feature of CNBC programming. On this par-ticular interview, Miss Bartaromo asked thetrader what internet stocks he liked. This wason a day when most all stocks were higher,but the internet stocks were flying. Hisrsponse was something like, “Pizza.com looksinteresting." Maria took the bait and said thatshe wasn't familiar with Pizza.com, but whydid he like it? The trader, embarrassed by hisplayful joke, immediately tried to assure herthat he was only joking. She sheepishly ac-Larry Pesavento
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 Stock Trading Using Pattern Recognition and Geometric Ratios
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knowledged the prank. Anything with .com inits name was in vogue on this day on WallStreet. This is just one example of the ludi-crous stories that propel worthless stockshigher and higher Thirty-plus years of study-ing ¢very bull and (bear?) market since thetulip mania to the Florida Land Boom makesthis observation valid.
Fredrick Lewis Allen's book, Only Yester-day (Bantam 1946), is a vivid account of the1919-1932 period of the economic and moralaspects of the quality of living in the UnitedStates. Virtually no one reading this book wasalive or trading stocks in that era. But the bigbull gasped it's last breath on September 3rd,1929. Ten weeks later (in early November), theStock Market had dropped 50 percent. A rallywould then take stocks up 50 percent the oldhigh in April 1930!
There is an unusual company name thatpops up in both the current stock market eraand the 1929 era, Cable and Wireless was oneof the growth stocks in the early 1920s. It surehad a great story—communication (radio, tele-phone) was the thing of the future. By the mid1930s, the stock had gone into oblivion andwas worthless. Every morning on CNBC theyreport on the European stock markets. Thesemarkets have far surpassed the United Statesin percentage gains during the last three years,And you will probably be surprised to learnthat one of the big speculative plays on theLondon Stock Exchange is none other than anew version of Cable and Wireless, I wonder ifhistory will be kinder to this company,
Stocks that have already gone through acatharsis in the 1990s are Western Digital Cor-poration, off 80 percent of its highs;Quarterdack, $38 to 62¢ per share; Iomega,lost 90 percent of its value; Micro Technology,lost 80 percent of its value. There are manyothers. It has always intrigued me that over 85
percent of the professional mutual fund man-agers cannot beat the returns of the S&P 500Index.
As I follow the stock market actively(seven days a week), several things pop outthat give me cause for “grave" concern:
1, The Gross Domestic Productwas 89 percent of the stock mar-ket in 1929, In 1998 it is 130 per-cent. Once stocks drop, con-sumption will drop because in-vestors will have less assets.
2. The volume of these paperstocks is well over 100 timesthat of the 1974—the last timewe Saw a bear market,
3, The expansion of credit andcredit cards is beyond ludicrous.The rates these banks chargeused to be called usuary and itwas a felony.
4. It seems that most of the CNBCinvestment stars were still ingrade school during the crash of1987. They have no concept ofwhat a bear market can do. Andthey all are trained to think longterm.
5. Major economic upheavals havealready occured in Japan, South-east Asia, Korea and Russia.Should this economic depres-sion cast its pall over China, itwould place one-half of theworld in a depression,
6. The money has poured into the112
stock mark in the last 25 years.Since 1990, it has been a deluge.They all say that “they are in forthe long haul,” But, that will notbe the case, They will panic,they will cease to invest, theywill pull what's left from theiraccounts. Another bottom willform and another generationwill begin to play the game.
Larry Pesavento
 Stock Trading Using Pattern Recognition and Geometric Ratios 113
The 1929 Bull Market
American Can 77 181 7/8American Telephone & Telegraph 179 1/2 304
Anaconda Copper 54 1/2 131 1/2General Electric 128 3/4 396 1/4General Motors 139 3/4 72 3/4Montgomery Ward 132 3/4 137 7/8New York Central 160 1/2 256 3/8Radio 94 1/2 101
Union Carbide & Carbon 145 137 7/8United Btates Steel 138 1/8 261 3/4Westinghouse E, & M. 91 5/8 289 7/8Woolworth 180 3/4 100 3/8Electric Bond & Share 89 3/4 186 3/4
Source: Only Yesterday, Frederick Lewis Allen
The stocks listed above illustrate the last push upward in stocks during 1928-1929.Most of these stocks doubled in price in 18 months, much like we have seen in 1998.What is interesting about these stocks is that they dropped 90 percent in value over thenext four years. After the April 1930 rally, Radio Corp. was reorganized as RCA Corp.,Electric Bond & Share went bankrupt. It would take these stocks over 35 years to re-cover to the 1928-29 levels.
