these studies to have been statistically important for predicting stock
returns include a variety of interest rates, monetary growth rates, changes in industrial production,
1114 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

and in#ation rates among others. These variables are believed to be suitable proxies for business
conditions, and since they may a!ect both corporate cash#ows and risk, using these variables to
construct a prediction model may produce a reasonable explanatory/forecasting model. Whether
this predictability is a form of market ine$ciency or time-varying risk premia is largely an
unresolved issue. Nevertheless, to the extent that stock market returns are predictable and this
predictability is economically signi"cant net of transaction costs, a portfolio switching strategy
between T. bills and stocks may yield higher (risk-adjusted) returns than obtained by simply being
in the market at all times.
In principle, interest rates are used in discounting future equity cash #ows; hence, they are
believed to vary inversely with future stock returns. Default spreads constructed as the di!erence in
yields on high- and low-quality instruments, and term spreads, constructed as the di!erence in
yields on instruments of identical quality (but di!erent maturity), have long been identi"ed as
important predictors of future stock market returns. Default spreads provide a measure of business
conditions, as they are high when conditions are weak and low when conditions are strong. Future
stock returns have been found to correlate positively with default spreads and changes in industrial
production. Term spreads are measures of future interest rates; they decrease near peaks in
economic activity, and increase near economic troughs. This relation results because short-term
interest rates generally rise faster than long-term interest rates in an expanding economy, and fall
further during a contraction. Empirical evidence suggests that future stock returns are negatively
correlated with term premia and in#ation rates because of the impact that these variables have on
real economic activity. Monetary growth rates a!ect stock market returns through their impact on
interest rates. Thus, stock returns are higher in expansive monetary policy periods (low interest
rates) than in restrictive periods (high interest rates), which suggests that monetary stringency
a!ects investors required returns and, hence, stock prices and realized returns.
The economic interpretation of stock market return predictability is, however, highly controver-
sial with at least three lines of research. Since the variation in realized returns can, in principle, be
decomposed into two components: variation in expected returns, and variation in unexpected
returns, one line of research suggests that the predictable components in stock market returns
re#ect rational variation in expected (required) equilibrium returns due to economic uncertainty. In
this case, predictability of stock returns is, in principle, consistent with an e$cient stock market.
The second line of research takes expected (required) equilibrium returns as constant and regards
predictability of stock returns as evidence of stock market ine$ciency. Accordingly, forecasting
models may be used to actually `timea the market, i.e., predict periods when market returns are
negative, and periods when they are positive, thereby allowing investors to earn abnormal pro"ts.
The third line of research suggests that predictability of stock market returns, on its own, does not
imply market ine$ciency, and can be interpreted only in conjunction with an intertemporal
equilibrium model of the economy. Inevitably, all attempts at interpretation of return predictability
will be model dependent and, hence, inconclusive. Our approach in this paper to evaluating the

 In the Finance literature, an e$cient market is one in whcih it is impossible to construct a trading rule based on
publicly available information that is capable of yielding positive excess pro"ts (discounted at an appropriate risk-
adjusted discount rate). As Jensen [28] puts it: `A market is e$cient with respect to some information set if it is
impossible to make economic pro"ts by trading on the basis of this information seta.
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1115

predictability of stock market returns is by determining if such evidence could have been success-
fully exploited in pro"table investment/trading strategies without drawing any conclusions regard-
ing the source or cause of this predictability.
Many of the above studies utilize regression analysis whereby, stock returns are regressed on one
or more predictor (predetermined) variables. A linear additive relationship is implicitly assumed, as
shown in the following equation:

R "a #b f #b f #2#b f #e , (1)

GR G G R\  R\ GL LR\ GR
where R is the return of index i, f the predetermined factors, b the model parameters or
GR\ GR
loadings, and e the residual returns on index i.
GR
However, there is no a priori reason to believe that the relationship between stock returns and
the predetermined variables should be linear and additive as given in Eq. (1) above. In other words,
it is possible that these remaining price #uctuations e are, to some extent, due to non-linear
GR
processes at work in the market place [2].
Therefore, it may be possible that non-linear models, such as ANN, are able to produce
more reliable predictions and investment decision rules because of their ability to better capture
the data generating process of stock returns, and because of their success in "ltering out more of
the noise components which might otherwise remain when using standard linear parametric
estimators.
The case for non-linear dependencies in the context of "nancial markets can be made by
understanding feedback mechanisms in price movements. In particular, when the price of an asset
becomes too high, self-regulating forces usually drive the price down. If feedback mechanisms are
non-linear, then the correction will not always be proportional to the amount by which the price
deviates from the asset's fair value. It is not unreasonable to expect such non-linear corrections in
the "nancial markets if one is willing to admit that investors and "nancial markets tend to exhibit
waves of overreaction and underreaction to news (good and bad). Furthermore, it is generally
accepted that market imperfections such as taxes, transaction costs, and the timing of information
arrival introduce non-linearities and clustering of price changes [2]. All of these e!ects potentially
make the relation between stock market returns and the predetermined economic and "nancial
variables non-linear rather than linear.
Non-linear models such as neural networks may provide a more reliable method of modeling
asset returns because they make no a priori assumptions about the nature of the relationship
between R and the selected predetermined variables (factors) as in Eq. (1). The ANN approach is
GR
to model returns as a non-linear combination of the variables and the loadings b ∀k"1,2, n.
GI
Having done so, predicted returns and residual returns themselves can be regarded as non-
linear functions of the predetermined factors and the factor loadings. Indeed, there is substantial
evidence that many macro series including stock returns are non-linear. Hinich and Patterson
[19], Scheinkman and LeBaron [20], Renshaw [21], Refenes and Bolland [2] document
non-linearities in stock returns. The latter, for example, report that neural networks signi"cantly
outperform multiple linear regression in out-of-sample forecasting accuracy. Their evidence
supports the view that the relation between economic/"nancial variables and stock index
returns is non-linear even though classical regression analysis fails to spot any obvious non-
linearities.
1116 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

