Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner


Dec. 1-15, 2005


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Lessons in Management, from Steve Wisdom

I just saw an excellent stage production of David Copperfield at the newly-renovated Westport Country Playhouse. A beautiful renovation, but lamentably (as with Carnegie Hall) so splendid and costly as to drive ticket prices up to a level amenable only to swells & seniors, who were indeed the bulk of the audience.

Tough to market Dickens. "David Copperfield" (and his others) are promoted as "children's books," though they're anything but. The juiciest plot line in "Copperfield" involves the oily Uriah Heep, yes-man to the distinguished attorney Mr. Wickfield. Obsequious to Wickfield's face, an "'umble" servant, Heep schemes behind his back to defraud him, drain his bank account & etc. Young Copperfield wrestles with whether to expose Heep or just mind his own business. Does he owe Wickfield the truth? Deep mud indeed for a "children's book." Finally, rather unsatisfactorily, Dickens finds a deus ex machina: Mr. Micawber, a quasi-comic character modeled after Dickens's father, gets a job as Heep's assistant (after Heep "makes partner" at Wickfield's firm), exposes Heep's defalcations, and Heep is dragged off to jail. So we never learn whether Copperfield would have found the backbone.

And such a theme speaks across the centuries. A yes-man is such an enticement! A perfect employee, drained of all the animal spirits, the p!ss & vinegar, indeed the very marrow of life. Programmable like a computer. Siliconized carbon. Saves all the fuss & bother of interacting human-to-human. Your wish is my command. But of course, there's no free lunch, and in due time the yes-man (as with Heep) always extracts repayment for his suppressed resentments. In my experiences (including a very painful one recently), once the yes-man turns on you, the cost is 1- 3 orders of magnitude greater than the benefit from luxuriating in the obsequy during the fair-weather period. All well understood by Dickens, 155 years ago (and 110 years before How to Succeed in Business).

Mitchell Jones adds:

And, horribly, almost everyone goes right on liking yes-men, despite being burned in exactly the way you described, over and over and over again.

Why do the victims of yes-men almost never learn? Because most people, to varying degrees, go through life with wounded egos, due to childhood abuse. Because they have profound doubts about their own intelligence, knowledge, and understanding, they desperately crave the incessant praise that yes-men provide, and they are easily shattered by criticism. Result: they surround themselves with people who discourage intellectual growth, and avoid those who encourage it. (If a person is perfect in every way, then growth is not required, or, indeed, even possible, now is it?)

Strong Letter to Follow, from Victor Niederhoffer

Mr. Dude from California, who specializes in individual stock trading at my firm, made a presentation yesterday and was not pleased with all the "completely consistent with random" feedback he heard. Afterwards he fired off an email to me with something like the following, "I was completely dissatisfied with your reaction to my results. This may be the only firm in the world where if you work from 6am to 8pm every day the way I do, including Sundays, you're told 'that adds to the randomness of your results because it means you tested more hypotheses and thus are more prone to multiple comparison errors.' I don't wish to talk to you for a few days, in this world and never in the next. Strong letter to follow."

Yes, if you develop 50 hypotheses during the course of your work, and then exult over the best one that is less than 5 in 100 to have occurred by chance, you have a 0.92 chance of falsely rejecting the randomness hypothesis. I find the book Multiple Comparison Procedures by Hochberg and Tamhane helpful in this regard. They review and systematize a plethora of methods for adjusting for multiple comparisons, starting with Fisher's very conservative procedure to consider that if you have five different means to consider and thus 10 different comparisons to make, you adjust your probability of rejection down from the normal 5% to 0.5%. A much more interesting and informative procedure is outlined in A Contingency Table Approach to Non-parametric Testing by Rayner and Best, which I have been reviewing in conjunction with my continuing study of clustering, and I recommend highly.

Professor Pennington Comes to the Rescue:

Since the Chair is suspicious of industriousness, he should consider moving over to the value investing camp, where one can learn the permanent principles of investing in one sitting and then rehash them contentedly with favored chums. As Warren said, "Lethargy, bordering on sloth should remain the cornerstone of an investment style."

Upon taking on the value approach, it will no longer necessary to labor on learning of new kinds of cuisine. If one samples many different cuisines and finds the n'th dish better than average, it's likely this just follows from Father Random, as Warren sensed early in life:

"My ideas about food and diet were irrevocably formed quite early--the product of a wildly successful party that celebrated my fifth birthday. On that occasion we had hot dogs, hamburgers, soft drinks, popcorn, and ice cream." (quote from Janet Lowe, "Wit and Wisdom of Warren Buffett")

And value investing's advantages carry over to the field of humor. It's no longer necessary to devise new jokes, as there is already a canonical list, tabulated by Warren and Charlie over the years. For example, there is this:

"Rule Number 1: Never Lose Money. Rule Number 2: Don't forget rule Number 1."

If a value investor stumbles upon a new joke, he/she rightly senses that, given the many jokes that have been sampled, it's likely that the new joke is not statistically significantly better than all the old ones. Joel Greenblatt illustrates the principle in his new book, on page 106:

"Rule 1: Most people have no business investing in individual stocks. Rule 2: Reread rule number 1." .. Rule 5: Most people have no business investing in individual stocks. (Did I already mention that?)"

And do you tire just from the thought of meeting new people and learning new games? The shrewd value maven understands the likelihood that if new games and new people seem better than the old ones, it's just an artifact of randomness, and so he sticks with the old, even if it means learning how to use a computer:

"Now it is much easier to get the game (bridge) up and running with the same people I usually played with, only now we all sit thousands of miles apart."

And so, Mr. Dude, eschew industriousness going forward; cease all experimentation, and stick with the old hypotheses, the tried and true.