 Stock Trading Using Pattern Recognition and Geometric Ratios
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The Non Random Nature of Chaos
Theory
The Tomahawk Neural Network
 
My introduction into the world of artificialintelligence came about purely by accident.About ¢ight years ago (1992), one of my stu-dents called to tell be about a man in Bakers-field, California who had been working onaneural network, I had no idea what a neuralnetwork was or how it could be applied to trad-ing. Fortunately for me (and I always seem tobe fortunate), my good friend Jim Twentymanand I were sharing a trading house in PismoBeach, California. Jir’s expertise is in num-bers and computers and he jumped at thechance to start working with neural networks.Little did he realize that he was taking on amonumental task—one that would go on in-definitely.
The first experience we had with neuralnets was amazing, to say the least, The manwe would eventually work with sent us a faxone morning indicating that the S&P 500 wasgoing to have a 10 point ($5000) move thatday. Now I’m sure most of of you reading thishave been a giver or receiver of this type of“boardroom tipsters." I certainly confess to thatfact, But this time it was different! Not onlydid the neural net forecast a huge move in theS&P 500, it also forecast a very large countertrend move shortly after the opening (aboutone hour). Imagine my elation and surprisewhen the S&P did exactly as the neural net-work had predicted, Had I finally sturnbled onthe infamous “Holy Grail?" Stumbled is a goodword to use because, over the course of thenext four years, I would almost lose my life
and two very special people in my life becauseof my dedication to neural networks. You musttealize that I am “computer phobic." I knowvery little about computers and have beenafraid to learn anything about them, although1 do have sense enough to hire the best towork with me, My fear of computers began in1970 when I finished my Master of BusinessAdministration. I was offered a job with everymajor company, except IBM. I had taken acomputer test and the recruiter said it was thelowest score at my school. Later, I found out itWas a test for software programming, forwhich I had no interest. But this experienceanchored my fear of computers and it hasstayed with me for 25 years.
After the first experience with a neuralnetwork, Jim and I embarked on our journeyto find out what it was all about. Very little waswritten on the subject and those who knewanything were not talking. Our only source ofinformation was from the gentleman inBakersfield who sent us the fax predicting thehuge move in the S&P.
In the 25-plus years I have been in thisbusiness, many incredibly bright people havecrossed my path. Dennis Regan was certainlyone of the brightest. He was an electrical engi-neer by trade, obtaining a Ph.D. and workingfor the United States Navy on the Tomahawkmissile. His project was to use a heat-seekingdevice to make the missile hit its target. Forthis purpose the Navy employed a neural net-work. Dennis had been working on a neural116
Larry Pesavento
network for market analysis for over two yearswhen Jim and I first met him. As it turned out,the first S&P prediction we received, althoughstartling, was not indicative of things to come,Dennis had very little experience in financialmatters, especially trading. He was self-taughtin all areas of his life. He professed that heknew more than anyone and he really be-Heved it, This later became a great obstacle toany improvements in the neural network. Thereasons will be readily apparent later, but firstlet me explain what happened on the day afterthe first neural net S&P prediction.
I do a lot of trading. Probably too much,at times. It takes very little to get my interestin a trade. If you can, picture someone at theracetrack giving a tip on a horse that goes offat 50 to one and wins. What will] his next tipbe? It rerninds me of a classic racetrack scam.A man approaches a bettor and shows him hiswinning ticket {usually $2) on the race thatjust finished. Little does the bettor know thatthe scam artist has purchased a ticket on everyhorse in the race and kept them in separatepockets, pulling out the winning ticket as if bymagic. He now sells his information on thenext race for an exorbitant price due to his“magic touch.” He then disappears into thecrowd to find another "dupe." Should the horsewin by some miracle, he knows where to findhis pigeon. If the horse doesn’t win (which isusual) and the dupe accosts him, the scam art-ist simply says, “That's horse racing—nothingi8 guaranteed!"