3. Arti5cial neural networks (ANN)

The two popular alternative approaches used in "nancial forecasting are linear regression and
arti"cial neural networks (ANN). Linear regression models have been widely used in business and
"nance. The success of ANN in modeling "nancial data can be partly attributed to the speci"c
characteristics of many "nancial and economic time-series and relationships which, in most cases,
tend to exhibit various forms of non-stationarity (in mean and variance), non-linearity, and
asymmetry. In addition, forecasting of "nancial and economic time-series relies on the use of
historical data which tend to be noisy and irregular which complicates conventional parametric
modeling and estimation.
ANN use a dynamic knowledge base consisting of processing elements (PEs) structured in
a multi-layered network of interconnections. ANN is a non-linear mathematical model mimicking
the neural architecture of the human brain [22]. ANN is modeled through training processes where
the multi-layered perceptron network learns the relationships between the independent (input)
variables and the dependent (output) variable. This training process is continual and, hence, ANN
provides a dynamic learning knowledge base. Backpropagation is currently the most popular
neural network training technique, it may not be the most accurate. Because the gradient search
process proceeds in a point-to-point fashion and is intrinsically local in scope, convergence to local
rather than global minima is a distinct possibility [23]. An alternative to backpropagation is
genetic algorithm. A genetic algorithm's search of the error surface sweeps from one population of
points to another. By searching the parameter space in many directions simultaneously, the
probability of convergence to local optima is greatly reduced. For a more in-depth discussion of
this technique, please refer to Rumelhart [24] and Wasserman [23].
ANN provide several advantages over regression prediction techniques. ANN are not pro-
grammed, like some software packages, but rather are `traineda by exposing the network to
individual examples of the data to be used for predictions or classi"cations. The process is repeated
until the neural network recognizes underlying patterns between inputs (independent variables)
and outputs (dependent variables). In addition, ANN do not require any assumptions for the
underlying data to be forecaste. For example, multi-linear regression requires that the data meet
certain conditions of homoscedasticity (variance) and independence of variables and assumes that
the underlying relationship of the data is linear rather than exponential. Other forecasting
techniques require other assumptions for the data. Therefore, using ANN requires no tests to be
conducted for these assumptions, as other statistical techniques require. Finally, ANN can develop
models from incomplete or imperfect data. In other modeling techniques, missing data is a serious
problem. ANN are able to develop an accurate model with a measure of acceptable fault tolerance,
despite the absence of some of the data. In linear regression, missing data may present serious
problems.

4. Data and modeling approach

We use monthly data on a variety of US stock indices (identifying code in parentheses): Nasdaq
Composite Index (HCCXR), Nasdaq Industrials Index (HCDXR), New York Stock Exchange
Composite Index (NYER), New York Stock Exchange Industrials Index (NYIR), Standards
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1117

& Poor's 100 Index (OEXR), Russell 3000 Index (RUAZR), Russell Large-Cap 1000 Index
(RUIZR), Standard & Poor's 500 Index (SPXR), Standard & Poor's Mid-Cap Index (SNPR),
Value Line Index (VALR), and the Wilshire 5000 Index (WLSR). The selection of these indices is
predicated on their popularity as widely followed barometers of the US stock market. These indices
di!er in terms of breadth of coverage and medium of trading (for example, stock exchange indices
versus over-the-counter indices). Stock Index data are closing values on the last day of each month
over the period from January 1990 to August 1998. The data were obtained from Dial Data Inc.
(a major "nancial data provider on Wall Street).
Returns on these indices are the output variables, and are computed as follows:

R "(P !P #D )/P , (2)

GR GR GR\ GR GR\
where P is the value of the index in month t, P is the value in month t!1, and D is the
GR GR\ GR
dividend on the index in month t. In addition, we collected data on a variety of short- and
long-term interest rates which the literature has identi"ed as systematically linked with stock
market return predictability. Interest rates are measured on the last trading day of each month, and
are computed as the average of bid and ask yields of that month. Interest rates are the input
variables used to model stock index returns. We constructed a variety of default and term spreads
from interest rate levels since the literature suggests that interest rate spreads are more systemati-
cally related to stock market returns than are the levels. A description of the input and output
variables used in this study is contained in Table 1.
In total, we had 11 output variables (corresponding to 11 stock indexes) and 28 input variables
representing a variety of interest rates in levels and in "rst- and second-di!erences, sampled
contemporaneously, on a one-month-lagged basis, and on a two-month-lagged basis with the stock
index data. Our sample period contains a total of 99 non-missing monthly observations for each

Table 1
In-sample and out-of-sample Pearson correlations between realized and predicted returns

