Computers & Operations Research 32 (2005) 2499 – 2512

www.elsevier.com/locate/dsw

A comparison between Fama and French’s model and arti&cial

neural networks in predicting the Chinese stock market
Qing Caoa , Karyl B. Leggioa , Marc J. Schniederjansb;∗
a
Henry W. Bloch School of Business and Public Administration, University of Missouri-Kansas City, Kansas City,
MO 64110-2499, USA
b
College of Business Administration, University of Nebraska-Lincoln, Lincoln, NE 68588-0491, USA

Accepted 29 March 2004

Abstract

Evidence exists that emerging market stock returns are in5uenced by a di6erent set of factors than those
that in5uence the returns for stocks traded in developed countries. This study uses arti&cial neural networks
to predict stock price movement (i.e., price returns) for &rms traded on the Shanghai stock exchange. We
compare the predictive power using linear models from &nancial forecasting literature to the predictive power
of the univariate and multivariate neural network models. Our results show that neural networks outperform
the linear models compared. These results are statistically signi&cant across our sample &rms, and indicate
neural networks are a useful tool for stock price prediction in emerging markets, like China.
? 2004 Elsevier Ltd. All rights reserved.

Keywords: Arti&cial neural networks; Fama and French model; Capital asset pricing model; Stock price prediction;
Comparative analysis; Emerging market; Chinese stock market

1. Introduction

Industry analysts attach importance to the possibility of decoding previously undetected regularities
in asset price movements; &nding these regularities could lead to increased investor wealth. One
methodological possibility for &nding these regularities is with arti&cial neural networks (ANN) [1].
Previous studies applied ANN to stock price returns in the mature markets of the United States. There
is, though little research in that has appeared in the literature on the value of ANN to predict stock
price movement in emerging markets. Harvey [2] found emerging market returns are more likely

∗
Corresponding author. Tel.: +1-402-472-6732; fax: +1-402-472-5855.
E-mail address: mschniederjans1@unl.edu (M.J. Schniederjans).

0305-0548/$ - see front matter ? 2004 Elsevier Ltd. All rights reserved.
doi:10.1016/j.cor.2004.03.015
2500 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512

to be in5uenced by local information than developed markets; in fact, emerging market returns are
generally more predictable than developed market returns. Bhattacharya et al. [3] noted that the
emerging Mexican stock markets did behave di6erently than the US markets. Their research showed
that in the Mexican emerging market, the prevalence of insider trading results is not announced with
public news releases and their e6ect diJcult to capture. This leads to the basic question this paper
seeks to determine; will ANN be able to successfully exploit the ineJciencies and idiosyncrasies in
emerging markets to provide a technology for investors to utilize to earn excess returns?
China’s stock markets have received relatively little attention until recently. Now there is more
interest and research on Chinese market data due to the country’s rapid growth and potential oppor-
tunities for investors. Since the establishment of the Shanghai Stock Exchange (SHSE) in December,
1990, and the Shenzhen Stock Exchange (SZSE) in July, 1991, China’s stock markets have expanded
rapidly. Within 6 years, there were 720 A-share stocks listed in China’s stock markets (372 traded
on SHSE and 348 traded on SZSE) with total market capitalization exceeding $200 billion, or 20%
of the country’s GDP [4]. Conspicuously missing are published literature and research studies of
stock prediction research on China’s stock markets.
The purpose of this study is to demonstrate the accuracy of ANN in predicting stock price move-
ment for &rms traded on the SHSE. As a further demonstration of ANNs accuracy, a comparative
analysis with two other commonly used &nancial forecasting methods will be presented. Speci&cally,
we will compare the capital asset pricing model (CAPM) [5,6] and Fama and French’s 3-factor
model [7,8] to the predictive power of the univariate and multivariate neural network models.
The remainder of this paper is organized into four sections. Section 2 will detail the literature on
the use of ANN in &nancial modeling and the other &nancial models used in the paper. In Section 3
we describe our methodology, data and hypotheses. Section 4 will report the results from the com-
parative analysis. In Section 5 we present our conclusions.

