The Speculator
Four in a row? The
odds are against it
Based on what happened in 2002, it looks unlikely
to us that bonds will post another strong year. But we'd bet that stocks won't
suffer a fourth down year in a row.
By Victor
Niederhoffer and Laurel Kenner
We
began 2002 with one of our most pessimistic assessments ever. We wrote:
Our misgivings were amply confirmed. The market declined
for the third year in a row, for the first time in 60 years. We strayed from
our pessimism subsequently, expecting after many of the bearish squalls that
the market and individual stocks would reverse. They didn’t. We and the bulls
got hurt, particularly during the summer.
All
the more reason for that strategy to work in the coming year.
As
we begin 2003, we are feeling pragmatic, rather than bullish or bearish. We
have two trades to suggest: short bonds and long stocks.
The first
is a statistical trade, based on the correlation between bond returns and stock
returns. The data, using continuous futures contracts, appear in the table
below.
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Winners and losers |
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*adjusted by Niederhoffer Investments
We
studied various combinations of lags and combinations. The best we could come
up with is that bond returns are correlated about -0.30 between consecutive
years.
After
the seven years that bonds were up 9% or more, the average change in bonds in
the next year was -3%. After the other 12 years, the bonds returned some 8%.
In
2002, bond futures returned about 10%. That would mean that the best prediction
for bonds in 2003 is about -3%. We’ll go with that as our best statistical
trade for the coming year.
(We
note in passing that there is one market where a continuation strategy rather
than a reversal strategy seems indicated. That is gold, where the correlation
between consecutive years is about 25%. Gold was up 23% in 2002. Thus, the best
prediction for gold in 2003 is up 6%. However, we are not going to be buying
gold. Vic had enough of that in 1980, when he bought gold at $300, pyramided it
up to a 200-fold gain and then lost a fast 80% of that before he stopped
himself out the next year.)
Our qualitative trade: stocks
Our
other trade is qualitative, based largely on our feeling that there is too much
negativism out there. We think it’s a good time to buy stocks with a horizon of
a few months or more.
After
all, how many times has the market gone down four years in a row? (Answer: Just
once during the past 100 years, from 1929-1932).
Assume
that the market, like a coin toss, has a 50% chance of a rise. (The market is
very far from being a coin toss, but bear with us for a moment.) We would
expect that four declines in a row would occur about 1 in 16 times. That would
mean there should have been about six occasions in the last 100 years when
stocks declined four years in a row.
The
chance of obtaining one or no four-year down streaks in a situation like this
turns out to be about 0.04. So we can say that a four-year decline occurs less
frequently than it should by chance alone.
The
market, as we said, is not a coin toss. It’s a bazaar where the shoppers are
sometimes overly gloomy and sometimes overly enthusiastic. In time, those
swings tend to correct themselves.
After all,
the market has to go up sometime. The U.S. stock market, as measured by both
the S&P 500 ($INX) and the all-inclusive Wilshire
5000 ($TMW.X), lost half its value in the 2½
years between its March 2000 high and its October 2002 low. Note that even
after the 15% rally since Oct. 9, the S&P 500 is still below its August
high.
Admittedly,
2002 was not a good year for reversion-to-mean strategies. However, we’ve often
placed statistical bets that don’t work on the predicted day but work with a
vengeance on the day after.
Final note
Canes
are the rage among collectors these days. We spotted a window display of
antique canes in the high-end East Side stationery and gift shop Sui Generis
the other day and stopped in for a look. We had to wait, because the
well-dressed woman ahead of us was playing with a 19th-century sword cane.
Store manager Stephen Vanilio said shoppers and passers-by have been dropping
in continuously to look at the canes. His canes, decorated with mermaids,
crocodile heads and other fantastic carvings, come with research notes and are
priced at several thousand dollars apiece.
Maybe
the baby boomers are getting old. But we’d prefer to think that the fashion for
canes relates more to a passage we’ve written about now and then from a 1887
book by Henry Clews called "Twenty-Eight Years in Wall Street":
"But few gain sufficient experience in Wall Street to command success until they reach that period of life in which they have one foot in the grave. When this time comes, these old veterans of the Street usually spend long intervals of repose at their comfortable homes, and in times of panic, which recur sometimes oftener than once a year, these old fellows will be seen in Wall Street, hobbling down on their canes to their brokers’ offices. Then they always buy good stocks to the extent of their bank balances, which they have been permitted to accumulate for just such an emergency. The panic usually rages until enough of these cash purchases of stock are made to afford a big 'rake in.'”
Final note II
With
all the malfeasance coming to light in 2002, we developed new indicators. The “5 genuine buys on a Street of impostors” we wrote about on
Oct. 24 are up 3.7%, vs. 2% for the S&P 500. These picks relied on a triple
combination of cash indicators: a buyback announcement, a big decrease in
inventory and a big decrease in accounts receivable. We believe systems based
on cash will continue to work well.
We
wish all of our readers a happy and prosperous New Year. Thanks to all who sent
their thoughts, critiques and praise to us in 2002. Please write us through our
Web site, at request@dailyspeculations.com. We’ll be
updating all our pieces there, along with extensions and current readings on
our new volatility prediction system, the VIC.