Output De"nitions Pearson correlation

variable
Linear regression ANN

In-sample Out-sample In-sample Out-sample

HCCXR Nasdaq Composite Index 0.42 0.41 0.54 0.24

HCDXR Nasdaq Industrial Index 0.43 0.41 0.54 0.03
NYER New York Stock Exchange Composite Index 0.42 0.41 0.56 0.31
NYIR New York Stock Exchange Industrial Index 0.40 0.35 0.24 0.23
OEXR Standards & Poor's 100 Index 0.36 0.34 0.58 0.08
RUAZR Russell 3000 Index 0.45 0.42 0.58 0.31
RUIZR Russel Large-Cap 1000 Index 0.42 0.41 0.56 0.33
SNPR Standards & Poor's Mid-Cap Index 0.38 0.33 0.16 !0.13
VALR Value Line Index 0.38 0.36 0.47 0.11
WLSR Wilshire 5000 Index 0.44 0.42 0.52 0.24
SPXR Standards & Poor's 500 Index 0.50 0.40 0.55 0.33
1118 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

input and output variable (a few observations will be missing by virtue of the needed lagging of
variables). The training period for estimating the model used 66 months of data starting January
1990 to October 1995. The out-of-sample forecast and trading period was from November 1995 to
August 1998 for a total of 33 months.

4.1. Model implementation

ANNs are implemented in a three-stage process. First, decisions must be made as to what the
input variables will be, how many layers and nodes in each layer the network will have, the transfer
function, and other training (or learning) parameters. Next, the network is trained using in-sample
data until the average error between the forecast and actual values is reduced to a minimum
(typically as close to zero as possible). Finally, the trained network is used to forecast with new
out-of-sample data to test whether or not the decisions made in the "rst stage were appropriate.
The development of a neural network may take several iterations until a su$ciently accurate
network model is generated.
The entire data set in our model was imported into a spreadsheet software. A neural network
plug-in application was used to develop the ANN forecasting model. The data set was categorized
into two dimensions: (1) input versus output variables, and (2) in-sample versus out-of-sample
forecast periods. The input (independent) variables from the in-sample data set were used by the
neural net software for training the forecasting model. Once the forecasting model was developed,
we applied it the out-of-sample data set to generate the predicted values for the output variables.
The neural net application automated much of the time-consuming process of manipulation,
selection and pruning of data in building neural network applications. The spreadsheet environ-
ment also provided a ready access to all parameters of the neural network model such as, the
learning algorithm, number of hidden layers (see Fig. 1), and others.

4.2. Data analysis, Transformation and variable selection

Converting the data into a form suitable for constructing an e!ective learning model using ANN
is generally a di$cult and tedious task. However, our plug-in application automated the data
analysis and transformation processes. It provided mechanisms to automatically transform data
into formats suitable for ANN training. In addition, the neural net application performed a variety
of analyses like multiple regression to determine which input variables should be included, and how
it might be transformed to maximize the performance of the model. For example, during the
training process it used a genetic algorithm to "nd good subsets of the full set of input variables
which act in a synergistic manner. Of the 28 input variables, 20 variables were selected as good
predictors; these were used in various combinations throughout the recursive modeling stage. In
the linear regression environment, we rely on backward stepwise regression for dimensionality
reduction. This method starts with all input variables in the model and deletes them one at a time.
The criterion for retention of variables is to select those variables with signi"cant t-statistics. This
allows us to reduce the "nal input variables to a manageable level to create a parsimonious model.

 PREDICT from NeuralWare, Inc.

 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1119

Fig. 1. ANN model for market indices.

The factors selected through stepwise regression are then used in estimating monthly returns. Of
the 28 input variables, stepwise regression selected 4 variables (related to alternative measures of
default spreads) as good predictors. A list of the variables is found in Tables 2a and b along with
a determination of their usage.
The neural net software used for our model provided several sophisticated data transformation
techniques to convert the data to the most suitable form for the learning algorithm such as
continuous, logical, enumerated integer, enumerated string, fuzzy, quintile, and others. We experi-
mented with several of these techniques in an attempt to arrive at the best model speci"cation.
Furthermore, it allows the user to change the model parameters so as to adjust the algorithm
according to some prior beliefs in some model parametrization. In our study, we do not choose this
option, rather, we assume an open-minded investor with no strong prior beliefs in any particular
model.

4.3. Training the neural net

There are several techniques available for training a multi-layer perceptron. Most of them are
either supervised, unsupervised, back propagation, or feed-forward learning algorithms. Back
propagation is most suitable for forecasting-type applications. Back propagation is a method for
assigning responsibility for mismatches to each of the processing elements in the network; this is
achieved by propagating the gradient of the objective function back through the network to the
hidden units. There are two types of learning rules in neural network: an adaptive gradient learning
rule, a form of back propagation, and a Kalman learning rule, applicable to regression-type
problems with a few input variables. We use the adaptive gradient rule because we have a reason-
able large set of input variables, 28 of them, and our data is not noisy; we hardly have any missing
observations. In addition, most of our variables are `calculateda variables created from the `rawa
data. Other learning parameters were 50 line search iterations, line search tolerance of 0.00001,
weight decay of 0.0005 for the hidden layer, and 0.0001 for the output layer. The input function
used is tanh and the output function used is sigmoid.
Training schemes use a "xed number of hidden layers for the neural net. Our neural net software
uses a constructive method known as Cascade Learning for determining a suitable number of
hidden nodes. In this method, invented by Fahlman and Lebiere [25], hidden processing elements
1120 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