2. Review of literature

The “eJcient market hypothesis” assumes stock prices follow a random walk, in essence leading
to the conclusion that the asset’s future price is completely unpredictable using publicly available
information. Some authors question this random walk hypothesis. Gencay [9,10] found technical
trading rules such as using a moving average are more successful at predicting exchange rates than
a model that assumes exchange rates follow a random walk. The eJcient market hypothesis portends
that pro&table opportunities are fully exploited as soon as they occur and do not, therefore, continue
to exist. Evidence exists that indicates the eJcient market hypothesis is not an accurate description
of the market in the United States. For example, Ja6e et al. [11] found evidence of a size and
earnings yield e6ect. Pesaran and Timmermann [12] reported when market volatility is high, stock
price returns are predictable. Campbell [13] showed that the term structure of interest rates can
be used to predict excess returns for stocks. Lo and MacKinley [14] use variance estimators to
demonstrate the illogic of the random walk model. A study by Darrat and Zhong [15] rejected the
notion that Chinese stock markets followed the random-walk theory. Other studies on Chinese stock
market also showed similar results (e.g., see [16–18]).
In addition, the eJcient market hypothesis failings to support the existence of technical analysis the
hypothesis suggests there should be no value in looking at historic data and variables to try to predict
 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512 2501

stock price movement since no new information is contained in historic data. Yet traders continue
to seek to systematically exploit ineJciencies and deviations in the market to create portfolios with
performance that exceeds market performance. The trick is to identify the ineJciency and exploit it
before it disappears. Seeking to achieve greater levels of accuracy, traders look for new quantitative
forecasting methods to compare to methods currently in use.
There are a variety of methodologies that have appeared in the literature that have been used
to predict stock price movement. Jorion [19] found “implied standard deviation” models are more
valuable in predicting volatility in foreign exchange markets than time series models. Hutchinson
et al. [20] reported learning networks such as multilayer perceptrons are valuable when parametric
methods are unavailable. This is important to this paper since learning enhances the performance
of trading systems. Neural networks are a knowledge acquisition tool [21]. ANNs are designed
to mimic the knowledge-acquisition and organizational skills of the human brain. The network is
taught by presenting sample data as inputs and by varying the weighting factors in the algorithm
that determines the corresponding output states. ANNS accumulate, store, and recognize patterns of
knowledge based on experience, but also retrain as the environment evolves. Results indicate ANNs
have the potential for improving managers’ ability to pick stocks [22].
ANN has also been shown to be a variable tool to discover patterns in the &nancial market,
which can then be used to predict future price movements. As noted by Sharda and Patil [23]
ANN is a promising alternative to time series forecasting. Qi and Maddala [24] found excess return
prediction models are improved by not imposing a linear structure to the model; neural networks
allow predictions based on non-linear models.
ANN has been successfully used in prediction or forecasting studies in all functional areas of
business, including accounting [25], economics [26], &nance [27–34], management information sys-
tems [35], marketing [36], and production management [37]. In one comparative analysis study after
another (see [38–40]) ANN consistently outperformed or is more accurate at predicting or forecast-
ing than other more traditional quantitative methods. In most of these applications, neural networks
outperformed traditional statistical models, such as discriminant and regression analysis [41,42].
Relevant to this paper are the applications of ANN to stock price prediction. Kryzanowski
et al. [22] used ANN with historic accounting and macroeconomic data to identify stocks that will
out-perform the market. McGrath [43] used market to book and price earnings ratios in an ANN
model to rank stocks based on the likelihood that a stock with beat earnings estimates. Ferson and
Harvey [44] and Kimoto et al. [45] used a series of macroeconomic variables to capture predictable
variation in stock price returns. McNelis [46] used the Chilean stock market to predict returns in the
Brazilian markets. As Bhattacharya et al. [3] noted the di6erences in the emerging Mexican stock
markets behave di6erently than the US markets. The prevalence of insider trading, the lack of public
news releases and other items unique issued related to each emerging market, requires the use of
uniquely capable methodologies that can adapt to those di6erences. This paper contends that ANN
may be ideally successful in predicting stock market prices in the emerging markets of China.
Of course, other existing forecasting models might be just as good as ANN and should also be
compared. The traditional linear model used to predict stock price returns is the CAPM proposed
in separate studies by Sharpe [6] and Lintner [5]. CAPM assumes that an asset’s return is a linear
function of the risk of the asset as compared to the market. CAPM says the eJciency of the market
portfolio leads to two implications: expected returns are a positive linear function of market betas
and market betas suJce to describe the cross-section of expected returns. However, an alternative
2502 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512