Tim Melvin Comments:

So I see the Professor has picked up the pipe. Mr. Buffett's comments were made in reference to his newly adopted growth style of investing, i.e., Coca-Cola, Gillette, and Amex, after closing his original fund in the 70s. He has not been a value investor since that time. Sit and wait is hardly the hallmark of a value investor. While it's true that our holding period is usually longer than the growth or momentum investor, the constant search for ideas, valuing companies, evaluating liquidations and arbitrage makes for industrious work indeed.

I am not a Buffett fan by any stretch. Using him as the prototypical value investor is akin to using the Pope as representative of Episcopalians. He may have started out that way but he ain't one anymore.

As for jokes, here are a few:

  • New paradigm
  • Revolutionary breakthrough
  • Justified multiple
  • Rational exuberance

    I would never argue physics or math with Professor Pennington. He is just too smart for me. But over the wisdom of buying assets and earnings streams on the cheap as opposed to buying at any valuation because of eternal growth prospects, that's another ball game.

    A Walk in the Woods, from Victor Niederhoffer

    Whenever the kids come home from school, I like to go for a walk with them in the woods, inspired by the example of Beethoven and Brahms. Invariably, I'll say something like "the shape of that oak tree trunk or maple tree leaf is very much like what happens in the market" and they'll ask "do you always just relate whatever your reading or seeing to the markets?" I do find insights from nature or other academic disciplines such as economics, anthropology, psychology, physics, biology, ecology, electronics, geology, geography, astronomy, sociology, history, statistics, games, sports, music, warfare and fishing, very helpful in formulating fruitful hypotheses and I only wish I knew more about these subjects. If I lived to 1000 years, I would still not find time enough to improve my understanding of these subjects in an effort to better surmount the challenges and opportunities presented by markets.

    Sui Generosity, from Dean Humbert

    In my life's journey, I happen on many people who inquire what I do.  My standard answer is, "We manage money for friends across the globe." They then relate to me on their big losses in the 2000-2002 bear market or tell me about the next Google or Microsoft or why the stock market can never make them money or how their CD rates are the highest in the land. Once in a while they ask what web sites I explore to further my modest level of intellectual capital. There is only one to feed the mind for a lifetime.

    The Weird Turn Pro, by Joe Hughes

    They called him Captain Weird. When his turn to speak came up at the weekly sales meetings, he would read aloud the latest Hunter S. Thompson column. He often said that if you remembered the Sixties, then you didn't have a good time. But when he left to start his own firm, he drilled his traders in such clockwork precision that nobody can remember any out-trades -- even when the firm was averaging 7,500 trades a day. "I hate to lose our bonuses to the error account,"  the Captain said.  Joe is inspired by Mizuho Securities' $342 million error to recount the methods he learned at the Captain's firm.

    Trap Door, by George Zachar

    So, yesterday's Fed meeting was a hinge moment, with trendfollowers learning, to their dismay, that they'd been standing on a trap door. Yen and gold positions, both clearly the November saviors of certain trendfollowers, became vacuums. 2005s that once looked salvageable are now beyond redemption. I think the story is less pernicious, and less interesting, on the debt side. Folks were modestly short (all the chatter was bearish) going into the meeting, so this is just an unwind/rebalance in a thin December market.

    P/E and Return, by Victor Niederhoffer

    One of the ideas of the day and the fray is that stocks are overvalued because P/Es are too high. The gist is that over the past X years the average P/E is, say, 14 -- but right now it is 20 and therefore stocks are too high. And if stocks revert to the long-term mean P/E, then stocks will decline of 30% or so, so get out now.

    Of the 22,000 relevant articles I Googled and am beginning to examine, I have not yet found one that uses the relation of  P/Es to returns for anything but a currently bearish forecast. But all these studies are deeply flawed. They don't use current data, they don't take account of interest rates, they use fictitious data from the early periods, they come from an ideological anti-optimistic bias, they confound results for individual stocks with the market as a whole, they suffer from a misplaced assumption that because a given level is above a retrospective mean it is likely to fall from its current level, and they place undue reliance on the biased and unreliable Shiller data and his conclusion that five-year returns are inversely correlated with P/E ratios. And they contain numerous armchair assumptions, usually about the excessive nature of earnings or forecasts that could make reported P/E artificially low.

    Most of all, they don't take account of the fact that relative to interest rates, stocks are currently at very low P/E ratios. And even more important, they don't take the trouble to test, to put pencil to paper as Tom Downing and I have done, to show that a prospective study of market P/Es, forecasted earnings and current interest rates during the last 25 years shows that a highly accurate forecast of future returns is possible. Such a prospective study shows that the current last 12 months' reported P/E of the market relative to actual 10-year interest rates has been highly predictive of future market returns during the last 25 years, with a correlation between prediction and actual on the order of 30% and that such a variable is quite bullish for the current year.

    During the 1970s, 50 high-flying stocks such as Xerox, Avon, Polaroid and Wal-Mart were classified as the Nifty Fifty. The popular legend was that these stocks were so highly valued that no matter what their subsequent growth might have been, that they were dead ducks. Apparently, the a la mode retrospective researcher Jeremy Siegel tried to deflate this story in the article "The Nifty Fifty Revisited," Journal of Portfolio Management, Summer 1995 (which I haven't read, since his work is always so amateurish) that concluded long run performance justified the high P/Es.

    Jeff Fesenmaier and Gary Smith of Pomona College revisited the article and concluded: "The basic elements of the Nifty Fifty story are sound with the spectacular exception of Wal-Mart, the glamour stocks that were pushed to relatively high P/E ratios in the early 1970s, and did substantially worse than the market, in both the short and the long run." But this is an abuse of statistics. If you take out the few extremely good performers from any small group, the remaining ones will perform substantially worse than the mean. The most extreme positive of any 50 normally distributed numbers with 0 mean and 1 standard deviation is ~2.25,  while for 100 numbers it's ~2.5 (and for a highly non-normal distribution, the expected maximum of 50 numbers is ~3.0). See, for example, Arnold et al, A First Course in Order Statistics, p.126. Thus, the remaining 49 would have a yearly compounded return of -2.25 with an average return of -0.05 times the standard deviation. Since the standard deviation of the yearly compounded return for these stocks over a 10 year period is approximately 40%, one would expect the mean return of the remaining 49 stocks, ex the best, to be about 2% worse than random. And indeed Fesenmaier and Smith report that the various indexes of Nifty Fifty ex Wal-Mart returned 10% a year for the next 30 years versus 12% a year for the S&P 500.