Table 2
Variable usage and de"nition

Input De"nitions Usage by Usage by

variables linear ANN
regression

TB3Y 90-day Treasury bill rate Notused Used

TB6Y Six month Treasury bill rate Notused Notused
TB1Y One-year Treasury bill rate Notused Notused
PP3Y One-month Commercial paper rate Used Used
PP6Y 90-day commercial paper rate Notused Notused
TERM3 Spread between yields on long-term US Treasury Notused Used
bonds & three month Treasury bills
TERM6 Spread between yields on long-term US Treasury Notused Used
bonds & six-month Treasury bills
TERM1 Spread between yields on long-term US Treasury Notused Used
bonds & one-year Treasury bills
DEFALT30 Spread between yields on long-term Baa corporate Used Used
bonds & long-term US Treasury bills
DEFALT3 Spread between yields on long-term Baa corporate Notused Used
bonds & 90-day US Treasury bills
DEFALT6 Spread between yields on long-term Baa corporate Notused Used
bonds & six-month US Treasury bills
DEFALT1 Spread between yields on long-term Baa corporate Notused Notused
bonds & US Treasury bills
DEFALTC Spread between yields on long-term Baa corporate Used Used
bonds & AAA-rated corporate bonds
TBDIF63 Spread between yields on six-month Treasury bills Notused Notused
& three-month Treasury bills
MCBYA Yield on long-term AAA-rated corporate bonds Notused Notused
MCBYD Yield on long-term Baa-rated corporate bonds Used Used
LTERM1 One-month lag of TERM1 Notused Used
LTERM3 One-month lag of TERM3 Notused Used
LTERM6 One-month lag of TERM6 Notused Notused
LDEF1 One-month lag of DEFALT1 Notused Used
LDEF3 One-month lag of DEFALT3 Notused Used
LDEF6 One-month lag of DEFALT6 Notused Used
LDEFC One-month lag of DEFALTC Notused Used
LDEF30 One-month lag of DEFALT30 Notused Notused
L2TERM1 Two-month lag of TERM1 Notused Used
L2TERM6 Two-month lag of TERM6 Notused Used
L2DEF1 Two-month lag of spread between yields on Notused Used
long-term Baa corporate bonds & one-year
US Treasury bills
L2BDIF63 Two-month lag of spread between yields Notused Used
on six-month Treasury bills & three-month
Treasury bills

Total Used 4 20
Total Notused 24 8
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1121

(PE) are added one or a few at a time. Also, new hidden layers are connected to both the input layer
and any previously established hidden units; training is stopped when performance on an indepen-
dent test shows no further improvement. We use the cascade learning rule with nine hidden layers.
The best correlation during testing and training was 0.746. Our model uses cascade connections
with weight limit at 40 and a reduction factor of 0.5.

4.4. The recursive modeling approach

Once the best model speci"cation is identi"ed, we use data over the period (t!66, t) to estimate
the model's parameters. The estimated parameters are used in conjunction with the selected best set
of predictors observed at time t to recursively generate predicted values with a "xed window size of
one month. This process allows not only the factor loadings, but also the identity of the factors to
change from one month to the next. Rolling or recursive estimation is one approach that addresses
possible non-stationarities in the data-generating process and is used for both regression and ANN
modeling. As time progresses and historical (in-sample) observations increase, the added informa-
tion is likely to change what is considered the best speci"cation. Hence, with each new month of
data, the search process for the best model is repeated, and new predicted and residual values are
generated in a time-series fashion. This sequential monthly updating and reestimation of the model
is intended to re#ect the learning process of the investor or the changing nature of the underlying
data generating process, or both.
In addition, we also generate residuals of the output variables and use them as alternative signal
indicators for establishing a trading position for the following month. These residuals can be
considered unexpected (or surprise) returns assuming that expected returns can be represented
fairly adequately by the conditional mean.
To "nd out if our recursive models "tted using ANN could have been used to generate higher
pro"ts than those earned by either employing regression-based models or simply following
a buy-and-hold (passive) investment strategy 2, we employ two types of signals. In the "rst,
predicted values from both "tted ANN and regression models are used in a simple switching
strategy to create a market-timing or actively managed return series. In the second, we use residuals
(lagged one month) generated by both ANN and regression models as signals for establishing an
investment position for the next month. In any event, our interest is in the sign and not the
magnitude of the predicted and residual returns. To summarize, the following describes the trading
rules:

Strategy 1 (Based on predicted returns). (1) If Predicted (t, t#1)'0 be fully invested in stocks,
and receive the actual return for the period t#1, i.e., for the subsequent month.
(2) If Predicted (t, t#1)(0 be fully invested in Treasury bills and receive the actual Treasury bill
return for month t#1;

Strategy 2 (Based on lagged residual returns). (1) If Residual (t, t#1)'0, be fully invested in
stocks, and receive the actual return for period t#1, i.e., for the subsequent month.
(2) If Residual (t, t#1)(0 be fully invested in one-month Treasury bills and receive the actual
Treasury bill return for month t#1.
1122 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

Either strategy is predicted on some form of `momentum-stylea investing whereby positive