3-factor model, proposed by Fama and French [7,8] demonstrates &rm size and the book to market
ratio, together with a market factor, is an alternative model to capture the cross-sectional variation
in average stock price returns.
In our paper, we test CAPM and the Fama and French 3-factor model in predicting stock price
returns. We construct a multivariate time-series model, thus placing our forecast models in a richer
context than the prior studies in stock price returns predicting. While there is still debate surrounding
the uncertainty and theoretical foundation of the neural network, Gorr [47] points out that it would
be appropriate to use the neural network approach for multivariate time-series forecasting. Thus, we
expect that by using the neural network method that takes into account the &nancial variables of
both the CAPM and the 3-factor model, considering variables that have been shown to be helpful in
predicting stock price returns in US markets, our research is likely to produce similar evidence on the
superiority of the neural network approach in forecasting stock price returns as results documented
by Fadlalla and Lin [41].

3. Methodology

3.1. Data

This study covers the time period of January 1, 1999 through December 31, 2002. We used
data for 367 public corporations traded on the SHSE. The data consists of daily closing prices,
quarterly book value and common shares outstanding. The source for the closing price data is SinoFin
(www.sino&n.net). Similar to the Center for Research in Security Prices (CRSPJ ) that maintains
premier historical US databases for stock (NASDAQ, AMEX, NYSE), indices, bond, and mutual
fund securities, SinoFin is the Chinese equivalent of CRSPJ . The book value and shares outstanding
data came from a manual review of the data from the annual reports of each &rm. A daily beta
was calculated by regressing the closing price for each stock on the closing price of the SHSE. One
year’s worth of daily closing prices were used, with the betas updated and recalculated daily.

3.2. Methodology

To test the basic research hypotheses on forecasting stock price returns in our paper, we compare
the performance using four model speci&cations. Speci&cally, we construct univariate (CAPM) and
multivariate (3-factor) linear and nonlinear models [49]. The four categories of models are de&ned
below, and are conceptually outlined in Table 1.

3.2.1. Linear models

Category 1: Univariate-linear model: A classic statistical problem is to determine the relationship
between two random variables X and Y . Univariate linear models attempt to explain this relationship
with a straight line &t to the data. The univariate linear model postulates that

Y = a + bX + e; (1)
 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512 2503

Table 1
A two-by-two research designa

Variables Linear models ANN models

Beta UVL (CAPM)b UANNc

Category 1 Category 3

Beta, Cap, and b/m MVL (3 factor)d MANNe

Category 2 Category 4
a
The research design includes four models: two linear models and two neural network models. The univariate models
represent the Capital Asset Pricing Model and the regressed stock price returns on the market returns (beta). The mul-
tivariate models represent the Fama and French 3-factor model. In addition to regressing the stock price returns on the
market return, the two additional dependent variables are the &rm’s market capitalization (cap) and the &rm’s ratio of
book value of equity to market value of equity (b/m).
b
UVL (CAPM)—Univariate Linear ().
c
UANN—Univariate Neural Networks ().
d
MVL (MR)—Multivariate Linear (, cap, and b/m).
e
MANN—Multivariate Neural Networks (, cap, and b/m).