But this time I knew I wasn't at the race-track when I saw the neural net prediction.Intuition was with me on this one. I have beeninvolved with cycles for many years from lin-ear regression, Fourier analysis and astro-har-monic planetary cycles. One of my favoritequotes from ancient Chinese literature (LaoTse) is: “When the student is ready, the
teacher will appear.” As the day of the predic-tion unfolded I was on the phone with Dennisseveral times, Fortune was again smiling onme as the S&P opened sharply lower, complet-ing a perfect pattern recognition signal. Ibought near the low of the day, and away theS&P went. My excitement level increased indirect proportion to the rising prices of theS&P 500. I remember this trade quite well be-cause, after about two hours, I had made aboutfour points which is more than the averagedaily trading range. I closed out the trade witha sizable profit and was quite happy. When Itold Dennis, his behavior put me in a state ofshock! He scolded me for exiting too soon andthen he hung up abruptly. It was at this pointthat I realized he was two French fries short ofa Happy Meal. This was not to say he wascrazy, he was just eccentric in every phase ofhis life (and | emphasize every),
Over the next several days, Jim and Italked with Dennis several times each day.This phase of the relationship lasted severalweeks, Dennis wanted several thousand dol-lars a month for his fax predictions. I paid thisin cash to him. Part of his eccentricity was hisprotesting the payment of taxes to the InternalRevenue Service. He had a longstanding dis-pute with them and owed them over $1 mil-lion in interest and penalties. These weekswere very frustrating to me because Denniswas 50 unreasonable and obstinate. Day afterday we listened to the genius and his right-wing philosophies.
I can't recall exactly what happened, butDennis and I argued about something (prob-ably money) and I decided it was in my ownbest interests to let Jim communicate withhim. I then could listen to the conversationsand sit back and laugh about it later with Jim.What I didn’t realize until much later was thatI had shirked some of the responsibility ofStock Trading Using Pattern Recognition and Geometric Ratios
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a
working on the project. All I did was pay themoney—which was the easiest part! The diffi-cult patt was working with Dennis. He was aclassic workaholic with paranoid tendencies.He was afraid of the IRS and trusting anyone!As you can imagine, this was a far cry fromaperfect working environment. So you ask methe big question: Why didn't I just tell him totake a hike? Believe me when I tell you that itcrossed my mind many times. You must re-member that Jim Twentyman was handlingthe day to day combat with Dennis so thatpressure was reli¢ved from me. Unfortunatelythe pressure didn’t disappear. It was simplytransferred to Jim. Dennis had an unbridleddesire to be perfect and this was reflected inhis work habits. Many times he would workday after day without sleep, becoming moreobstinate as ¢ach hour passed. Stress was get-ting to Jim and it became a very touchy sub-ject, Dennis would sometimes call in themiddle of the night wanting Jim’s advice orjust to talk shop. Classic signs of a depressedgenius were everywhere, but when you wantsomething so bad you overlook the obvious, Idon't quite remember what triggered Jim's an-ger, but he finally threw up his hands in dis-gust and dropped the neural network projectright in my lap. In retrospect, he was using hisown body's defense mechanism to survive.Approximately eight or nine monthstranspired, The money was going down a bot-tomless black hole. First, there was Dennis’consulting fee (always in cash or gold), Next itwas a very expensive ($12,000) personal com-puter with every bell and whistle imaginableOf course, the price dropped in half shortlyafter I purchased the computer and sent it toDennis. Later it became necessary to buy awork station in order to increase the speed ofthe neural net—another $20,000. Ironically, Iwas almost as bad as Dennis in my zeal to find
answers. The difference was that I kept it in-ternally and only those very close to me wereaware of what was happening. It wasn’t toolong when everyone would know what washappening.