(expected or unexpected) returns on a stock index in one month are presumed to be followed by
continued positive returns in the following month. A trading strategy which exploits this price
pattern has been found successful in a number of previous studies, albeit, these studies have used
regression-based speci"cations. It is our intent to see if the same results carry through when using
non-linear-type ANN models. In addition, the use of residuals as trading signals is intended as
a hedge against possible non-stationarities in the mean of the predicted returns series. If the
predicted values exhibit mean non-stationarity, the reliability of the corresponding trading signals
may be compromised. A trading strategy based on mean non-stationary predictions may yield
sub-optimal results non necessarily due to the low quality of the predictions, but, rather, due to
problems associated with the statistical properties of the generated series. Using residuals, which
are, essentially, transformations of predicted values (Residual"Actual!Predicted) is tantamount
to a "rst-di!erence transformation used to induce stationarity to otherwise, potentially, non-
stationary series.
For any month when there is a switch in signals, i.e., a change from stock to Treasury bills or vice
versa, we subtract a transaction cost of 0.5% from returns 3. We then compute cumulative returns
for each stock index (i) as follows:
Cum R "P(1#R )!1, ∀t"1,2, 33
GR GR
where P indicates the product of the individual monthly return factors. We do not allow short
selling of assets, nor do we assume that investors can use leverage when investing. Also, in the
absence of a published time-series on transaction costs, we make the simplifying assumption that
these costs are constant over the out-of-sample forecast period, and that they are symmetric with
respect to whether the investor is buying or selling assets.

5. Empirical results

5.1. Evaluating predictive accuracy

One possible approach to evaluating forecasting performance is to investigate whether tradi-

tional measures such as those based on the correlation between actual out-of-sample returns and
their predicted values correlate strongly. However, there is some evidence in the literature
suggesting that traditional measures of forecasting performance such as the correlation (or squared
correlation) between realized out-of-sample returns and predicted returns may not be strongly
related to pro"ts from trading [9].
An alternative approach is to look at measures of directional accuracy (i.e., the proportion of
times that the signs of returns on the market indices are correctly predicted). A distribution-free test
procedure for testing directional accuracy of forecasts has been developed in Pesaran and Timmer-
mann [26] and is utilized herein. This test uses only information on the signs of the predictor and
predicted variables. Furthermore, the stationarity assumption is not required for the test to be
valid.
Let x be the prediction of y formed with respect to the information available at t!1. Suppose
R R
there are n-observations on (y , x ). Under the null hypothesis of predictive failure, a
R R
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1123

non-parametric test of the predictive performance of x for y can be based on the following
R R
standardized test statistic:

P¹"(P!PH)/[var(P)!var(PH)] (3)

which is asymptotically distributed as N(0, 1), P is the proportion of times that the sign of y is
R
correctly predicted and, PH is the expectation of P under the null hypothesis of predictive failure.
It is shown in [21] that PH"P P #(1!P )(1!P ), where P is the proportion of times that
7 6 7 6 6
X '0, P is the proportion of times that > '0. Also note that var(P)"n\PH(1!PH) and
R 7 R
var(PH)"n\(2P!1)P (1!P )#n\(2P !1)P (1!P )#4n\P P (1!P (1!P ).
6 6 6 7 7 7 6 7 6
As noted in Renshaw [21], the last term in var(PH) is asymptotically negligible. Furthermore,
only positive and statistically signi"cant values of the test statistic P¹ provide evidence of market
timing.
In Table 1, we report the Pearson correlations between predicted and realized returns for both
in-sample and out-of-sample periods. As expected, the in-sample correlations exceed in magnitude
their out-of-sample counterparts which may be explained by model uncertainty, parameter uncer-
tainty or both.
Table 3a sheds light on the accuracy of directional forecasts that use the signs of predicted
returns and residual returns from ANN as alternative trading signals. This table shows the number
of months in the out-of-sample forecast period when predicted and subsequently realized returns
had given signs (similar or dissimilar). As shown, using the signs of predicted returns as trading
signals allows an investor to correctly anticipate the sign of the market's following month's return

Table 3

Forecasts generated using lagged predicted returns as trading signal

Realized returns Predicted Residuals

(t, t#1)'0 (t, t#1)(0 Total (t, t#1)'0 (t, t#1)(0 Total

(a) Evaluation of directional forecast accuracy using ANN

(t#1)'0 138 (61.1%) 88 (38.9%) 226 142 (62.8%) 84 (37.2%) 226

(t#1)(0 69 (60%) 46 (40%) 115 77 (67%) 38 (33%) 115
Grand total 341 (100%) 341 (100%)
Overall directional Percent correct 184 (54%) Percent correct 180 (52.8%)
accuracy Percent incorrect 157 (46%) Percent incorrect 161 (47.2%)

(b) Evaluation of directional forecast accuracy using linear regression

(t#1)'0 91 (26.7%) 151 (44.3%) 242 116 (37.1%) 126 (37.1%) 242
(t#1)(0 59 (17.3%) 40 (11.7%) 99 50 (14.3%) 49 (33%) 99
Grand total 341 (100%) 341 (100%)
Overall directional Percent correct 131 (38.4%) Percent correct 165 (48.4%)
accuracy Percent incorrect 210 (61.6%) Percent incorrect 176 (51.6%)
1124 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