where the “residual” e is a random variable with mean zero and the “slope” a and the “intercept” b
are determined by the condition that the sum of the square residuals is as small as possible. In our
study, the coeJcient for the independent variable X is  or the market risk factor, the independent
variable is the market returns, and the dependent variable depicts the stock price returns.
Category 2: Multivariate-linear model: This category is a multivariate time-series model of stock
price returns using three variables: the market risk factor, the &rm’s market capitalization, and the
book-to-market value of the &rm. In the multivariate linear model, the dependent variable is assumed
to be a linear function of one or more independent variables plus an error introduced to account for
all other factors:
Yi = a1 X1 + · · · + ak Xik + ui : (2)
In the multivariate model in Eq. (2), Yi is the dependent variable, X1 ; : : : ; Xk are the independent or
explanatory variables, and ui is the disturbance or error term. The goal of multivariate analysis is to
obtain estimates of the unknown parameters a1 ; : : : ; ak which indicate how a change in one of the
independent variables a6ects the values taken by the dependent variable.
The multivariate linear model in this study is described as follows
Y = a1 X1 + a2 X2 + a3 X3 + u; (3)
where Y is the stock price returns, X1 the , X2 the market capitalization, cap, X3 the book-to-market
value, b/m, u the disturbance or error term.

3.2.2. Arti:cial Neural Networks (ANN)

An ANN is a parallel distribution processor made up of processing units, which have a natural
propensity for storing experiential knowledge and making that knowledge available for use. Major
bene&ts of ANN include nonlinearity and adaptivity which traditional model-&tting techniques (i.e.,
regression) do not possess. First, ANNs are capable of detecting and extracting nonlinear relationships
2504 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512

x1 Σσ

x2 Σσ
Σ y∧

.
.
.

xn Σσ

Fig. 1. Three-layer feed forward network with one output.

and interactions among predictor variables. Second, ANN’s inferred patterns and associated estimates
of precision do not depend on any assumptions relating to a distribution of the variables. The design
of an ANN is motivated by an analogy with the brain, which is a living proof that fault tolerant
parallel processing is not only physically possible but also fast and powerful.
It has been widely accepted that a three-layer feed forward network (i.e., one type of “multilayer
perceptrons” models).
According to Hornik et al. [48], it is widely accepted that a three-layer feedforward network with
an identify transfer function in the output unit and logistic functions in the middle-layer units can
approximate any continuous functions arbitrarily well, given suJciently many middle-layer units.
Fig. 1 illustrates a three-layer feed forward network with inputs x1 ; : : : ; x n and output ŷ. Each arrow
in the &gure symbolizes a parameter in the network. The network is divided into layers. The input
layer consists of just the inputs to the network. Then, it follows a hidden layer, which consists of any
number of neurons, or hidden units placed in parallel. Each neuron performs a weighted summation
of the inputs, which then passes a nonlinear activation function , also called the neuron function.
Mathematically the functionality of a hidden neuron is described by
 
n
 w j xj + b j  ; (4)
j=1

where the weights {wj ; bj } are symbolized with the arrows feeding into the neuron.
The network output is formed by another weighted summation of the outputs of the neurons in the
hidden layer. This summation on the output is called the output layer. In Fig. 1, there is only one
output in the output layer since it is a single-output problem in this study. Generally, the number of
output neurons equals the number of outputs of the approximation problem.
The output of this network is given by
 
nh
 n
ŷ() = g(; x) = wi2   wi;1 j xj + b1j; i  + b2 ; (5)
i=1 j=1

where n is the number of inputs and nh is the number of neurons in the hidden layer.
 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512 2505