    My goodness! The stocks selected, the beginning of the period (right before a market decline), and the lofty values involved were almost ideally suited to a "value beats growth" conclusion. If after such a heroic retrospection the authors were still unable to carry their point, how limited the possibilities and how difficult it must be to debunk such an easy target. Regrettably, the Fesenmaier and Smith study is one of the best I have seen relating individual stock returns to P/E, and almost all other such studies use Compustat or other retrospective data sources that are terribly biased against growth stocks, since they throw out the value stocks that went belly up, and don't count the growth stocks during their early stages, and base their conclusions on events that took place in such irrelevant times as the 70s, the 30s, or in the case of Shiller and his followers, on the periods 30 years before, when contemporaneous earnings series were not even available, even assuming for a moment the absurdity that what happened in 1890 is relevant to today.

    A Poem from Alan Gillespie

    There is a number which people fear,
    add a few zeros and the S&P is near,
    Take a zero away, divide, and look at 1996,
    when the Nikkei crossed its river Styx,
    Or add from the 1974 bottom a great rally,
    to what percentage gain did the Dow tally?
    In 1906, a year before the Boy Wonder,
    Dr. Shiller's reports P/Es of 14.5,
    while Homer inversion and 4.75% for 1 year and under.
    In 1936 the Dow extended before in 1937
    it quickly relented.
    Thus while my work suggests we are 12.5% too low,
    I think one will know whether to change and which way to go,
    Shortly after the Fed passes.

    More on P/Es, from an Objectivist Researcher

    Having read Practical Speculation and Vic's critiques of various studies that suggested value outperformed growth, as well as Vic's presentation of the Value Line growth/value study, I am hoping there is some way to reach a conclusion on whether value generally beats growth. I have not seen the Value Line study in detail, and do not know whether people have inspected that study for bias, so am not prepared to accept that as the last word on the issue.

    My first thought was that in the value/growth debate, "the proof is in the eating." Ideally, one would like to see how actual mutual fund managers pursuing value and growth styles have done over the years. If growth stocks beat value stocks, that should show up in actual fund return differentials. Unfortunately, I don't know where to find long term data for investment manager category performance. Lipper? Can any reader submit the results? I've only seen Lipper performance for the past ten years, during which value has beaten growth, but which is too short of a time span.

    I did find the Russell 3000 data on the Bloomberg. I cannot vouch for the unbiasedness of their index construction techniques, but I'm not aware of fund managers complaining about Russell's unfair benchmarks or the uninvestibility of its index, so I'll presume for the moment that it's a fair reflection of equity returns. They offer a Russell 3000 growth and Russell 3000 Value index, going back to 1980, so that's 25 years of data we have now.

    On Bloomberg, I typed RU30GRTR Index COMP Q, and added RU30VATR Index in cell #2, then hit GO. From 12/31/1980 to 9/30/2005, the growth index offered a total return of 1070%, (10.3% annualized). For the same period, the value index offered total return of 2428% (13.8% annualized).

    Value appeared to pull ahead of growth in 1983, and stayed ahead until 1999, when growth for one year could claim to offer the best long term returns, by a small margin. Since Sept 2000, value has jumped far ahead.

    For the medium term, I suspect that whatever investment style the typical gullible investor finds most appealing, is the most likely to under-perform over the next five years. So I impatiently await my upcoming holiday visit to my sister-in-law, a people person who slavishly pursues fading investment trends borrowed from friends in a most Peter Keating-esque manner, and then communicates them to me, seeking my approval. Perhaps she will begin asking me for my favorite value fund -- if so, I'll be sure to reallocate my own portfolio soon thereafter.

    J. T. Holley on Regression to the Mean

    1. Consider my weight over my lifetime. I am never going to revert back to the average. I am constantly growing.
    2. The average driving distance on the PGA Tour is growing by the decade and will never go back to its 1950s or 1970s level by reversion.
    3. The amount of love felt for my wife over the last eight, going on nine, years is growing and will not revert back to a mean.

    These are just a few of the examples I wrote quickly on a scrap of paper. Aren't P/Es the same way?

    What should we call this? Infinite expansion without reversion! The peaks and the valleys are there, that's reality. The line though drawn through these, as Headmaster Peabody said at Roosevelt's inauguration, is upward and always advancing. The son of my son's son may think P/Es of 150 are deep value. Capitalism, education, technology, and, as Nock would say, "seeing things as they are" are beautiful things. Why can't people see the hard work, effort and success behind high P/Es?

    Tim Melvin Bristles:

    J. T., are you smoking a little Christmas crack down there, my Southern friend? It's bad enough that a group that mostly trades from the long side based on some form of mean-reversion of prices, i.e. buying the market cheap and selling it dear, whether intraday or longer (we call that value trading) continues to tweak the evidence to attempt to prove that "growth" beats "value", but to claim non-reverting P/E ratios? Give me a break! Paying a 100 multiple for a stock, even in today's low rate environment, implies about a 45% annual growth rate in earnings. This means a buyer of a business at such a price would have to wait six years for his return on capital to creep above 10%, providing nothing goes wrong over that time span. To pay that multiple is not a belief in the future, it's pure Pollyanna. Only a company that offers a permanent cure for cancer or a way for men to actually understand women would be worth such a multiple.