in about 61.1% of the cases for an up-market and about 40% of the cases for a down-market.
Overall, ANN predictions help investors to correctly establish an anticipatory market position in
about 54% of the cases. By the same token, using the signs of lagged residual returns as a trading
signals allows an investor to correctly anticipate the market's following month's return in about
62.8% of the cases for an up-market and 33% for a down-market. Overall, the directional forecast
accuracy of ANN models in conjunction with the lagged residuals signal is 52.8%.
As for regression-based signals, the evidence is less encouraging. Using predicted-return signs for
trading signals allows an investor to correctly anticipate the sign of the market's following month's
returns in about 27% of the cases in an up-market and about 12% of the cases in a down market
with an overall predictive accuracy of 38%. When using the residual signs as the basis for trading
signals, we are able to correctly predict the sign of the market's following month returns in about
37% of the cases in an up-market, and about 33% of the cases in a down market, for an overall
predictive accuracy of 48%.
To further gauge the predictive accuracy of our forecasts, we report in Tables 4a and b the P¹
[26] test statistics for directional accuracy based on ANN and regression, respectively. These are
reported for all 11 indices, and for both types of trading signals. The variables in Tables 4a and
b are de"ned as follows:
E P1"proportion of times that the sign of the output variable is correctly predicted when using
predicted returns as trading signal;
E P2"proportion of times that the sign of the output variable is correctly predicted when using
residual returns as trading signal
E Px1"proportion of predicted returns that exceed zero;
E Px2"proportion of residual returns that exceed zero;
E P1H"E(P1)"P P #(1!P )(1!P );
7 6 7 6
E P2H"E(P2)"P P #(1!P )(1!P );
7 6 7 6
E var(P1)"n\P1H*(1!P1H);
E var(P2)"n\P2H*(1!P2H);
E var(P1H)"n\(2P1!1)P (1!P )#n\(2P !1)P (1!P )#4n\P P (1!P )
6 6 6 7 7 6 7 7
(1!P )
6
and where var(P2H) in Tables 4a and b is computed by simply substituting the designation x for

x in the above equation for var(P1H). Finally, the P¹ and P¹ are the Pesaran and Timmermann
  
[19] test statistics computed as follows:
P¹1"(P1!P1H)/[var(P1)!var(P1H)],
P¹2"(P2!P2H)/[var(P2)!var(P2H)],
where the P¹ statistic tests the information content of predicted value-based signals, while the

P¹ statistic tests the same for residual-based signals. For a one-tailed test of the null hypothesis of


 A market index can be considered as tradeable asset as it can be easily replicated by an investor. Indeed, the wide
proliferation of `Index Fundsa attests to the popularity of that particular style of investing notably, `Indexationa. For
virtually all indices, any market index can be reproduced using a limited set of assets whose overall risk and return span
the risk and return space of the underlying index.
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1125

Table 4

Index P1 P2 PH1 PH2 <AR (P1) <AR (P2) <AR (PH1) <AR (PH2) P¹1 P¹2

(a) Test statistic for directional forecast accuracy using ANN

HCCXR 0.65 0.52 0.363 0.363 0.0074 0.0074 0.0014 0.0008 3.703 1.924
HCDXR 0.65 0.45 0.353 0.365 0.0073 0.0074 0.0017 0.0011 3.958 1.070
NYER 0.48 0.52 0.343 0.397 0.0072 0.0077 0.0005 0.0022 1.673 1.657
NYIR 0.58 0.68 0.381 0.308 0.0076 0.0068 0.0050 0.0012 3.913 4.967
OEXR 0.55 0.58 0.331 0.304 0.0071 0.0068 0.0009 0.0004 2.772 3.460
RUAZR 0.48 0.58 0.250 0.360 0.0060 0.0074 0.0007 0.0007 3.166 2.691
RUIZR 0.42 0.48 0.350 0.365 0.0073 0.0074 0.0009 0.0011 0.875 1.442
SNPR 0.42 0.74 0.354 0.413 0.0073 0.0078 0.0050 0.0026 1.381 4.565
VALR 0.68 0.42 0.494 0.372 0.0080 0.0075 0.0012 0.0007 2.246 0.584
WLSR 0.48 0.42 0.237 0.363 0.0058 0.0074 0.0015 0.0016 3.691 0.748
SPXR 0.42 0.55 0.285 0.325 0.0065 0.0070 0.0045 0.0017 3.022 3.073

(b) Test statistic for directional forecast accuracy using linear regression

HCCXR 0.64 0.44 0.681 0.524 0.0064 0.0073 0.0049 0.0004 !0.909 !0.994
HCDXR 0.64 0.50 0.657 0.500 0.0066 0.0074 0.0039 0.0001 !0.199 !0.000
NYER 0.67 0.44 0.707 0.541 0.0061 0.0073 0.0047 0.0004 !0.836 !1.211
NYIR 0.67 0.65 0.679 0.500 0.0064 0.0073 0.0037 0.0008 !0.067 1.818
OEXR 0.67 0.23 0.707 0.278 0.0064 0.0059 0.0046 0.0053 !0.836 !1.788
RUAZR 0.67 0.47 0.707 0.527 0.0060 0.0073 0.0046 0.0007 !0.836 !0.679
RUIZR 0.58 0.59 0.645 0.520 0.0067 0.0074 0.0045 0.0002 !1.208 0.816
SNPR 0.67 0.47 0.707 0.555 0.0060 0.0072 0.0046 0.0005 !0.836 !1.031
VALR 0.67 0.38 0.707 0.574 0.0060 0.0073 0.0046 0.0005 !0.836 !1.599
WLSR 0.53 0.65 0.595 0.491 0.0071 0.0073 0.0030 0.0008 !0.021 !1.932
SPXR 0.56 0.53 0.621 0.491 0.0069 0.0073 0.0046 0.0002 !1.307 !0.451

predictive failure (no market timing), the 5% critical value is 1.64. The P¹ and P¹ test statistics
 
in Table 4a are all positive and exceed the critical value in many cases regardless of the signal used.
The P¹ statistic is signi"cant in 9 out of 11 cases, while the P¹ statistic is signi"cant in 7 of the
 