The variables {wi;1 j ; b1j; i ; wi2 ; b2 } are the parameters of the network model that are represented
collectively by the parameter vector . In general, the neural network model will be represented by
the compact notation g(; x).
In training the network, its parameters are adjusted incrementally until the training data satisfy the
desired mapping as well as possible; that is, until ŷ() matches the desired output y as closely as
possible up to a maximum number of iterations.
ANN learning algorithms: A commonly used learning method in ANNs is the backpropagation
algorithm Rumelhart and McClelland [50]. The back propagation algorithm consists of two phases:
the forward phase where the activations are propagated from the input to the output layer and the
backward phase where the error between the observed actual and the requested nominal value in the
output layer are propagated backwards in order to modify the weights and bias values. The standard
backpropagation learning algorithm was introduced by Rumelhart and McClelland [50]. It is the most
common learning algorithm. The backpropagation weight update rule reads as follows:

Zwij = j oi ;


 fj (netj )(tj − oj ) if unit j is an output unit;
j =  (6)
 fj (netj ) kk wjk if unit j is a hidden unit;

where Zwij is the weight changes,  the learning factor eta (a constant), j the error (di6erence
between the real output and the teaching input) of unit j, tj the teaching input of unit j, oi the
output of the preceding unit i, i the index of a predecessor to the current unit j with link wij from
i to j, j the index of the current unit, k the index of a successor to the current unit j with link wjk
from j to k.
This algorithm is also called online backpropagation because it updates the weights after every
training pattern.
In summary, the three-layer feed forward network was selected as the learning algorithm—a
widely accepted learning algorithm for multilayer ANN architecture. The variable parameters of a
three-layer feed forward network include the number of hidden neurons, learning-rate parameter,
and the momentum constant. The criterion used to &nd the optimal variable parameters of the
network is to achieve an acceptable rate of correct classi&cation. Moreover, Calibration was used
to optimize the network by applying the current network to an independent test set during training.
For backpropagation networks, Calibration saves the network at the point where it gives the most
accurate answers for patterns outside the training set. A commercial ANN package (NeuroShellJ )
was employed in this study to created ANN models.
Category 3: Univariate-neural network model: According to de Carvalho [51], any three-layer
feed forward network can use a standard notation as following: n–m–o, where n is the number of
the input, m is the number of neurons in the hidden layer, and o is the number of the output. Thus,
UANN model can be expressed as 1–m–1. The optimal number of hidden neurons of each UANN
model was between 4 and 10 in this study.
Category 4: Multivariate-neural network model: By the same token, MANN model can be shown
as 3–m–1. The optimal number of hidden neurons ranged from 5 to 15.
2506 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512

3.2.3. Forecasting accuracy procedure

While a total of 261 observations are used in ANN model training for each company, we use
80 observations for forecasting the stock returns. We compute the following three error metrics to
measure forecast accuracy in Eqs. (7)–(9):

1 
341
Mean absolute deviation (MAD) = |Yt − Ŷ t |; (7)
80 t=262

1  Yt − Ŷ t
341
Mean absolute percentage error (MAPE) = ; (8)
80 t=262 Yt

2
1 
341
Yt − Ŷ t
Mean squared error (MSE) = ; (9)
80 t=262 Yt

341
(Yt − Ŷ t )2 t=262 (Yt − Ŷ t )2
Standard deviation (SD) = = ; (10)
n−1 79

where Ŷ t is the forecasted value of stock price returns for period t. Observations with a zero-stock
price return are eliminated.
Both MAD and MSE are measures of unbiased-ness of the predictions. The distinctive feature
of MAPE is that the error terms are standardized to facilitate comparisons across variables with
di6erent scales. Standard deviation is used to observe variations.

3.2.4. Hypotheses
To formally demonstrate the accuracy of the models in this study, a number of hypotheses were
developed.
Hypothesis 1 (H1): There is no forecasting accuracy di6erence in linear models and nonlinear ANN
models when Beta, cap, and b/m are present. For purposes of statistical testing, this hypothesis is
subdivided into two parts:

H1a: There will be no forecasting accuracy di6erence in univariate linear and multivariate linear
models when Beta, cap, and b/m are present in the multivariate models.
H1b: There will be no forecasting accuracy di6erence in univariate nonlinear ANN models and
multivariate nonlinear ANN models when Beta, cap, and b/m are present in the multivariate
models.