A normal trading day for me starts at 4a.m, checking on the foreign equity marketsand the major currencies. It was August 15th,1992, and over two years of neural networkhad been completed. I was having a normalday and a student was with me watching metrade. It was a fun day and we were just aboutfinished trading and getting ready to go tolunch. The student commented that I looked alittle pale and was soaking wet. Sure enough,he was right, My first response was to assumethat I was coming down with the flu—that’sthe standard response. We decided that Iwouldn't go to lunch and I proceeded to gohome and take a nap, although I didn't fee) ill.However, | was a bit tired, Sleeping for anhour or so refreshed me and I decided towatch the Market Wrap Show on CNBC. Wewere scheduled to go to the State Fair thatevening, but I was too tired. I went to bedaround 7 p.m. At 3:30 a.m. I began to makemoaning sounds and stumbled into the bath-room. One look in the mirror told me I was introuble, I had a rapid pulse, my skin color wasgrayish yellow and I was sweating profusely.Even with my limited medical training I knewit was internal bleeding. Paramedics rushedme to the hospital emergency room and a vas-cular surgeon greeted me. After X-rays andblood tests, he diagnosed an aneurysm in myesophagus. I had been bleeding internally forseveral days and I didn’t have any clue as towhat was happening. Immediately followinglaser surgery to repair the bleeding, | wasplaced in intensive care for four days. Suppos-edly, I was within hours of dying. I had nopain or discomfort at all. The only complaint118
Larry Pesavento
eso $[[$$S(((9(9(9(9(9“_S(<_J_ II 00. SS SS5 iC SSS
was fatigue and muscle weakness. Recupera-tion was very lengthy and required that I onlywork part time for several months. My generalhealth had been excellent and my physiciancommented that is probably why I handled thecrisis as well as I did. This was my first officialhospital visit and it scared me beyond belief.Two months before the incident I took out ahealth plan, As it turned out, it was my besttrade of the year because it saved me $25,000in out-of-pocket medical expenses. Havingbeen in excellent health up to that time, I as-sumed I was oblivious to an emergency or anaccident. My appreciation of the simple thingsin life was increased immensely. Severalmonths later I was back in the same work rou-tine, but this time I was very cautious aboutmy health, Ironically, the most vivid memoryI had was in the ambulance on the way to thehospital, The paramedic kept telling me wewould be at the hospital soon and not to panic.Quite the contrary, I was very peaceful andthought that if this was how death was to be, itwas nothing to fear. My children held my clos-est thoughts as well as my fiancée, Benida.Without her I would surely have died. I will al-ways owe her a debt of gratitude
Dennis completely changed his relation-ship with me once I returned to work, He wascordial, patient and understanding. | didn'tknow at first if he was being genuinely kind orif he had finally realized that all of his support-ers had abandoned him because of the diffi-culty working with him. It became quite ap-parent that he was truly kind and caring.
Now that I was working with Dennis onmy own it became necessary to travel to hishome in Bakersfield. Several trips were madeto deliver computers and others to discuss howto proceed with the neural net research. Thetrip across the desert took about 2 1/2 hours.Upon arriving I was totally amazed at what I
found. Dennis and his wife and two small chil-dren were living in a small three room house.And I do mean a small house, My office wasmuch bigger. It was incredibly messy, withPepsi cans and empty potato chip bags on thefloor The scene did not change on subsequentvisits. You must imagine how it felt to leave a$20,000 computer in this environment, espe-cially with Dennis’ background as an IRS pro-tester. But I now felt comfortable with him andknew he trusted me,
Dennis was a huge man of 6’3" and over300 pounds. He was totally bald and kept hishead cleanly shaved—a very imposing figure.His office was in an 8x10-foot room with wallto wall computers and a small cot which heslept on, There was a huge steel safe five feethigh with double door—the kind you used tosee in Western movies, I never knew what wasin the safe because, when I asked, he wouldchange the subject abruptly. He always had anopen can of Pepsi and a big bag of potato chipshandy. Exercise was out of the question be-cause it took time out from the neural networkresearch, | really did not like to visit him be-cause there was no place to sit down in his of-fice, so I planned trips only when necessary.