11 indices. This evidence suggests that ANN may be economically useful tools in investment
management. The evidence reported in Table 4b points to a rather disappointing performance of
regression-based signals. Most of the test statistics are insigni"cant at any reasonable level
regardless of the signal used (predicted values or residuals). However, given the reasonably short
out-of-sample period (about three years), this comparative evidence should interpreted with
caution. Nevertheless, the results are suggestive of the usefulness of neural networks in uncovering
market trends.

5.2. Summary investment performance measures

Tables 5a and b present summary performance measures for all 11 market indices for both ANN
and regression, respectively. Results are reported for the passive (buy-and-hold) strategy and the
Table 5 1126

Index Passive strategy (Buy & Hold) Active trading strategy I Active trading strategy II
(Based on predicted returns) (Based on residual returns)

Cum Risk adj Variance Std Mean Cum. Risk adj Variance Std Mean Cum. Risk adj Variance Std Mean
returns return deviation returns return deviation returns return deviation
(sharp (sharp (sharp
ratio) ratio) ratio)

(a) Out-of-sample summary performance measures using ANN

HCCXR 70.118 0.310 32.364 5.689 2.262 62.306 0.377 23.582 4.001 2.010 103.14 0.790 12.795 3.577 3.327
HCDXR 40.261 0.146 30.060 5.483 1.299 36.834 0.170 18.014 4.045 1.188 96.97 0.864 9.252 3.042 3.128
NYER 60.802 0.398 13.454 3.668 1.961 56.931 0.459 10.274 2.912 1.836 83.49 0.792 7.672 2.770 2.693
NYIR 57.669 0.387 12.361 3.516 1.860 45.802 0.359 7.336 2.725 1.477 79.34 0.788 6.825 2.613 2.559
OEXR 20.797 0.015 122.013 11.046 0.671 18.008 0.026 117.302 3.153 0.581 107.05 0.717 16.956 4.118 3.453
RUAZR 62.187 0.387 15.136 3.891 2.006 59.495 0.463 11.625 3.064 1.919 86.34 0.816 7.842 2.800 2.785
RUIZR 64.252 0.399 15.502 3.937 2.073 58.627 0.459 12.763 3.029 1.891 87.35 0.804 8.307 2.882 2.818
SNPR 56.003 0.332 15.474 3.934 1.807 23.334 0.143 3.918 1.762 0.753 69.75 0.645 7.353 2.712 2.250
VALR 39.196 0.204 14.053 3.749 1.264 41.741 0.325 9.816 2.601 1.346 72.05 0.821 4.942 2.223 2.324
WLSR 61.485 0.333 19.858 4.456 1.983 65.786 0.530 15.763 3.063 2.122 89.56 0.746 10.246 3.201 2.889
SPXR 66.169 0.409 15.990 3.999 2.134 57.544 0.442 13.002 3.069 1.856 92.26 0.870 8.101 2.846 2.976

(b) Out-of-sample summary performance measures using linear regression

HCCXR 70.118 0.310 32.364 5.689 2.262 27.457 0.035 7.766 2.786 0.104 21.659 0.328 29.557 5.436 1.790
HCDXR 40.261 0.146 30.060 5.483 1.299 !8.875 !0.114 26.121 5.110 !0.580 51.262 0.146 33.234 5.765 0.846
NYER 60.802 0.398 13.454 3.668 1.961 35.999 0.136 6.465 2.543 0.351 5.556 0.451 13.826 3.718 1.681
NYIR 57.669 0.387 12.361 3.516 1.860 11.401 0.425 14.733 3.088 1.637 31.687 0.089 6.808 2.609 0.237
OEXR 20.797 0.015 122.013 11.046 0.671 2.309 !0.067 101.47 10.073 !0.677 24.716 0.055 112.976 10.629 0.598
RUAZR 62.187 0.387 15.136 3.891 2.006 35.677 0.128 6.662 2.581 0.336 15.531 0.433 15.240 3.904 1.696
RUIZR 64.252 0.399 15.502 3.937 2.073 39.141 0.164 6.497 2.548 0.423 !3.465 0.455 15.153 3.893 1.777
L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

