Stock market prediction

Stock market prediction is the act of trying to determine the future value of a company stock or other financial instrument traded on an exchange. The successful prediction of a stock's future price could yield significant profit. The efficient-market hypothesis suggests that stock prices reflect all currently available information and any price changes that are not based on newly revealed information thus are inherently unpredictable. Others disagree and those with this viewpoint possess myriad methods and technologies which purportedly allow them to gain future price information.

The Efficient Markets Hypothesis and the random walk

The efficient market hypothesis posits that stock prices are a function of information and rational expectations, and that newly revealed information about a company's prospects is almost immediately reflected in the current stock price. This would imply that all publicly known information about a company, which obviously includes its price history, would already be reflected in the current price of the stock. Accordingly, changes in the stock price reflect release of new information, changes in the market generally, or random movements around the value that reflects the existing information set. Burton Malkiel, in his influential 1973 work A Random Walk Down Wall Street, claimed that stock prices could therefore not be accurately predicted by looking at price history. As a result, Malkiel argued, stock prices are best described by a statistical process called a "random walk" meaning each day's deviations from the central value are random and unpredictable. This led Malkiel to conclude that paying financial services persons to predict the market actually hurt, rather than helped, net portfolio return. A number of empirical tests support the notion that the theory applies generally, as most portfolios managed by professional stock predictors do not outperform the market average return after accounting for the managers' fees.

While the efficient market hypothesis finds favor among financial academics, its critics point to instances in which actual market experience differs from the prediction-of-unpredictability the hypothesis implies. A large industry has grown up around the implication proposition that some analysts can predict stocks better than others; ironically that would be impossible under the Efficient Markets Hypothesis if the stock prediction industry did not offer something its customers believed to be of value.

Even one of the most famous and successful investors, Warren Buffett, rebutted the Efficient Market Hypothesis in 1984 during his speech at Columbia University.

Intrinsic value

Intrinsic value (true value) is the perceived or calculated value of a company, including tangible and intangible factors, using fundamental analysis. It's also frequently called fundamental value. It is used for comparison with the company's market value and finding out whether the company is undervalued on the stock market or not. When calculating it, the investor looks at both the qualitative and quantitative aspects of the business. It is ordinarily calculated by summing the discounted future income generated by the asset to obtain the present value.

Prediction methods

Prediction methodologies fall into three broad categories which can (and often do) overlap. They are fundamental analysis, technical analysis (charting) and technological methods.

Fundamental analysis

Fundamental analysts are concerned with the company that underlies the stock itself. They evaluate a company's past performance as well as the credibility of its accounts. Many performance ratios are created that aid the fundamental analyst with assessing the validity of a stock, such as the P/E ratio. Warren Buffett is perhaps the most famous of all fundamental analysts. He uses the overall market capitalization-to-GDP ratio to indicate relative value of the stock market in general, hence this ratio has become known as the "Buffett Indicator".[1][2][3]

What fundamental analysis in stock market is trying to achieve, is finding out the true value of a stock, which then can be compared with the value it is being traded with on stock markets and therefore finding out whether the stock on the market is undervalued or not. Finding out the true value can be done by various methods with basically the same principle. The principle being that a company is worth all of its future profits added together. These future profits also have to be discounted to their present value. This principle goes along well with the theory that a business is all about profits and nothing else.

Contrary to technical analysis, fundamental analysis is thought of more as a long-term strategy.

Fundamental analysis is built on the belief that human society needs capital to make progress and if a company operates well, it should be rewarded with additional capital and result in a surge in stock price. Fundamental analysis is widely used by fund managers as it is the most reasonable, objective and made from publicly available information like financial statement analysis.

Another meaning of fundamental analysis is beyond bottom-up company analysis, it refers to top-down analysis from first analyzing the global economy, followed by country analysis and then sector analysis, and finally the company level analysis.

Technical analysis

Technical analysts or chartists are not concerned with any of the company's fundamentals. They seek to determine the future price of a stock based solely on the trends of the past price (a form of time series analysis). Numerous patterns are employed such as the head and shoulders or cup and saucer. Alongside the patterns, techniques are used such as the exponential moving average (EMA), oscillators, support and resistance levels or momentum and volume indicators. Candle stick patterns, believed to have been first developed by Japanese rice merchants, are nowadays widely used by technical analysts. Technical analysis is rather used for short-term strategies, than the long-term ones. And therefore, it is far more prevalent in commodities and forex markets where traders focus on short-term price movements. There are some basic assumptions used in this analysis, first being that everything significant about a company is already priced into the stock, other being that the price moves in trends and lastly that history (of prices) tends to repeat itself which is mainly because of the market psychology.

Machine learning

With the advent of the digital computer, stock market prediction has since moved into the technological realm. The most prominent technique involves the use of artificial neural networks (ANNs) and Genetic Algorithms(GA). Scholars found bacterial chemotaxis optimization method may perform better than GA.[4] ANNs can be thought of as mathematical function approximators. The most common form of ANN in use for stock market prediction is the feed forward network utilizing the backward propagation of errors algorithm to update the network weights. These networks are commonly referred to as Backpropagation networks. Another form of ANN that is more appropriate for stock prediction is the time recurrent neural network (RNN) or time delay neural network (TDNN). Examples of RNN and TDNN are the Elman, Jordan, and Elman-Jordan networks. (See the Elman And Jordan Networks.)