The next few months ran smoothly. Den-nis’ demands for more money abated. As longas he had a steady income each month he washappy. It enabled him to provide for his familyand research neural networks. When I firstmet Dennis he was managing a $100,000 com-modity account in which he received 25 per-cent of the profits. In the first three months,the profits were over $250,000. The client thenstopped trading, closed the account and movedto Costa Rica. Later, Dennis told me that theman was also an IRS protester. Dennis foundanother client with $50,000. It was my goodfriend, Dr. Jim Elder. Jim is an M.D. specializ-ing in Pathology. We had been friends aboutStock Trading Using Pattern Recognition and Geometric Ratios
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a
three years at that time and, on one of his vis-its to Pismo Beach, he was very impressed atwhat the neural networks could do. Immedi-ately after Jim opened his account I went toMexico for a vacation. During that week Den-nis lost over half of the account. His tradingwas wild and erratic and had nothing to dowith the neural networks. There was nomoney Management strategy of any kind.Shock could not adequately describe how Ifelt. I knew what Dennis had tried to accom-plish. He assumed that he could trade thesame way that he did in the other account.What happened to him has happened to manyother traders in the past. His first few tradeswere quite large and incurred losses, Not cata-strophic losses, but substantial enough to hurt.He then tried to make the money back on thenext trade. Each time he would fail to put in astop loss, hoping for the market to turn aroundand save him. This reminds me of one of MarkDouglass’ favorite quotes from his book TheDisciplined Trader—“Don't expect the marketto save yOu, you must save yourself.”
Dennis lost more than 80 percent of the$50,000 in just a few short weeks. It was im-possible to talk to him about his trading. Hethought he knew more than anyone. Finally,he became paranoid that the brokers in thepits were “picking off* his two and three lottrades. This was totally absurd, but he refusedto listen. Dr, Elder's account was down to justa few thousand dollars when Dennis decidedto quit trading due to total frustration and lackof confidence. It would prove to be the bestthing for all of us later on because he was ableto return to his research and it released himfrom the stress of trading. Dennis and Jim El-der became friends and spoke often on thetelephone about the neural network research.Jim Elder came to Pismo Beach to visit meseveral times each year. On one of these visits
 
in December of 1992 he mentioned that hewanted to visit Dennis. We drove together toBakersfield one foggy morning, Jim was alsostartled by the living conditions of Dennis.Since only two people could be in the room atany one time, I decided to go to a movie whileDennis and Jim talked computers. It was theSmartest thing to do because the two of themknew computers and I would have only beenin the way. There was not room to get in theway! After the visit, Jim and I drove home. Aswe drove across the desolate stretch of desert,Jim told me that only a handful of people hadthe intelligence of Dennis. He was a true ge-nius! That helped explain his bizarre behaviorto a great extent,
As the Christmas holidays approached,Dennis and | focused our attention on how tomarket the neural net program. The programwas copyrighted by me under the name“Tomahawk." Tomahawk was chosen for tworeasons. First, it had the cutting precision ofatomahawk. Second, the principles of vibrationand harmonics in the formulas were similar tothose in the neural net software used by theTomahawk missiles. They are by no means se-cret formulas because they are used by electri-cal engineers frequently. Even though the soft-ware program was not perfected, it certainlywas better than anything I had ever seen inmy 27 years in the commodity business. Mostof the improvements would come at a laterdate.
This closes the opening chapter of theneural net saga. Little did ! realize how my lifewas going to change over the next few weeks.The ancient Chinese adage, “That whichdoesn’t destroy me shall make me stronger,”was certainly coming my way without anyforewarning
Bells began to toll for me soon afterChristmas 1992, one of the most enjoyable120
Larry Pesavento
 
holidays I can remember. | was able to visitwith many old friends, and especially with mytwo daughters. My health was excellent, butthis was not unexpected because I have alwaysbeen in good shape physically. Dennis hadcalled me early one morning and it was quiteapparent that he was sick with a horrible caseof the flu, complete with fever, sore throat andlung congestion. We agreed that he should restand recuperate before we proceeded any fur-ther. This was really the appropriate strategyprimarily because his health was sv important,but secondarily because he had not taken aday off in the three and a half years I knewhim. He remained bedridden over the nextfew days. Meiko, his wife, and I kept in dailycontact on the progress of his health. Antibiot-ics were used to protect against pneumonia.For a short time he appeared to be recovering.Then his health took a turn for the worse andhe had to be rushed to the hospital for admit-tance. Now I was really worried! Dennisweighed over 300 pounds and never exercised,a deadly combination. The doctor came backwith news that Dennis had a serious heartproblem and would have to lead an even moresedentary life and reduce outside stress. Hewould be a cardiac invalid! All of us who werefriendly with Dennis were very sad, but notsurprised. The compulsive work habits and theabsence of any diet/exercise program hadtaken its toll. The cardiologist assigned to Den-nis wanted to do bypass surgery. Risk in sur-gery is always present, but with his weight andmedical history, increased risk was apparent.A cardiac catheterization test was ordered andit verified our worst fears—Dennis' heart wasabout 25 percent functional. Then catastrophicnews came, As the physician was removingthe cardiac catheter, Dennis had a heart attack,His heart stopped and had to be restarted, buthe made it through.
