In graduate school, I learned about Principal Components Analysis and did a project with it. Years later, I was curious to try this on stock prices.
In the past, I've tried automating a number of stock trading strategies based on Technical Analysis described in a number of investing books. Most technical analysis methods use only stock price and volume data which makes them easy to automate. However, I slowly came to the painful conclusion that it is very easy to write a convincing book and show several winning stock strategies when one has the benefit of applying them to historical data and can cherry-pick the ones that fit their model.
Our world today is highly interconnected. Companies produce products that drive other companies' production of their own products. Most investment advice suggests a diversified portfolio -- but what is diversity? For example, success of a steel manufacturing company and an automobile company are likely to be codependent. However, an automobile company is likely not to be impacted if a cosmetics company fails (Although sales of pink Cadillacs may be impacted).
I was curious if PCA analysis could help with this...
My limited experiments so far reveal both some expected and unexpected outcomes. The graph below shows most (~29) of the Dow Jones Industrial Average stocks. [My list of DJIA stocks is a bit outdated and pre-dates the acquisition of SBC by AT&T]
Principal Components Analysis (PCA) finds the factors the contribute to the variance in a data series. Applied in this manner, PCA just indicates correlations between stocks without explaining why. Of course, correlation is not causation... A few expected simiarities are shown:
However, there are some things which seem odd.
|AIG||American International Group Inc.|
|AXP||American Express Co.|
|DIS||Walt Disney Co.|
|GE||General Electric Co.|
|GM||General Motors Corp.|
|HD||Home Depot Inc.|
|HON||Honeywell International Inc.|
|IBM||International Business Machines Corp.|
|JNJ||Johnson & Johnson|
|JPM||J.P. Morgan Chase & Co.|
|MO||Altria Group Inc|
|MRK||Merck & Co.|
|PG||Procter & Gamble Co.|
|SBC||SBC Communications Inc.|
|UTX||United Technologies Corp.|
|VZ||Verizon Communications Inc.|
|WMT||Wal-Mart Stores Inc.|
|XOM||Exxon Mobil Corp.|