Empirical evidence of the fractal model of markets offers less explanatory power than the linear models they are supposed to replace.

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Empirical evidence of the fractal model of markets offers less explanatory power than the linear models they are supposed to replace.

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statisticians to discover their hidden pattern. Simple time series analyses

including AR, MA, ARMA, and ARIMA were eventually replaced with more

sophisticated instruments of torture such as spectral analysis. But the data

refused to confess.

researchers that the movements were random. The so called random walk

hypothesis (RWH) of Osborne and others was developed into the efficient

market hypothesis (EMH) by Eugene Fama. The `weak form of the EMH says

that movements in stock returns are independent random events independent of

historical values. The rationale is that if patterns did exist, arbitrageurs would

take advantage and thereby quickly eliminate them.

Both the RWH and the EMH came under immediate attack from market

analysts and this attack continues to this day partly because statistics used in

tests of the EMH are controversial. The null hypothesis states that the market is

efficient. The test then consists of presenting convincing evidence that it is not.

The tests usually fail. Many argue that the failure of these tests represent a Type

II error, that is, a failure to detect a real effect because of low power of the

statistical test employed.

Besides, the methods of analysis assume a normal and linear world that is

difficult to defend. All residuals are assumed to be independent and normally

disrtributed, all relationships are assumed to be linear, and all effects are

assumed to be linearly additive with no interactions. At each point in time the

data are assumed to be taken from identically distributed independent

populations of numbers the other members of which are unobservable.

Econometric models such as ARIMA assume that all dependencies in time are

linear.

It is therefore logical to conjecture that the reason for the failure of statistics to

reject the EMH is due not to the strength of the theory but to the weakness of

the statistics. Many hold that a different and more powerful mathematical

device that allowed for non-linearities to exist might be more successful in

discovering the hidden structure of stock prices.

In the early seventies, it appeared that Catastrophe Theory was just such a

device. It had a seductive ability to model long bull market periods followed by

catastrophic crashes. But it proved to be a mathematical artifact whose

properties could not be generalized. It yielded no secret structure or patterns in

stock prices. The results of other non-EMH models such as the Rational Bubble

theory and the Fads theory are equally unimpressive.

Many economists feel that the mathematics of time series implied by Chaos

Theory is a promising alternative. If time series data are allowed to be non-

linearly dependent, rather than independent as the EMH requires, or linearly

dependent as the AR models require, then much of what appears to be erratic

random behavior or "white noise" may to be part of the deterministic response

of the system. Certain non-linear dynamical system of equations can generate

time series data that appear remarkably similar to the observed stock market

data.

what appears to be a random time series. One technique, attributed to Lorenz,

uses a plot of the data in phase space to detect patterns called strange attractors.

Another method proposed by Takens uses an algorithm to determine the

`correlation dimension' of the data. A low correlation dimension indicates a

deterministic system. A high correlation dimension is indicative of randomness.

The correlation dimension technique has yielded mixed results with stock data.

Halbert, Brock, and others working with daily returns of IBM concluded that

the correlation dimension was sufficiently high to regard the time series as

white noise. However, Schenkmann et al claim that weekly data of IBM returns

have a significant deterministic component. These structures may not be

inconsistent with the EMH if the discovery of the structure, though providing

insight to economic theorists, do not provide arbitrage opportunities.

A third technique for discovering structure in time series data has been

described by Mandelbrot, Hurst, Feder, and most recently by Peters . Called

`rescaled range analysis', or R/S, it is a test for randomness of a series not

unlike the runs test. The test rests on the relationship that in a truly random

series, a serial selection of sub-samples without replacement should produce a

random sampling distribution with a standard deviation given by

obtained by drawing samples without replacement of size n from a population

of size N, and sigma is the standard deviation of the population, i.e., when n=1.

However, when the time series has runs, it can be shown that the exponent of n

in the term `n^0.5', will differ from 0.5. The paper by Peters describes the

following relationships.

where R is the range of subsample sums, S is the standard deviation of the large

sample, and N is the size of the sub-samples . The `H' term is called the Hurst

constant and is equal to 0.5 if no runs exist and the data are sequenced

randomly. If there is a tendency for positive runs, that is increases are more

likely to be followed by increases and decreases are more likely to be followed

by decreases, then H will be greater than 0.5 but less than 1.0. Values of H

between 0 and 0.5 are indicative of negative runs, that is increases are more

likely to be followed by decreases and vice versa. Hurst and Mandelbrot have

found that many natural phenomena previously thought to be random have H-

values around 0.7. These values are indicative of serious departures from

independence.