    Much has been made of the flaws in studies that prove value beats growth. I accept that. There are also many flaws in research that suggests growth outperforms. But in practice, the best value guys beat the best growth guys, and the average value guys beat the best growth. What can't be argued is that even when buying growth companies, the price you pay matters. It is suggested that holding the Nifty Fifty of the 1970s actually worked out, and so it did with a market rate of return. However it took over 20 years to break even, a holding time beyond my ken. Further, most of the eventual return was clustered in a few of the stocks. 30 years later, many of them are still underwater.

    If you buy 100 multiple stocks, you are either a short term trader or you go broke. I eagerly await any evidence that I am wrong. Until then, put down the pipe.

    Dr. Phil McDonnell Remarks:

    What a conundrum! Our two intrepid pub explorers at rhetorical odds!

    The issue seems to be growth versus value. The side issues are the definitions of growth and value. In a sense I must agree with J. T. that properly-defined growth seems to perform better. However, I cannot accept the assertion that P/Es are destined to go ever higher. P/Es should be expressed as E/P. In that form they are simply the earnings yield of the stock. If one believes the Fed Model, then interest rates have a significant influence on stock prices. However, the long term history of interest rates is that they are cyclical and not simply going ever lower.

    If interest rates are expected to decline, then growth will rule, because the future cash flows will rise in value. But if interest rates are stable or rising then value will rule. Cash in hand will carry the day, as expressed by balance sheet data.

    It is not correct to assume that this time is different and that interest rates will continue to go lower. They cannot go below zero. Thus the reciprocal E/P cannot grow to the sky. At any given time there is a limit to the amount of money in the world. There is also a limit to the growth rate of the world GDP.

    The bottom line is I'm a growth stock guy, but it has to be with reasonable valuation.

    Mr. E. Explains:

    There is an answer to the conundrum.

    There are periods when investors -- if you will -- look at factor coefficients. Chose growth over value and vice versa. Factor analysis can swing back and forth rapidly but how you measure it and the quality of your data matter a lot; using standard macro data will drive you to the nuthouse. For example, lately the market has wanted high or bad credit risks because the market hasn't been worried about short term economic momentum and in such times growth predisposes and credit risks are small worries.

    As far as P/Es, the market hasn't moved in a year, while sales and earnings are higher, which means quality of earnings are being questioned with MFA or repatriations influencing valuation.

    Fred Crossman Adds:

    Two finance professors, Eugene F. Fama of the University of Chicago and Kenneth R. French of Dartmouth, report that value stocks have beaten growth stocks by 3.7 percentage points a year on average from 1927 to the end of 2002.

    I believe a value stock is merely a growth stock whose price has faltered. PFE was a growth stock last year at $38. now a value stock at $22. assuming PFE begins to resume its old growth rate (or appears to resume it) it is currently more of a bargain in terms of fundamental data such as P/E, P/Sales, dividend yield, etc than it was last year. more importantly, its expectations are so low, that even worse earnings projections will have little downward effect on the stock (David Dreman has done studies showing this.) whereas a slight earnings miss on a high P/E growth stock could result in a large price drop (for ex. eBay, a fast-growing company, in January).

    I believe when Dan Grossman buys a company he first looks at value with growth potential. Price matters. The price you pay for an asset determines its future return, not the category it is in.

    Steve Ellison Remarks:

    I have still not seen a definition of either value or growth. I humbly propose the following.

    Value: Seeking to own assets whose prices are low compared to a generally accepted accounting amount, e.g., earnings, cash flow, book value.

    Growth: Seeking to own shares of companies whose sales and earnings have increased at a significantly greater rate than GDP in recent periods.

    Momentum (a subcategory within growth): Seeking to own shares of companies whose earnings have increased at a greater rate than the expectations that had been priced into the market in recent periods.

    Gregory van Kipnis offers:

    In addition to the problem of having a good definition of growth and value there is a broader question: Is that classification relevant to anything?

    All definitions of growth stocks and value stocks are an attempt at taxonomy, classifying things, and may not have any analytical value to determining future price action, even though the terms seem important. For example, to trivialize, if you classify all people into fat and thin and attempt to explain personal wealth by weight you will find mixed results. Weight isn't the determining factor to wealth. So is it true for value and growth. Neither classification explains or predicts future increases in value (prices). It sounds like it might, but not really.

    What explains out performance in prices is the ability to surprise. Growth companies usually have the edge here. They are growing rapidly and are exploiting/creating new markets. No one can be too sure if that is sustainable and if they can maintain the same pace or better. The usual expectation is that growth will fall off at some point. When it does not their stock price reacts to the 'surprise' and outperforms, even from already high P/E levels.

    Value companies usually have the potential to surprise in a different way. Not through an unexpected burst of growth, though that is possible, but usually through improved profitability. They may cut costs, improve productivity, extend the life of products and services. If it appears sustainable their P/E will increase from lower levels.

    The search for superior returns won't be found in analyzing the difference between value and growth stocks, it will be found by identifying correctly companies with the ability to surprise.

    Jeremy adds:

    I agree Greg. One of the problems in this kind of broad view is that the constituency of the categories---whether large vs small or growth-vs value---is always changing. Year 2000's large are today's small. In 1985 seven of the top ten growth stocks were energy companies---after which they "descended", year after year, into the value category. If the names change so much over broad time frames, and the businesses change so much over broad time frames, what's the point in analyzing the relative movements or returns over broad time frames (unless you're an institutional consultant needing feedstock for your hot-air device)? Over shorter time frames---like one market "cycle" (whatever that is!) investors may be voting a preference for certain industries or companies. And with sensitive detection of that, money may possibly be made.

    GEstant Hubris, by Victor Niederhoffer

    Yes, the GE silo for earnings is still replete with unrealized gains from assets bought decades ago, and even in a year such as 2001, when their three main businesses, aircraft, insurance and financial services, were decimated by 9/11, they still have the ability to grow by 10-15% . In the 2001-2002 environment, such an absurd hubristic utterance was enough to call for a new pitcher from the bullpen, and deep skepticism of anything that the relief pitcher could dish, to the tune of a 50% decline in the stock. But now, the basketball player is back and depending on how the market takes the report on the state of the spigot in the granary, we shall see whether excesses of hubris are treated with that alacrity that the weekly financial columnist always uses to tell whether the market is finally at the low.

