The Speculator
Confidence pays off, if it's earned

You can be sure of the markets because of their long history of profit. And you can be sure of your trades if you've committed the blood, sweat and toil to test your strategies.

By Victor Niederhoffer and Laurel Kenner

Posted July 31, 2003

Welcome to Spec Talk, where Laurel and Victor answer readers queries no matter how provocative, covering such topics as how to gain maximum mileage, repair portfolios and figure out which way the market is headed.

All readers whose questions are used will receive a Spec Duo cane designed to be used when the market has broken down and all hope appears lost.

The best possible environment for learning is created when teacher and student agree that no question is too dumb to ask. Students are much more likely to master a subject if they are free enough -- and humble enough -- to confess ignorance without embarrassment. The teacher also benefits, as the student’s question may lead him to re-examine a principle, fill gaps in his own knowledge, or find a better way to articulate an explanation.

The Spec Duo has been taking lessons or teaching all their lives. The story of Vic’s father, Artie, driving him to tennis, piano and clarinet lessons is told in Vic’s first book, which is not called "The Education of a Speculator" for nothing.

For her part, Laurel took some 20 years of piano lessons and master classes, and she taught piano herself starting at age 11. When she switched to journalism, she had to learn and master a new body of knowledge. Eventually, she became responsible for training all new market reporters in Bloomberg’s New York bureau, not to mention market writers from foreign bureaus. In 1999, Vic undertook Laurel’s education in markets and science. Since January 2000, the Spec Duo has embraced the unique ease of access made possible by the Internet, and we and our readers have been mutually educating ourselves via our Speculator columns.

We answer all queries, and often share the ones of broad interest.

Of baboons and bears
Our first query this week comes from a longtime critical reader who has repeatedly flagellated us for daring to utter bullish items during the past year. He writes:

“Now that interest rates have come up sharply with the 10-year bond yield up from 3% to 4.3% in just the last month, are you two jokers finally going to turn bearish or are you so set in your (expletive deleted) ways that no matter how bad the comparison of interest rates to stocks is, you still stick your heads in the sand?”

Laurel: Your query is dripping with the exact venom that Vic has been avoiding on his trip this month through the wilds of South Africa. He’s called in to acknowledge that the Puff Adder Mamba snake and the baboon have been his most formidable natural adversaries, making this a highly relevant issue. The increase in the last month in the difference between the 10-year bond yield and the earnings yield of stocks in the S&P 500 Index ($INX) is one of the most ominous ever. For example, the interest yield has moved up 120 basis points from 3.1% to 4.3%, while the earnings yield on stocks (estimated for 2003) has moved from 5.9% to 5.2%, a drop of 70 basis points. That’s a significant divergence. Going back to 1982, we only find three months with comparable gaps, and one of those was in July, 1987, mere months before the October 1987 crash, the greatest one-month percentage decline in the stock market’s history.

Vic: Yes, a baboon bared its fangs as it climbed to the highest point on the Cape Veldt. But just before it could steal my ice cream and possibly bite me in the process, I threw the enticement into the forest and was safe. Readers should be able to become similarly secure with as little effort. But don’t just take my word for it. Let’s count it out.

Since April 30, 1982, there have been 66 months in which bonds showed a decline from the previous months’ close to the current month’s close, while simultaneously the S&P 500 Index registered a rise, the way it is shaping up so far in 2003. Of the four possible combinations (both stocks and bonds up, both down, stocks up/bonds down, and bonds up/stocks down), this scenario is the most negative for stock returns in the following month. But the average move in the S&P 500 Index in the following month has been a decline of 0.1% with a standard deviation of 8%. (More details on our study of these configurations are available on our Web site.)

Bear in mind (as we pointed out in our two articles on the Fed model, in which we predicted the market would rise some 15% this year when the yield gap starts at very bullish levels; click here and here), stocks according to one good prediction model were about 50% undervalued.

This month’s stock/bond move is worrisome. It means stocks now seem only 40% undervalued, not enough of an edge for us. The best thing for investors to do is stay with the sweeping 1.5-million-percent-a century-returns from random selection documented in the greatest trading book ever, “Triumph of the Optimists” by Dimson et al, as well as in our own book, “Practical Speculation.”

Dear Vic: I have been trying to absorb the main lessons of both your books, such as:

1. Count everything and test it.
2. Apply the scientific method for above.
3. Concentrate on the tails of a distribution.
4. Don't get in over your head.
5. Above all, remember the cycles will change.
6. Remember, also, the Titanic.

Is there anything at all I could do to return the favor? -- Karamvir Singh Bisht

A. Yes. You should remember that one market leads another, and that feedback cycles vary between weeks and even between intraday hours. Also, that deception and imposture are rampant. Consonance usually occurs, paths often repeat and “obvious” similarities are highly suspect. Furthermore, that the enterprise system and the provision of risk capital to growth companies is the source of our civilization’s material and personal freedom. Enjoy music and books. I like being a mentor, and it is good to know that I have inspired you.