Once `H' is determined for a time series, the autocorrelation in the time series is

computed as follows:

CN = 2(2H-1) -1

which the elements of the time series are dependent on historical values. The

interpretation of this coefficient used by Peters to challenge the EMH is that it

represents the percentage of the variation in the time series that can be

explained by historical data. The weak form of the EMH would require that this

correlation be zero; i.e., the observations are independent of each other.

Therefore, any evidence of such a correlation can be interpreted as to mean that

the weak form does not hold.

Peters studied 463 monthly returns of the S&P500 index returns, 30-year

government T-bond returns, and the excess of stocks returns over the bond

returns. He found, using R/S analysis, that these time series were not random

but that they contained runs or persistence as evidenced by values of CN

ranging from 16.8% to 24.5%. The correlation estimates indicate that a

significant portion of the returns are determined by past returns. This finding

appears to present a serious challenge to the efficient market hypothesis.

computed R/S for each N. To estimate H he converted his equation 4 to linear

form by taking logarithms to yield

log(R/S) = H * log(N)

and then used OLS linear regression between log(R/S) and log(N). The slope of

the regression is taken to be an unbiased estimate of H. The results are

summarized in Table 1.

TABLE 1

Summary of Results Using Logarithmic Transformations

Constant H CN

Bonds -0.151 0.641 0.215

Premium -0.185 0.658 0.245

of the linear regression parameters raise some questions that require a re-

examination of his results. First, consider the logarithmic conversion.

The OLS regression procedure minimizes the error sum of squares between the

predicted log(R/S) and the observed log(R/S). However, it does not necessarily

follow that the value of H at which the error sum of squares of the log(R/S) is at

a minimum is conincident with the value of H at which the error sum of squares

of R/S is also at a minimum. This is because of the nature of exponential

functions which assures that R/S changes more rapidly at the high end than at

the low end for the same change in log(R/S).

For instance, an error of 0.1 when the ln(R/S) = 4, implies an error in R/S of

about 6 but the same error in logarithms at ln(R/S)=8 carries an error in R/S of

313. To the OLS regression routine working on logarithms, these errors are

equivalent. This means that it would give up an error of 300 on the high end to

gain an error reduction of 6 on the low end.

NHand taking logarithms would yield log(R/S) = log(1) + H * log(N)or,

specifically, since log(1) = 0, we can write log(R/S) = 0 + H * log(N).

This means that to fit the model as stated, the intercept term must be tested

against zero. If the interecept term is significantly different from zero, then the

model must be rejected. In all three regression equations above, the intercept is

negative and significantly different from zero. Therefore, we would expect that

the computed slope is an over-stated estimate of `H.

An Alternative Interpretation

avoided by applying a non-linear least squares fit directly to the model. The

results of such a procedure are so different from those obtained by logarithmic

transformations that the interpretation and conclusion must be re-evaluated.

Table 2 shows the data used by Peters to infer his regression parameters. Figure

1 shows the error sum of squares plotted against values of H. An unbiased

estimator of H is that at which the error sum of squares is at a minimum. These

values of H, shown in Table 3, are significantly different from those shown in

Table 1 and they are closer to 0.5 than previously thought. In particular, the

correlations are much lower; that is, a much lower proportion of the variance in

security returns are determined by runs or persistence. Rather than 16% to

25% , past prices only explain 5% to 13% of returns variance.

TABLE 2

The Data Used in the Regression Models

N R/S

Stocks Bonds Premium

463 31.877 45.050 27.977

230 22.081 21.587 18.806

150 16.795 15.720 15.161

116 12.247 12.805 11.275

75 12.182 10.248 11.626

52 10.121 9.290 8.790

36 7.689 7.711 7.014

25 6.296 5.449 4.958

18 4.454 4.193 4.444

13 3.580 4.471 3.549

6 2.168 2.110 2.209

TABLE 3

Summary of Results Using Non-Linear Regression

Constant H CN

Bonds 0 0.59 .1329

Premium 0 0.54 .0570

Figures 2, 3, and 4. In each case, the non-linear fit follows the data more closely

while the logarithmic fit shows wide dispersions at the high end as expected.

Conclusions

This analysis shows that the amount of variance in returns explained by the

fractal model is very low. It has not been established that the correlation is

significantly different from zero. Even if it were, the low magnitude of the

correlation precludes any conclusions of practical significance either in terms of

arbitrage profits or financial theory.

with regard to behavior of the market and the results may not be considered to

be inconsistent with the efficient market hypothesis.

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