SNPR 56.003 0.332 15.474 3.934 1.807 10.967 0.057 7.765 2.786 0.164 39.865 0.329 17.222 2.303 1.370
VALR 39.196 0.204 14.053 3.749 1.264 !2.021 !0.047 10.759 3.280 !0.149 9.322 0.213 17.124 4.138 0.889
WLSR 61.485 0.333 19.858 4.456 1.983 34.889 0.057 8.901 2.983 0.176 9.123 0.384 19.464 4.411 1.698
SPXR 66.169 0.409 15.990 3.999 2.134 42.834 0.477 6.569 2.563 0.436 9.544 0.477 15.144 3.891 1.862
 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129 1127

two active strategies based on two alternative signals. Performance measures used are: cumulat-
ive returns (which show compounded total returns), risk-adjusted returns which measure
excess returns per unit of risk (risk de"ned by the standard deviation of returns), mean
returns representing average monthly returns on the indices, and standard deviation and variance
as general measures of risk computed on a monthly basis, all computed over the out-of-sample
period.
The evidence in Table 5a, based on ANN, shows that, whereas a passive buy-and-hold
strategy achieves cumulative returns of between 39.2 and 70.1%, depending on the market
index, the active trading strategies achieve cumulative returns between 18 and 66% (using
predicted returns), and between 69 and 107% using residual returns over the out of sample
period. These latter results are quite impressive, and suggest that a risk-neutral investor inter-
ested only in cumulative returns could have `beatena an indexed (passive) investment
strategy by about 10% per year. For risk-averse investors, reducing risk while maximizing
returns is the more appropriate strategy. This is captured by some measure of risk-adjusted
performance. Once more, a passive (buy-and-hold) strategy yields average monthly risk-
adjusted returns that vary between 0.015 and 0.409%, depending on the market index.
On the other hand, the corresponding ranges are 0.143}0.530% using predicted returns, and
0.645}0.870% using residual returns. Hence, there is substantial value added from employing
ANN-type models. The gain in performance compared to a passive-type strategy is multifold
* quite impressive. On the other hand, Table 5b, based on regression, shows much
lower cumulative returns and risk-adjusted returns, compared to the corresponding "gures in
Table 5a.
These results are also con"rmed by comparing the monthly mean returns and standard
deviation of returns generated using both ANN and regression. First, using ANN, the monthly
mean varies from 0.67 to 2.26% for the passive buy-and-hold strategy. On the other hand, an active
strategy that relies on predicted-return signals, would have yielded a monthly mean return in the
range of 0.58}2.1%, but more impressive gains could have been achieved in monthly mean returns
when using residuals as trading signals. Monthly mean returns range from 2.25 to 3.45%
depending on the index. As for the standard deviation of returns, a passive buy-and-hold invest-
ment strategy would have exposed the investor to substantial monthly risk, whereas the gains in
monthly risk-reduction are considerable through successful (active) market timing strategies as
shown.
Second, using regression, monthly mean returns vary from !0.67% to 0.44% based on
predicted-value signals, from 0.24 to 1.86% using residual-based signals; these are markedly below
the corresponding "gures from a passive buy-and-hold strategy and ANN. The risk pro"les of both
trading strategies are not encouraging either. An investor who relied on regression analysis would
have witnessed a considerably higher risk pro"le compared to a buy-and-hold or ANN-based
market predictions.

 Floor traders have negligible trading costs, while institutional traders face costs of about $0.02 to $0.06 per share.
A cost of $0.06 on a typical $40 stock is a charge on wealth of about 15 basis points (or 0.15%). In the interest of being
conservative, we use 0.50% transaction cost per one way trip (buying or selling).
 The annualized standard deviation can be computed by multiplying the monthly standard deviation by the square
root of 250 (roughly that many trading days per year).
1128 L. Motiwalla, M. Wahab / Computers & Operations Research 27 (2000) 1111}1129

6. Summary and conclusions

Previous studies have shown that stock market returns are predictable by means of publicly
available information on a number of economic and "nancial variables with an important business
cycle component. While earlier investigations have, for the most part, relied only on linear
estimators, this paper reexamines the evidence using both non-linear ANN and linear regression.
The main focus is on comparing the performance of both ANN- and regression-based signals in the
context of anticipatory stock market positions. Investment performance is judged using several
metrics such as: cumulative returns, mean returns, risk-adjusted returns, etc. The evidence suggests
that ANN models are more successful (compared to regression) in providing a good "t to the
data-generating process of stock returns and in issuing pro"table trading signals. A switching rule
conditioned on out-of-sample one-step-ahead ANN predictions produces superior cumulative and
risk-adjusted returns compared to either regression or a passive buy-and-hold strategy. Further,
signi"cant risk-reduction bene"ts are attainable with trading based on these signals as opposed to
not trading. The robustness of the results across many market indices is encouraging; it suggests
that further work on re"ning and "ne tuning the ANN model parameterization, extending the
out-of-sample period as more data becomes available, looking at alternative in-sample and
out-of-sample period combinations, as well as employing White's [10,27] new bootstrap procedure
that allows computation of Reality Check P-values may be a fruitful area of further research.

Acknowledgements

We would like to thank special issue editors: Drs. Gupta & Smith and the anonymous reviewers
for their helpful comments in improving the focus and thrust of this paper.

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Luvai F. Motiwalla is Associate Professor of MIS in the college of Management at the University of Massachusetts,
Lowell. He has a Ph.D. and M.S. in Management Information Systems from the University of Arizona and a B.B.A. from
Penn State University. His areas of interest include application of distance learning, e-commerce, knowledge engineering,
database management, and arti"cial intelligence. He has published articles in several national & international academic
conferences and in several journals including Journal of MIS, Journal of Organization Computing, Information & Manage-
ment among others.
Mahmoud Wahab is Associate Professor of Finance in the Department of Economics, Finance and Insurance at the
University of Hartford. He received his Ph.D. from the George Washington University in 1989. He has published in
numerous mainstream Finance and Economics Journals such as Journal of Futures Markets, The Financial Review, Journal
of Portfolio Management, Journal of International Money and Finance and Applied Economics.