    Steve Wisdom on Mr. Hats

    Mr. Hats, our great friend and business partner, as immortalized in the line-sketch on pg 401 of EdSpec, likes to smoke cigars, drink coffee, eat lunch, read his faxes, take cell phone calls, talk with his hands & etc. while driving his Audi A4. Lamentably, this leaves him with no hands available for actual driving, so he employs the clever expedient of always leaving the car in 3d gear and just letting the RPMs drift up to 5,000 or down to 1,000. For years I thought this was horrific, and indeed it caused me psychic pain to sit in the passenger seat, but finally I realized: the damage he does to his car, amortized over the hours of abusive driving, is less than the value-add from conducting various forms of business while driving. So from an economic point of view, omitting safety-related externalities, he comes out ahead.

    Heel and Toe, from George Zachar

    Keeping its foot on the brake, but lifting its heel ever so slightly, the Fed artfully teases that the end of the rate hike process just might be on the horizon: "some further measured policy firming is likely to be needed." But my focus is here: "possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures." So series like unemployment and capacity utilization will now be viewed as (potential) leading indicators of inflation, and deconstructed with an eye toward forecasting price pressure.

    Posts on India and Nepal in Our New Section Notes from Abroad

    Bear Corner: The Latest from the Senior Weekly Financial Columnist

    A cantankerous spec sent a trenchant post today about an easily refuted lie, and it set me off on a tangent. The weekly financial columnist, in his Monday, Dec. 12 piece, has a beautiful example of a perfect lie, one that is impossible to refute but that serves to enhance the believability of related self-serving inexactitudes in the rest of the corpus.

    After going into the usual 25 reasons that he is bearish for 2006, which we have chronicled often and systematized in Practical Speculations,* he states that he is not always a perfect forecaster of the market. This is like saying that Christian Guzman of the SS Nationals, generally regarded as the worst player in Major League Baseball, with a batting average of .219, does not always get on base.

    The columnist says the reason he's not a great forecaster is that he still believes in things like sales, earnings and book value. This is true, of course, but what he doesn't say is that he has been consistently bearish for 40 years. Indeed, Collab was unable to find one counterexample, though she performed a content analysis on all of his columns from 1990 to 2002, and read almost all of the others. The columnist became bearish circa Dow 600 in 1964 and has consistently been trotting out these same 25 reasons, "an excess of enthusiasm" or "lack of a true selling climax," ever since.

    As I was chuckling over his latest, Collab said to me, "What about his venerable and savvy friend who's very bearish now?" Sure enough, next in the column was a technical analyst whose record has been brilliant. He caught the entire Japanese rally, but frankly is not so bullish on it now. He sees a major technical catastrophe shaping up in the market for 2006 but sees a buying opportunity on any significant break. The friend is given anonymity, as is appropriate, for to be joined with a personage such as the financial weekly columnist, who perhaps has the worst record of forecasting in history, why, that would be tantamount to professional opprobrium.

    However, to finish up the perfect deflection, the financial weekly columnist lets you know that he agrees with his venerable friend completely.

    *A disturbingly unanimous expectation among professional forecasters for 4% GDP growth next year; the possible dark consequences of an end to the housing boom; a bleak prediction by the UCLA Anderson Forecast; Detroit's woes; the federal deficit; inflation that "continues to rear its insidious head"; high energy costs; high gold prices that "likely bode ill for the economy."

    A Cantankerous Spec Reads the Newspaper, a Continuing Feature

    Cl#nton on Stronach: I never advised that woman
    By The Canadian Press
    MONTREAL — Former president Bill Cl#nton says he was just as surprised as everyone else when former Conservative MP Belinda Stronach defected to the Liberals last spring. Cl#nton, a friend of Stronach’s, says he had no prior knowledge of her stunning decision last May, which helped the governing Liberals barely survive a non-confidence vote. He says he had nothing to do with her decision, though he later concluded she had a "principled reason" for doing it.

    What struck me about this piece was the unnecessary lie at the end, where Cigarman said Stronach jumped parties for "principled" reasons. Even the dimmest political bulb knows she switched for only one reason: a ministerial post in return for her tipping-point vote to keep the uber-corrupt Liberals in power. Cigarman could have plausibly denied talking to her ahead of time, but why throw in the gratuitous falsehood?

    Ephemera, by Victor Niederhoffer

    Today's rise in the Nikkei to the 16,000 area, a five-year high, emphasizes again that ephemeral and predictable factors that cause declines are great buying opportunities. The ephemeral factor in the Nikkei was the fat-fingered trader at Mizuho Securities who sold 41 times too many shares of the IPO J-Com Co. But one might have predicted that the decline would be temporary, because the loss was part of a zero sum game. Also, fat fingers were a predictable tendency of many fingers, and the fact that it occurred was a realization of a known probabilistic phenomenon.

    Larry Harris gives, as an example of an ephemeral phenomenon, the undue rise in Occidental Petroleum following the death of Armand Hammer, which led everyone to think that now the company would be run better. But his death was anticipated once he hit 90, and it shouldn't have caused such a reaction. Harris notes the stock fell the next day.

    Recently, Jon Markman predicted that the decline in stocks in early October in conjunction with the R#fco crisis would be reversed imminently, and it was. A notable sidelight during that period has been the astonishingly high coterminous correlation between the daily returns of R#fco and the general market, approximately 30% during the heat of the fray. If  only one knew where R#fco was going to close during that period, even though it traded at less than $1.20 a share the whole time with a market value of less than 150 million, one would have had the open sesame to the whole market.