For the next question, we enlisted the help of The Speculator’s official market shrink, Dr. Brett Steenbarger.

Crisis of confidence
Q. I need more confidence in my trading. I've been trading the markets for about six months using setups I learned at two excellent seminars. My trades set up in the morning but then I don't do anything about it. Yesterday I watched the market go higher and then beat myself up for not following the techniques that I learned. But when I do follow the techniques, I get stopped out and I become discouraged. How can I become more confident? -- Anonymous

Steenbarger: The late Ayn Rand advised people faced with a dilemma to "check their premises." I think that might be good advice in this situation. Your premise is that you should be more confident. That might seem like a given, but perhaps it is exactly the problem.

If there is one thing we know about self-esteem and confidence in one’s judgments, it is that these must be earned. During the past few decades, educators have opined, without evidence, that students would learn better if they felt better about themselves. As a result, educators altered public school curricula to build self-esteem. Outcome research discovered, however, that the educators had confounded cause and effect: Students who were more successful at learning developed greater confidence and esteem -- not the reverse.

The same is true in trading. Confidence in itself will not build successful trading results. Indeed, undeserved confidence in a poor trading system might lead a trader to throw bad money after good. That is the conclusion of some intriguing behavioral finance research. A study performed at the London Business School by Mark Fenton-O'Creevy, Nigel Nicholson, Emma Soane and Paul Willman (“Trading On Illusions: Unrealistic Perceptions of Control and Trading Performance") examined 92 traders in simulated trading exercises. Unbeknownst to the traders, however, the trading patterns presented to them were entirely random.

The traders who expressed the greatest confidence in their ability to find and trade patterns in the data (called “illusions of control" by the authors) tended to have the worst performance in their actual trading careers, as measured both by themselves and their managers. In short, confidence might have been their undoing -- precisely because that confidence hadn't been earned.

So we have a dilemma: You want to be confident to trade well, but confidence comes from trading well. How is a beginning trader to survive his or her learning curve?

Developing confidence in trading ideas is one psychological benefit of historical backtesting. Whether you are trading a breakout system, a form of predictive modeling, a trend-following formula, a pattern-recognition scheme, or fundamental research, it is important to: 1) explicitly formulate the ideas on which you are trading and 2) see if those ideas would have provided you with an acceptable return on capital without undue risk and psychological damage.

Seeing how your trading methods have performed in various markets, trade after trade, week after week, month after month, provides a sense of efficacy that cannot be duplicated simply by emulating the methods of others.

Let's take a common example: trend-following trading systems. These are appealing to many traders because they promise large returns during times of high market directionality. Many traders don't realize, however, that even the best trend-following systems give back a high percentage of open profit as the price they pay for staying in the really good trends. Indeed, Keith Fitschen, developer of the well-known Aberration system, estimated in a Futures Truth magazine interview that this "give-back" figure is as high as 50%.

Lest readers think this is an exaggeration, I recommend a perusal of the Futures Truth audits for mechanical trading systems submitted for evaluation (www.futurestruth.com). Even the most successful systems tend to have a high degree of variability of performance over time, with periods of significant drawdown. If well-designed and rigorously audited trading systems require fortitude to trade, chances are that your methods are no different. Without a historical perspective to help you weather the inevitable periods of flat and negative performance, it is difficult indeed to stick to your guns.

Vic: As always, Brett, you are much too kind and much too indirect in your response to the questioner's lament. While you may find it necessary from the viewpoint of diplomacy to build hope in your practice at the university, a comparable mollycoddling here could lead to certain financial death.

The problem here is not lack of self-esteem or desire for unearned rewards. Rather, it's a belief in magic and mumbo. To call a spade a spade, your questioner is a member of a cult, ready to adopt any guru's recommendations based on how much he hasn't already been bilked. Lacking any means of independently evaluating ideas, our questioner is buffeted around like a ship without a rudder. There are so many worthless, untested technical systems being peddled to the credulous and unsuspecting that even if there were some good ones out there, it would be impossible to distinguish them from the chaff. A little counting, a little paper trading in the real world and a little familiarity with the laws of ever-changing cycles will do more for our questioner than all your well-meaning and doubtless valid attempts to get at the root cause of his problem.

Brett:: Vic, belief in mumbo is rooted in a desire for the unearned. Truth cannot come through mystical means; it can only come empirically -- through efforts of the mind. It is the desire to avoid such efforts and yet share in the rewards of labor that drives the mystical bent.

Final Note
The Spec Duo announces that after 180 consecutive weekly articles at this site, we will be ending our writing as of Sept. 3, 2003. Thanks much for the mutual education and inspiration that you have provided, and as always, great appreciation to our editor, Jon Markman, our boss, Mark Pawlosky, and our point and detail guides and checkers, Charles Blaine and Ron Prichard.