The Second Editor of The Wall Street Journal Was Pretty Good at Figuring Out Markets

During a misspent youth Alfred Cowles was one of my heroes, with the Cowles Commission Monograph no. 3 being one of the great early statistical works on the stock market: "The Cowles Commission's Common Stock Indexes 1871-1937."*

The Cowles Commission has, over the years employed some bemedaled worker bees:
Tjalling Koopmans, Kenneth Arrow, Gerard Debreu, James Tobin, Franco Modigliani, Herbert Simon, Lawrence Klein, Trygve Haavelmo and Harry Markowitz, all of whom went on to win Nobel econ prizes.
The Commission is now at Yale where another Laureate, Robert Shiller, oversees the renamed "Cowles Foundation for Research in Economics"

In addition to Common Stock Indexes  we've posted some of Cowles' other stuff including a quick hit in January 2008, after the August 'ought-seven' quant-quake but before things got really ugly in September '08:

"Can Stock Market Forecasters Forecast?" is the title of a paper by Alfred Cowles III.

It appeared in Vol.1, No. 3 of Econometrica, after having been read to a joint meeting of the Econometric Society and the American Statistical Society.

Mr. Cowles answer to the question?

"It is doubtful."

December 31, 1932.

However...

Today's paper, from the Social Science Research Network

46 Pages Posted: 11 Feb 1998

 

The Dow Theory: William Peter Hamilton's Track Record Re-Considered

Abstract

Alfred Cowles' (1934) test of the Dow Theory apparently provided strong evidence against the ability of Wall Street's most famous chartist to forecast the stock market. In this paper, we review Cowles' evidence and find that it supports the contrary conclusion -- that the Dow Theory, as applied by its major practitioner, William Peter Hamilton over the period 1902 to 1929, yielded positive risk-adjusted returns. A re-analysis of the Hamilton editorials suggests that his timing strategies yield high Sharpe ratios and positive alphas. Neural net modeling to replicate Hamilton's market calls provides interesting insight into the nature and content of the Dow Theory. This allows us to examine the properties of the Dow Theory itself out-of-sample.

SSRN Download page

Introduction

Alfred Cowles’ (1934) test of the Dow Theory apparently provides strong evidence against the ability of Wall Street’s most famous chartist to forecast the stock market. Cowles’ analysis is a landmark in the development of empirical evidence about the informational efficiency of the market. He claims that market timing based upon the Dow Theory results in returns that lag the market. In this paper, we review Cowles’ evidence and find that it supports the contrary conclusion - the Dow Theory, as applied by its major practitioner, William Peter Hamilton, over the period 1902 to 1929, yields positive risk adjusted returns.

The difference in the results is apparently due to the lack of adjustment for risk. Cowles compares the returns obtained from Hamilton’s market timing strategy to a benchmark of a fully invested stock portfolio. In fact, the Hamilton portfolio, as Cowles interprets it, is frequently out of the market. Adjustment for systematic risk appears to vindicate Hamilton as a market timer. To estimate the risk adjusted returns that may have been obtained by following the Dow Theory over the Hamilton period, we classify the market forecasts he made over 255 editorials published in The Wall Street Journal during his tenure as editor.

Using the riskless rate as a benchmark, we find that Hamilton’s ratio of correct to incorrect calls was higher than would be expected by chance. Using total return data for the Cowles index of stock market returns and the S&P index over the 27-year period, we find that the systematic risk of a trading strategy proposed by Cowles based upon editorials published in The Wall Street Journal is relatively low. We apply market timing measures used to identify skill to the time-series of returns to the Hamilton strategy, and we find significant positive evidence. An event-study analysis of the Dow Industrial Index around Hamilton’s editorials shows a significant difference in mean returns over a 40-day period following “Bull” vs. “Bear” market calls. The event study also shows that Hamilton’s forecasts were based upon a momentum strategy. Our finding suggests a plain reason why the Dow Theory remains to this day a popular method for timing the market. During thef irst three decades of this century it appeared to work. Regardless of whether it has worked since then, this early success established a reputation that has endured for decades.....MUCH MORE (46 page PDF)

And if interested, here's Mr. Cowles' (and Doc Shiller's) gift:

 Common Stock Indexes...

....My favorite tidbit is the listing, among the pre-1871 industrials, of New York Guano.
Some things never change.

http://cowles.econ.yale.edu/P/cm/m03/index.htm
It leads to a big ‘ol hog of a PDF.

Here's "New York Guano".

And for what it's worth, momentum is one of the few factors that still seems to produce some—although diminishing—alpha.
Here are some of our posts on momo.