    Another example was the supply situation of British Petroleum during the October 1987 crisis. Every nuance of the situation caused ebullience of distress in the US markets.  After all, the white shoe brokerages might lose more money if they were called on to make good on their commitments.

    The Long-Term Capital collapse and the Barings debacle were other examples of ephemera where the market cratered for weeks before the announcement on the rumors and not one legitimate buyer surfaced until all the supply was requited. Of course, in both situations, indeed in all such situations, the situation was exacerbated by interested parties with inside information of the coming surplus of supply who front-ran the actual selling, thereby precipitating and exacerbating the decline. Many such organisms specialize in such activities in all major biota systems, and despite the useful redistribution function served by such detritovores as vultures, worms, maggots and bacteria, and their counterparts in the markets, I look upon them with a certain revulsion.

    The general question remains how to quantify ephemera on a prospective basis and know when they've caused a temporary market decline or rise (in those without a positive drift), and take advantage of it with reasonable sangfroid?

    In researching ephemera I find myself in strange company, as almost all the 82,000 entries for "ephemera" "stock market" on Google are to very bearish commentators who state that any market rise is due to ephemeral factors. Another strange phenomenon is that almost all the "ephemera" labels were from very old articles. For instance, my friend Charlie Minter wrote on the "ephemeral" nature of the P/E ratio, and how it's much too high, in 2003, circa S&P 950, decrying the predictive properties of the Fed Model, as is common among practitioners and academics.

    Shui Mitsuda adds:

    This is a breakdown of the Mizuho disaster.

    A Human resource service company "J-com" went to public listing on 8th Dec.

    Mizuho Security (subsidiary of Mizuho bank) receives a SELL order from a customer:

    SELL 1 SHARE of J-com @ 610,000 YEN

    and then disaster happens the Mizuho operator keyed in:

    SELL 610,000 SHARES of J-com @ 1 YEN

    # of J-com shares offered public on 8th Dec was only 14,580 shares which meant 44 times volume of the shares issued went for short sell.

    The trade caused low limit of the day 572,000 yen from its opening 672,000 yen. 85 seconds later the operator's colleague realized the miss-input and tried to cancel the trade but large # of trades were already locked in. One of them who bought the sell order was no mercy Nikko City Securities.

    8th Dec final trade.

    Open 672,000 yen, High 772,000 yen, Low 572,000 yen, Close 772,000 yen. Volume 708,124 (for tiny 14,580 issued) ($3.5 billion worth of trade)

    As of today 13th Dec, there are outstanding 96,236 shares unsettled 6.6 times of totally issued #, that Mizuho Security is unable to deliver. Today the stock commission have decided to force settle the trade at 912,000 yen as substitutes for delivery of shares. This will result in 40bil yen (= US$ 336 million) loss for Mizuho Securities in just a single trade.

    Very unfortunate incident for the operator but knowing this can happen to any electronic traders (who are a little careless or tired), it reminds us spending extra time ensuring what we have entered for the trade is worth spending. (or may be nice old fashion of tel or e-mail trades might be better.)

    Following is what I am doing now for trading.

    1. Use BIG ! LCD screen.
    2. Point the finger at figures and speak out " CHECKED ! " for all the entry figures before executing the order.
    3. spend extra time on research and take heavy odds trades only that a few extra minutes won't matter.

    Pikers, by James Lackey

    After a few years of reading Daily Speculations, I find a couple of things remarkable. One is the reaction to the dumb-bomb that Mr. E. drops on the young and the brilliant. They lash out like they never heard anyone call them stupid before. Pure emotion fires out from their pride.

    Marcellus Wallace to Butch the Boxer, "Pulp Fiction":

    The night of the fight, you may feel a slight sting. That's pride $@#%ing with you. Forget pride. Pride only hurts, it never helps. "You see, this profession is filled to the brim with unrealistic mothers. Mothers who thought their ass would age like wine. If you mean it turns to vinegar, it does. If you mean it gets better with age, it don't.

    The second remarkable thing is how insecure traders are about their position size. Everyone wants to be bigger. That is as bad as those spam e-mails how to increase your size by taking a magic pill... Read the whole post

    Integrity: In Memory of My Father, by Joe Hughes

    Beauty: In Memory of My Mother (July 10, 1924-Dec. 12, 2004), by Laurel Kenner

    Jeff Rollert on Dollar Cost Averaging

    Many planners find that getting each client to make a decision on when to invest requires too much communication time. Dollar averaging is a time management technique as it doesn't require large amounts of client contact time.

    My greatest sources of alpha have come from watching what methods people use to leverage their time. Many techniques have outlasted their usefulness and leave a few breadcrumbs of profit as a result.

    Jeff Sasmor adds:

    Dollar-cost averaging is one of the investing parables that stockbrokers like to tell their clients. Others I have heard include:

    1. If you're not in the market on the best days of the year you will lose most of your possible gains.
    2. Load (sales charge) mutual funds perform better -- they're higher quality.
    3. Buy and hold works, (well sometimes it does, but it's like a stopped clock: right twice a day).

    I'm sure we all have our favorites.

    Islands, from Alston Mabry

    I know a few people who rode the market down from March 2000, bailed out at the bottom, and have stayed "safe" in cash ever since. The triple whammy: catching the market ride down, missing the market ride back up and watching their cash seriously devalued against real estate.

    The Sage was worried about his 'two islands' situation where eventually the industrious island owns the lazy island, but the Fed has quite strategically devalued the US$ so vigorously against real estate that the industrious islanders can't afford to buy our island any more than they could five years ago. No matter how many T-bonds they have!

    The Senator Writes from India

    From the 12/9 Hindu Times, here in New Delhi (where there has been a Gargantuan bull market and P/E's are still low):

    Siju Jose, perhaps the first Keralite to go through the routines of an American jail in occupied Iraq, is a free bird. And if his words are true he had a nice time in a Baghdad jail, in the custody of "highly courteous and concerned" U.S. soldiers... "The Americans cared for me, gave me the Bible and a rosary to pray... I was treated quite well."