The H1 hypothesis requires a joint comparison between univariate linear with multivariate linear,
and univariate ANN with multivariate ANN models. We would expect based on prior research that
the movement from CAPM to the 3-factor model will cause an improvement in forecasting accuracy,
resulting in a rejection of the null H1.
 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512 2507

Hypothesis 2 (H2): There is no forecasting accuracy di6erence between linear models and non-
linear ANN models. For purposes of statistical testing, this hypothesis is subdivided into two
parts:

H2a: There will be no forecasting accuracy di6erence between the univariate linear and univariate
ANN models.
H2b: There will be no forecasting accuracy di6erence between multivariate linear and multivariate
nonlinear ANN models.

The H2 hypothesis requires a joint comparison between univariate linear with univariate ANN,
and multivariate linear with multivariate ANN models. We would expect based on prior research that
ANN models will outperform linear models in forecasting accuracy and as such render a rejection
of the null H2.

3.2.5. Hypotheses testing procedure

3.2.5.1. Paired sample t-test: Based on the results of the forecast accuracy statistics, statistical
comparisons using the “paired sample t-test” of four sets of models are carried out in the basic
hypotheses testing design (refer to Table 1). Recall that we test H1 by examining H1a and H1b
separately. For H1a (i.e., whether the inclusion of additional &nancial variables improves the ex-
planatory power of future stock price returns in a univariate linear model versus a multivariate linear
model), we will compare models of Category 1 against 2. For H1b (i.e., whether the inclusion of
additional &nancial variables improves the forecast accuracy for future stock price returns in an uni-
variate nonlinear ANN model versus a multivariate nonlinear ANN model), we will compare models
of Category 3 against 4. To determine the signi&cance of H1a and H1b, we conduct the paired
sample t-test [52] to gauge the di6erences in various stock price returns forecast models. A similar
testing procedure is also used for testing H2.

3.2.5.2. Diebold and Mariano test: However, a conventional t-test may not be a viable approach
in predictive accuracy hypothesis testing given the possible autocorrelation due to the relative
small-samples used in this study [53,54]. Diebold and Mariano [55] developed a test of the di6erence
in MSEs with an asymptotic justi&cation to measure the signi&cance in forecast improvements. In
this study, we examine the performance of the Diebold and Mariano [55] test in choosing forecasting
models, namely, H1 and H2 of the study (for detailed DM test procedure see [55]).

4. Results

4.1. Hypothesis 1

Table 2 reports the averages of the three forecast accuracy measures for all four categories of
forecasting models. Pertaining to H1a, we &nd that all three forecast accuracy measures (MAD,
MAPE, MSE, and SD) of the multivariate linear models in Category 2 (0.0198, 0.6123, 0.5728,
and 0.2223) are consistently higher than the univariate linear models in Category 1 (0.0177, 0.5636,
0.5259, and 0.1724). This implies and we conclude that moving from the CAPM to the 3-factor
2508 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512

Table 2
Comparisons of forecast accuracy measuresa

Overall

MAD MAPE MSE SD

UVL 0.0177 0.5636 0.5259 0.1724

MVL 0.0198 0.6123 0.5728 0.2223
UANN 0.0130 0.3437 0.2951 0.1247
MANN 0.0139 0.4102 0.3964 0.1435
a
A comparison of the mean absolute deviation (MAD), mean absolute percentage error (MAPE), and mean square error
(MSE) for the four categories of models. There are 367 &rms in the study.