For stock prediction with ANNs, there are usually two approaches taken for forecasting different time horizons: independent and joint. The independent approach employs a single ANN for each time horizon, for example, 1-day, 2-day, or 5-day. The advantage of this approach is that network forecasting error for one horizon won't impact the error for another horizon—since each time horizon is typically a unique problem. The joint approach, however, incorporates multiple time horizons together so that they are determined simultaneously. In this approach, forecasting error for one time horizon may share its error with that of another horizon, which can decrease performance. There are also more parameters required for a joint model, which increases the risk of overfitting.

Of late, the majority of academic research groups studying ANNs for stock forecasting seem to be using an ensemble of independent ANNs methods more frequently, with greater success. An ensemble of ANNs would use low price and time lags to predict future lows, while another network would use lagged highs to predict future highs. The predicted low and high predictions are then used to form stop prices for buying or selling. Outputs from the individual "low" and "high" networks can also be input into a final network that would also incorporate volume, intermarket data or statistical summaries of prices, leading to a final ensemble output that would trigger buying, selling, or market directional change. A major finding with ANNs and stock prediction is that a classification approach (vs. function approximation) using outputs in the form of buy(y=+1) and sell(y=-1) results in better predictive reliability than a quantitative output such as low or high price.[5]

Since NNs require training and can have a large parameter space; it is useful to optimize the network for optimal predictive ability.

Data sources for market prediction

Tobias Preis et al. introduced a method to identify online precursors for stock market moves, using trading strategies based on search volume data provided by Google Trends.[6] Their analysis of Google search volume for 98 terms of varying financial relevance, published in Scientific Reports,[7] suggests that increases in search volume for financially relevant search terms tend to precede large losses in financial markets.[8][9][10][11][12][13][14][15] Out of these terms, three were significant at the 5% level (|z| > 1.96). The best term in the negative direction was "debt", followed by "color".

In a study published in Scientific Reports in 2013,[16] Helen Susannah Moat, Tobias Preis and colleagues demonstrated a link between changes in the number of views of English Wikipedia articles relating to financial topics and subsequent large stock market moves.[17]

The use of Text Mining together with Machine Learning algorithms received more attention in the last years,[18] with the use of textual content from Internet as input to predict price changes in Stocks and other financial markets.

The collective mood of Twitter messages has been linked to stock market performance.[19] The study, however, has been criticized for its methodology.

The activity in stock message boards has been mined in order to predict asset returns.[20] The enterprise headlines from Yahoo! Finance and Google Finance were used as news feeding in a Text mining process, to forecast the Stocks price movements from Dow Jones Industrial Average.[21]

Market mimicry

Using new statistical analysis tools of complexity theory, researchers at the New England Complex Systems Institute (NECSI) performed research on predicting stock market crashes.[22][23][24] It has long been thought that market crashes are triggered by panics that may or may not be justified by external news. This research indicates that it is the internal structure of the market, not external crises, which is primarily responsible for crashes. The number of different stocks that move up or down together were shown to be an indicator of the mimicry within the market, how much investors look to one another for cues. When the mimicry is high, many stocks follow each other's movements - a prime reason for panic to take hold. It was shown that a dramatic increase in market mimicry occurred during the entire year before each market crash of the past 25 years, including the financial crisis of 2007–08.

Time series aspect structuring

Aspect structuring, also referred to as Jacaruso Aspect Structuring (JAS) is a trend forecasting method which has been shown to be valid for anticipating trend changes on various stock market and geopolitical time series datasets.[25] The method addresses the challenge that arises with high dimensional data in which exogenous variables are too numerous or immeasurable to be accounted for and used to make a forecast. The method identifies the single variable of primary influence on the time series, or "primary factor", and observes trend changes that occur during times of decreased significance in the said primary variable. Presumably, trend changes in these instances are instead due to so-called "background factors". Although this method cannot elucidate the multivariate nature of background factors, it can gauge the effects they have on the time-series at a given point in time even without measuring them. This observation can be used to make a forecast.