    You guys see this in any paper back home? I'll bet not.

    The Emperor's New Clothes, or How High Priests at Delphi Stay High, by Jim Sogi

    The market's slavish attention paid to the temple of the Fed is too obsequious. The market standstill before the oracular pronouncements and the panicked gyrations and stratospheric reactions on the announcement do not lend to a belief in market rationality. While the central bank carries weight and the governors are competent and serious people, they do not appear to have much if any more information than is available to the public, nor are they superior in intelligence or analysis to the market participants, nor does the announcement carry commensurate new information to justify the typical overreaction, nor do they directly control the longer end directly.

    Fed day is one of those trigger points that give the market an excuse to break out of its normal routine. Remember Robert DeNiro in Taxi Driver when he is standing in the mirror, "You talking to me? You talking to me?" Well the normally well behaved market wants an excuse to cut loose and do the stuff it is normally too embarrassed to do. Some in the crowd that are just all wired up, especially with the tense build up all day before and even the day before. It's all so silly, but that is the landscape. Alice didn't have any choice in Wonderland. Dorothy had to go along with the Wizard in the Oz. Harry Potter has his world. So must we.

    There is the "wait and see gang." There is the "wind up gang" and then the "itchy finger gang" and the "bait fish" that run and turn with the bait ball. The press calls it "knee jerk" which implies some sort of built in function. It seems to be the same itchy finger gang at first, and then when they are done, the crowd stampedes and surges on its own weight. Then there are the "predators" that follow or even herd the bait ball or the confused stragglers. One spear fishing technique is when approaching the fish, the fish sees you, panics, turns one way, then habitually turns the other, and as its turning back from the first turn, shoot it just as it turns - usually good for a dinner. Then again the last few meeting were followed by 40-100 point moves. All based on the turn of a few phrases, a few words. "Ignore that man behind the curtain! The great and powerful Oz has spoken!"

    Theater Review, from Jeff Sasmor

    Yesterday I went to see The Odd Couple starring Matthew Broderick and Nathan Lane after having bought the tickets last June. I have always been a fan of the film version, somewhat less so of the TV series, but if you can get tickets to the play it's definitely worth seeing. Lane makes a great Oscar Madison; Broderick uses a whiney voice and is good, but not great, as Felix Unger. But then that's my Tony Randall bias showing.

    The theatre is one block away from Times Square. I don't ever recall seeing so many people in that area on a Sunday before. This time everyone was carrying jammed-full shopping bags. It was crowded!

    Thoughts on Why Today's Market is So Tough, by Scott Brooks

    I was thinking of my senior year in college and playing poker. I paid for that entire year of school, bought some nice things, took a few fun short trips and still walked away with around $35,000 in my pocket. I did it all playing poker.

    The thing that I learned when playing was to figure out who the good players at the table were and which players were not so good. I simply left the good players alone. We could sit there all night and try and take money from each other, but playing against other "players" was just too much work and not enough reward.

    I concentrated on the two to four guys (or gals, I was an equal opportunity player) at the table who should not have been there. These were the people who were the "gamblers." I remember walking into a house to play poker, and all these guys would be sitting around the table. Every once in a while one of the hosts would walk in and say, "Larry, Notre Dame is up by three at the half," or "Bob, your horse placed at Fairmont," or some other such statement. That let me know that these guys were gamblers.

    When I would sit down to play, my goal was to identify who I was taking money from that night (the gamblers) and who I was leaving alone (the players). One of my other goals was not to take too much money away from the gamblers. I wanted to take just enough money to keep them coming back. If you took too much, you scared them away for awhile, or maybe forever. If they were scared away, I would end up having nothing but other "players" to play against. And remember, I don't care how good a player you are, it is much more difficult to take money away from other "players" than it is from gamblers.

    It was also important for me to make the gamblers feel good about losing to me. It was important that they win a nice hand now and then, but something that I found to be even more important, was to let them off the hook once in a while. For instance, if I knew I had the winning hand occasionally I would say something like, "Larry, I've got the nut hand" (translation, "I've got the winning hand"). Larry knew that when I said that I meant it. (You never wanted to be caught being a liar. It's OK to bluff, but not to lie) Larry would appreciate it when I did that, as it saved him throwing away good money for bad. What he didn't realize was that I was only trying to keep him in the game and keep him coming back so I could maximize my winnings.

    I would like to submit a theory to the list as to why it is so hard to make money in the markets right now.

    The reason is because the markets have scared away all the "gamblers." Everyone was making too much money in the '90s -- the gamblers, especially, were making too much money. The market corrected too much, thus scaring away the gamblers. They didn't mind playing when they were winning big, but they are emotional, illogical beings, and will run away like scared, confused rabbits when they lose big.

    We need the gamblers. They are the ones that make it so easy for the rest of us to make money. We simply need to figure out where the gamblers are going, and then capitalize on their lemming-like moves." Gamblers move like a school of fish. It's just like watching synchronized swimming. Gamblers also move on emotion. Very little logic or thought goes into their decision-making process, and if there is any, it's usually very superficial. The market has scared away the gamblers.

    The market also committed another terrible sin. It lied. It lied about the hand it was holding. How did it lie? It cooked the books. The balance sheets of Enron, WorldCom, Global Crossing and Adelphia were a pack of lies. And to top it off, the lies were confirmed by the likes of Arthur Andersen.

    It was OK for the market to bluff the average investor (gambler); they could accept that as long the market threw them a bone now and again. The market does this by giving them an occasional good year or a good trade, and even lets them make a decent return over the long haul if they stick with it.