model does not result in more accurate forecasts. On the contrary, the forecast accuracy is negatively
a6ected due to the inclusion of other &nancial variables.
A major problem with neural networks is the internal structure makes it diJcult to trace the steps
by which the output is reached. ANNs cannot tell how it processed the inputs to reach the output
conclusions [56]. We therefore, do not know why CAPM is preferred to the 3-factor model. An
explanation may be that the di6erences between established markets and emerging markets reduce
the value of adopting a 3-factor model to explain returns (see, [2,3]). There may be no size e6ect in
this emerging market. Whether this is the reason the CAPM model outperforms the 3-factor model
is unknown; however, it is interesting to note the predictive power of the CAPM is the superior
model in this emerging market. This result, that CAPM is the superior predictive model, warrants
additional study.
A comparison of the univariate and multivariate models when the neural network approach is
used, as suggested by H1b, yields similar results. The multivariate model using the neural network
approach (Category 4) has higher MAD, MAPE, MSE, and SD (0.0139, 0.4102, 0.3964, and 0.1435,
respectively) than those of the univariate model when employing the neural network approach in
Category 3 (0.0130, 0.3437, 0.2951, and 0.1247). The models are consistent: CAPM is the preferred
model for predicting stock prices whether a linear or neural network model is used.
To provide a more formal testing of H1a and H1b we conduct the paired sample t-test to gauge
the statistical signi&cance of the di6erences in the stock price return forecast models. We also apply a
Diebold and Mariano [55] test to detect the potential autocorrelation problem of the t-test. The results
of the tests in Table 3 show a signi&cant di6erence in forecast accuracy across the proposed models.
Table 3, Panel A presents the evidence in testing H1. The paired sample t-scores for comparing
univariate and multivariate models are over 2.0 consistently and the p-values are all under 0.05,
indicating that forecast accuracy varies signi&cantly between forecast models of Category 1 and 2
(the linear models) and between ANN models (Categories 3 and 4).
Table 4 reports the &ndings on the Diebold and Mariano test. Columns 2 and 3 contain the
observed value of the test statistic and the asymptotic p-value, respectively. Panel A shows the results
in testing H1a and H1b and both tests reject the null hypothesis at either 1% level (p-value=0:0043)
or at 5% level (p-value = 0:0251).
In summary, H1 in its null form is rejected. The results are statistically signi&cant in both the
traditional t-test and the Diebold and Mariano test and as such we conclude that the CAPM is a
better predictor of stock price movement than the 3 factor model.
 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512 2509

Table 3
Hypotheses testing—Paired sample t-testa

MAD MAPE MSE

t-score Sig. (2-tailed) t-score Sig. (2-tailed) t-score Sig. (2-tailed)

Panel A: Hypothesis 1
UVL vs. MVL (H1a) 2.9573 0.0000b 3.3196 0.0000b 3.3337 0.0000b
UANN vs. MANN (H1b) 2.2097 0.0033b 3.2882 0.0110c 3.2495 0.0047b

Panel B: Hypothesis 2
UVL vs. UANN (H2a) 5.7471 0.0277c 3.4516 0.0019b 3.5246 0.0031b
MVL vs. MANN (H2b) 6.7597 0.0000b 3.6862 0.0000b 3.6871 0.0000b
a
A comparison of the predictive power of the univariate models to the multivariate models (Panel A) and of the linear
models to the arti&cial neural network models (Panel B).
b
Indicates signi&cance at the 99% level.
c
Indicates signi&cance at the 95% level.

Table 4
Hypotheses testing—Diebold and Mariano testa

MSE

Observation value Asymptotic p-value

Panel A: Hypothesis 1
UVL vs. MVL (H1a) 2.3110 0.0043b
UANN vs. MANN (H1b) 2.1844 0.0251c

Panel B: Hypothesis 2
UVL vs. UANN (H2a) 2.4821 0.0245c
MVL vs. MANN (H2b) 3.1646 0.0019b
a
A comparison of the predictive power of the univariate models to the multivariate models (Panel A) and of the linear
models to the arti&cial neural network models (Panel B).
b
Indicates signi&cance at the 99% level.
c
Indicates signi&cance at the 95% level.