Notes
  1. "Buffett Indicator: Where Are We with Market Valuations?".
  2. Mislinski, Jill (3 March 2020). "Market Cap to GDP: An Updated Look at the Buffett Valuation Indicator". www.advisorperspectives.com. Archived from the original on 14 March 2020. it is probably the best single measure of where valuations stand at any given moment
  3. "Warren Buffett On The Stock Market What's in the future for investors--another roaring bull market or more upset stomach? Amazingly, the answer may come down to three simple factors. Here, the world's most celebrated investor talks about what really makes the market tick--and whether that ticking should make you nervous. - December 10, 2001". archive.fortune.com. Fortune Magazine. 2001. Archived from the original on 8 March 2020.
  4. Zhang, Y.; Wu, L. (2009). "Stock Market Prediction of S&P 500 via combination of improved BCO Approach and BP Neural Network". Expert Systems with Applications. 36 (5): 8849–8854. doi:10.1016/j.eswa.2008.11.028.
  5. Thawornwong, S, Enke, D. Forecasting Stock Returns with Artificial Neural Networks, Chap. 3. In: Neural Networks in Business Forecasting, Editor: Zhang, G.P. IRM Press, 2004.
  6. Philip Ball (April 26, 2013). "Counting Google searches predicts market movements". Nature. doi:10.1038/nature.2013.12879. Retrieved August 10, 2013.
  7. Tobias Preis, Helen Susannah Moat and H. Eugene Stanley (2013). "Quantifying Trading Behavior in Financial Markets Using Google Trends". Scientific Reports. 3: 1684. doi:10.1038/srep01684. PMC 3635219. PMID 23619126.
  8. Nick Bilton (April 26, 2013). "Google Search Terms Can Predict Stock Market, Study Finds". New York Times. Retrieved August 10, 2013.
  9. Christopher Matthews (April 26, 2013). "Trouble With Your Investment Portfolio? Google It!". TIME Magazine. Retrieved August 10, 2013.
  10. Philip Ball (April 26, 2013). "Counting Google searches predicts market movements". Nature. doi:10.1038/nature.2013.12879. Retrieved August 10, 2013.
  11. Bernhard Warner (April 25, 2013). "'Big Data' Researchers Turn to Google to Beat the Markets". Bloomberg Businessweek. Retrieved August 10, 2013.
  12. Hamish McRae (April 28, 2013). "Hamish McRae: Need a valuable handle on investor sentiment? Google it". The Independent. Retrieved August 10, 2013.
  13. Richard Waters (April 25, 2013). "Google search proves to be new word in stock market prediction". Financial Times. Retrieved August 10, 2013.
  14. David Leinweber (April 26, 2013). "Big Data Gets Bigger: Now Google Trends Can Predict The Market". Forbes. Retrieved August 10, 2013.
  15. Jason Palmer (April 25, 2013). "Google searches predict market moves". BBC. Retrieved August 9, 2013.
  16. Helen Susannah Moat, Chester Curme, Adam Avakian, Dror Y. Kenett, H. Eugene Stanley and Tobias Preis (2013). "Quantifying Wikipedia Usage Patterns Before Stock Market Moves". Scientific Reports. 3: 1801. doi:10.1038/srep01801. PMC 3647164.CS1 maint: multiple names: authors list (link)
  17. "Wikipedia's crystal ball". Financial Times. May 10, 2013. Retrieved August 10, 2013.
  18. Khadjeh Nassirtoussi, Arman; Aghabozorgi, Saeed; Ying Wah, Teh; Ngo, David Chek Ling (2014-11-15). "Text mining for market prediction: A systematic review". Expert Systems with Applications. 41 (16): 7653–7670. doi:10.1016/j.eswa.2014.06.009.
  19. Bollen, Johan; Huina, Mao; Zeng, Xiao-Jun. "Twitter mood predicts the stock market". Cornell University. October 14, 2010. Retrieved November 7, 2013
  20. Ramiro H. Gálvez; Agustín Gravano (2017). "Assessing the usefulness of online message board mining in automatic stock prediction systems". Journal of Computational Science. 19: 1877–7503. doi:10.1016/j.jocs.2017.01.001.
  21. Beckmann, M. (January 24, 2017). Doctoral Thesis: Stock Price Change Prediction Using News Text Mining. COPPE/Federal University of Rio de Janeiro
  22. Harmon D, Lagi M, de Aguiar MAM, Chinellato DD, Braha D, Epstein IR, Bar-Yam Y. (2015). "Anticipating Economic Market Crises Using Measures of Collective Panic." PLoS ONE 10(7): e0131871.doi:10.1371/journal.pone.0131871.
  23. D. Harmon, M. de Aguiar, D. Chinellato, D. Braha, I. Epstein, Y. Bar-Yam. 2011. "Predicting economic market crises using measures of collective panic." arXiv:1102.2620v1. http://necsi.edu/research/economics/economicpanic.html
  24. Brandon Keim. (2011). "Possible Early Warning Sign for Market Crashes." Wired, 03.18.11. https://www.wired.com/2011/03/market-panic-signs/
  25. Jacaruso, Lucas Cassiel (2018-12-08). "A method of trend forecasting for financial and geopolitical data: inferring the effects of unknown exogenous variables". Journal of Big Data. 5 (1): 47. doi:10.1186/s40537-018-0160-5. ISSN 2196-1115.

References
  • Graham, B. The Intelligent Investor HarperCollins; Rev Ed edition, 2003.
  • Lo, A.W. and Mackinlay, A.C. A Non-Random Walk Down Wall Street 5th Ed. Princeton University Press, 2002.
  • Azoff, E.M. Neural Network Time Series Forecasting of Financial Markets John Wiley and Sons Ltd, 1994.
  • Christoffersen, P.F. and F.X. Diebold. Financial asset returns, direction-of-change forecasting, and volatility dynamics. Management Science, 2006. 52(8): p. 1273-1287
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