Page 177 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes popularized by Hamilton Bolton. The EWP states that major moves take place in five successive
steps resembling tidal waves. In a major bull market, the first move is upward, the second
downward, the third upward, the fourth downward and the fifth and final phase upward. The
waves have a reverse flow in a bear market.

Kondratev Wave Theory

Nikolay Kondratev was a Russian economist and statistician born in 1892. He helped develop
the first Soviet Five-Year Plan. From 1920 to 1928 he was Director of the Study of Business
Activity at the Timiriazev Agricultural Academy. While there, he devoted his attention to the
study of Western capitalist economies. In the economies of Great Britain and the United States,
he identified long-term business cycles with a period of 50-60 years. He became well-known
after the US market crash of 1929, which Kondratev predicted would follow the US crash of 1870.
His hypothesis of a long-term business cycle is called the Kondratev Wave Theory.
Note that the market crash for 1987 occurred 58 years after the crash of 1929, a period consistent
with Kondratev's theory. Some modern economists believe that Kondratev's theory has merits.
Many others believe that significant macro-economic changes, such as floating exchange rates,
the elimination of the gold standard, and the reduction of barriers to free trade, make the
decision cycle less predictable. Still, many market analysts consider Kondratev's work in their
assessment of the stock market and its risks.

Chaos Theory

At recent finance conferences, a few researchers have presented papers on the chaos theory and
its application to the stock market. In physics, chaos theory is growing field of study examining
instances in which apparently random behaviour is, in fact, quite systematic or even deterministic.
Scientists apply this theory to weather prediction, population growth estimates, and fisheries
biology.
1. As an example of the latter application, a given volume of ocean water, left free from
human interference, will not necessarily reach an equilibrium population of the various
species that inhibit it. As fishes grow, they consume the smaller fry (of their own or a
different species) in increasing numbers. Fewer younger fishes are left to mature; this,
coupled with the natural death of the older fish, eventually results in a sudden drastic
reduction in fish population, causing dismay to fishermen and excitement in the local
media. At the same time, it results in reduced predation and competition for food among
the surviving fry, so the population begins to grow dramatically, and the cycle continues.
Interactions between species add complexity to the process.
2. Investment analysts have sought a pattern in stock market behaviour since the origin of
the exchanges. Much remains unknown about how security prices are determined, and
chaos theory may eventually provide some potential answers. If the apparent randomness
of security price changes, can be shown to be non-random, much of the theory of finance
would need revision.

6.5 Neutral Networks

A neutral network is a trading system in which a forecasting model is trained to find desired
output from past trading data. By repeatedly cycling through the data, the neutral network
eventually learns the pattern that produces the desired output. If the desired output remains
elusive, more data is included until a pattern is found. Neutral networks may also include a
feedback mechanism whereby experience gained from past errors.

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