4.2. Hypothesis 2

Pertaining to H1a, we observe that all three forecast accuracy measures (MAD, MAPE, MSE,
and SD) of the univariate ANN models in Category 3 (0.0130, 0.3437, 0.2951, and 0.1247) are
consistently lower than the univariate linear models in Category 1 (0.0177, 0.5636, 0.5259, and
0.1724). This indicates and we conclude that the univariate ANN models outperform the univariate
linear models in terms of forecasting accuracy.
A comparison of the three measures between the multivariate linear and ANN models yields
similar results. The multivariate model using the neural network approach in Category 4 has lower
MAD, MAPE, MSE, and SD (0.0139, 0.4102, 0.3964, and 0.1435, respectively) than those of the
2510 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512

multivariate linear model in Category 2 (0.0198, 0.6123, 0.5728, and 0.2223). As such, we conclude
that multivariate ANN models outperform the multivariate linear models in forecasting accuracy.
These results are in line with the previous research by Fadlalla and Lin [41] on the superiority of
the neural network approach in forecasting stock price returns.
Table 3, Panel B presents test results related to H2. The paired sample t-scores for comparing
univariate and multivariate models are again over 2.0 for all three forecast accuracy measures and
the p-values are all under 0.05, indicating that forecast accuracy varies signi&cantly between forecast
models of Categories 1 and 3 (the univariate models) and between the multivariate models (Cate-
gories 2 and 4). In other words, neural networks improve the forecasting accuracy for the SHSE.
Therefore, we conclude H2 in its null form should also be rejected.
Table 4, Panel B reports the Diebold and Mariano test results of H2a and H2b and both tests
also reject the null hypothesis at 5% level (p-value = 0:0245) and at 1% level (p-value = 0:0019),
respectively.
Based on the results reported in Tables 2–4, we generally conclude that there is a signi&cant
di6erence in the forecasting accuracy in both linear and nonlinear ANN models when we move
from testing the CAPM to the multivariate 3-factor model, and that there is a signi&cant di6erence
in the forecasting accuracy between the linear and nonlinear ANN models. Simply stated, we reject
both H1 and H2 and conclude, to our surprise, that CAPM outperforms Fama and French’s 3-factor
model in predicting stock price returns. We also conclude that ANN forecast models are superior in
predicting the stock price returns to the linear predictive model counterparts.

5. Conclusion

Investors continue to seek means to aid in the selection of stocks for their portfolios that will lead
to the creation of a portfolio than can consistently outperform the market. New technologies and
research methodologies may provide some hope. The results from this study indicate that arti&cial
neural networks do indeed o6er an opportunity for an investors to improve their predictive power
in selecting stocks, and more importantly, a simple univariate model appears to be more successful
at predicting returns than a multivariate model. Future research should be conducted in developing
markets to determine if other macroeconomic variables (e.g., volume, stock prices, leading economic
indicators, and other macroeconomic variables) added to ANN models might further enhance their
predictive powers.
ANNs have existed for many years and given our &ndings, why are they not being used consistently
to predict stock price movement? First, it is not easy to &nd predictable stock market patterns and if
you do, you have incentives to keep it a secret. In all likelihood, ANNs are being used by investors
who have incentives to maintain this proprietary information. Additionally, previous studies have
not found exploitable stock market patterns in developed markets. These observations may not be a
failure of ANNs but evidence of market eJciency in these informationally rich markets. However,
given the decreased availability of information in emerging markets and the sometimes-questionable
quality of the information, it appears ANNs can be used to enhance the predictive power for investors
in developing countries. Further re&nements into the creation of models with the ability to predict
returns in emerging markets are needed.
 Q. Cao et al. / Computers & Operations Research 32 (2005) 2499 – 2512 2511

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