Over the next several days he improveddramatically and his doctors were amazed athis recovery and overall health and stamina.He was scheduled to be released in a few days.Everyone was excited, He then died quietly inhis sleep the night before his release. Later, Iwas informed that only the immediate familyknew his days were numbered and they didnot want Dennis to know it was his time to go.It is not the choice I would have made, but itwas not my choice to make. He was crematedthe neat day by his family.
Meiko called me to see if I could pick upmy computers and if I wanted to buy any ofDennis’ office supplies. My trip ta his homewas very sad. I had grown to really care forDennis and his family and it was now over Iwas also facing a dilemma. How was I going tocontinue the neural net project? Computerswere foreign to me and I had a phobia of them.Jim Elder stepped in to help me. Without hishelp [ would have abandoned the project atthat moment. How was I going to handle aproject as computer intensive as a neural net-work?
Cal Poly State University was located inSan Luis Obispo and was blessed with an excel-lent computer science department. Placing anad for a computer jock was one of my betterdecisions, Offering to pay $3 per hour abovethe going hourly rate inundated me with appli-cants. I finally settled on a computer sciencemajor, Chris Nichol, in his junior year, Chriswas very energetic, capable and personable. Ithink he would have worked for me for free.With Chris' help and Jim Elder's support, wewere able to get the neural net working inabout a month. Jim had begun to makechanges in the program that dramatically in-creased the accuracy of the neural nets. Chrishad little experience with financial markets,but he learned quickly what we needed. It be-Stock Trading Using Pattern Recognition and Geometric Ratios
t21
came necessary to purchase a work station inorder to process the data each day. Memorywas not our problem—the speed of the calcula-tions were the problem. I bought the bestavailable computer. Why not get the best forsomething with as much potential as our pro-gram?
The Comdex computer show was in LasVegas so Chris and I traveled together to buy awork station. I had never seen so many peoplein one place (except for the Indianapolis 500Motor Speedway). There were over 250,000people registered. It is the biggest single eventof the year for Las Vegas convention resorts,Everything you could ever imagine for com-puters is there; Companies are showcasingtheir research and development capabilitie,new products are being introduced, orkshopsare held hourly, technical support people areeverywhere to answer questions and demon-strate their products. It would take three fulldays to go through the exhibits and that’s notleaving much time to stop and chat. Meals androoms in Las Vegas ate at premium levels. Youmust have reservations at any of the good res-taurants in order to be served, It is a classicz00-like scenario for the entire week ofComdex.
Chris and I spent one day going to thecompanies that offered what we needed. I hadno idea what the technicians were describingto Chris on what we needed versus what theyoffered. I might as well have been in China be-cause the language was so foreign. The nexttwo days I wandered about the exhibits tryingto learn anything I could by osmosis. All it didwas confuse me even more. My phobia of com-puters was apparent once again and it was in-tensifying. But there were neat little gifts suchas T-shirts, tool kits and posters that I col-lected. My rationale was that I was out to getsomething for all the money I was spending. I
did purchase a trackball keyboard system witha built-in mouse that is very helpful in myday-to-day charting. Chris spent all of his timegoing back and forth from vendor to vendorasking every conceivable question about theirproducts and how it might fit our needs. Fi-nally, we had exactly what we wanted and or-dered it for. 30 day delivery, because part ofthe computer had to be customized for ourspecific purpose.
The computer was delivered in February1994. It increased the speed of training timeby a factor of five. We needed this speed tomake three- to five-day projections. Havingsuch price and time projections would in-crease the flexibility of our neural net, particu-larly as it relates to the option markets. Forexample, if the neural net forecast is predict-ing a substantial price move in the next threedays, a volatility spread could be instituted.Buying both a put and a call would insure youwould be in the market when it starts itsmove. One would be worthless, but the otherwould have increased in value. Conversely, ifthe neural net indicated a flat market over thenext three to five days, you could sell a putand sell a call, gathering the premium on bothsides of the trade. As 1994 is drawing to aclose, we have not