    For instance, if you look at the return of the average mutual fund and then compare that to average return of average mutual fund shareholder you will see a serious disconnect. For instance, the average mutual fund may have had a 15% return in the '90s, but the average mutual fund investor only got around a 6% return (I'm just using those numbers for illustrative purposes. I don't recall what the real numbers were, but they were not that far off of my example). The average investor could live with that, because they had the occasional good year and they never really lost big in the process. The market lied and scared away the investors (gamblers) at the same time.

    The people that make it easier for us to make money have left the market in droves. Those left in the market are players. It's hard to make money from players, no matter how good you are. I don't know who the best trader is, but I know it's not I. But I know that no matter who he is, he's going to have a much easier time making money against an average Joe than he is against me. I may not be as good as he, but I am certainly not the one you want to "play" against. We all need the average investor back. When the lemmings, the schools or fish, or those that live on emotion come back to the markets, then our jobs will all be a lot easier.

    A New Story from Bo Keely: "The Rails Sing, Eh?"

    One-Sided Volatility? from Alston Mabry

    GOOG 409.20
    GOOG Jan 08 560 Calls: 52.00
    GOOG Jan 08 260 Puts : 16.00
    Beta = -0.17
    Source: MSN Money

    Clustering Analysis and Financial Performance, by Victor Niederhoffer

    In the course of studying the applicability of the use of clustering methods to financial markets, a field with several hundred thousand methodological and application papers, I came across an interesting line of studies applying qualitative clustering methods to determining companies' future financial performance from the content of their past quarterly reports.

    The studies by Kloptchenko from Abo Akademi University take 10 years of annual reports and classify the companies into bad, neutral and good return on equity improvements in the next year. He then takes the words used in each of the three categories of annual reports and sees if there are differences between them in the three categories that the words appear in. He was able to come up with 60% accuracy versus 33% random after the data mining. Good words were admissible:  approach, award, career, vary, wealth. Bad words were: burgeon, chance, collapse, complex. uncertain, undergo, unforeseeable.

    For example, "discreet, stockholder, intelligent, profit, diverse, extraordinary, innovative and succeed "were positive in the positive class but negative in the negative predictive model. Similarly, "stress, cumulative, losses, unknown, doubt" have positive weight in the negative class predictive model and negative weights in the positive class predictive model.

    By looking only at words that appeared a certain threshold of times, an improvement in accuracy was possible". The author in another paper has applied this work to analyzing future performance from past quarterly reports  the author concludes: "Before a dramatic change occurs in company financial performance, we see a change in the written style of a financial report. If a company's position is worse during next quarter, the report of the current quarter gets more pessimistic, even though the actual financial performance remains the same."

    There are so many variables, so many differences in company performance, so many implicit hypotheses, so much correlation and interaction of the content of the financial numbers with the future results, that with the small sample size of company years considered, possibly less than the number of hypotheses implicitly considered, it is a wonder the author didn't come up with 100% accuracy.. The results are completely useless for practical current work. However, the effort, the type of strategy employed, seems well worth improving upon by specinvestors.

    Sentimental Beta, from Dr. Kim Zussman

    Denys Glushkov constructs a pretty good sentiment measure from Investors Intelligence, CEF discount, IPO's, and  dividend premium. He finds that stocks with high "sentiment beta" (smaller, more volatile, and with higher analyst coverage) have lower returns than those with low SB. High SB stocks grew in popularity with institutions in the 1990s (along with everything else). So much for loving your stocks.

    Will Goetzmann's History, by Victor Niederhoffer

    Will Goetzmann is a Yale scholar (currently on leave for a year at Harvard Business School) who studies the history of markets. Some of the historical references and books on his Web page have timeless lessons. I particularly like the analysis of "The Perils of Wall Street Speculation" based on William Worthington Fowler's 1870 book Ten Years in Wall Street. Goetzmann reports the wary threat to stock market speculators with a link to the cartoon below the caption. This is similar to the Louis L'Amour story about the gold prospector who risks the whole mountain's falling on him with each blow of his axe that is memorialized in Practical Speculation by Susan Slyman's painting .

    "Drive the plow and reap the grain, sail over the sea, sweep the streets even, chose any honest calling, no matter how arduous, anything but speculation. Even if endowed by nature with gifts and favored by fortune, and you rise to be one of the money kings, your name will then only go down among the gigantic but disreputable shadows which flit through the traditionary landscape of Wall Street."

    Goetzmann comments, "Don't take the threat seriously. Our culture has always had a love-hate relationship with finance. The same people who depend upon professional investors for their future well being at the same time decry money managers for not doing real work. If you go into finance, you will have to live with this cultural duality."

    I feel that quantification of the degree of acceptance of the sentiment that investing in the stock market is likely to end in disaster is one of the best indicators of future return. Whenever all my relatives call to ask whether they should get out of the market, and all my readers send me hate mail because the market went down and I said something bullish in the last few months, or whenever the academics write books or articles saying that one should disregard the returns of the 20th century reported by the Triumphal Trio and realize that there were periods when you actually could have lost money in the market, and they are imminent and relevant now, so get out, why then I know that it's even a better time than usual to reach for the canes.

    Such fear can be quantified even more readily by runs of declines of parts of the day as suggested by Goetzmann's poignant non-quantitative take on "Three Days after Black Monday: The Crash of 1987."

    After reading the erudite, sharp and practical historical vignettes and analyses of Goetzmann, including references to many of the books that only I have in my library, and learning that he is teaching, indeed heading an important center at Yale, I  wondered we be so nearby yet not be in close contact. Then I realized that the lecture I gave at his class with Laurel and Liz Callaway, the article he wrote about my tally sticks, and the many times that he has been at my house for historical research must be augmented imminently.

    Jim Sogi adds:

    Look at some of the great company names from Dr. Goetzmann's NYSE data reflecting the technology of two centuries ago: rail, coal, canal. As Dr. Fitzsimmons described, the technology of the 1800s and the industrial revolution were more revolutionary and disruptive than current developments, and impacted life even more than current technological wonders. It is a primacy/recency phenomenon that gives us the illusion of the importance of recent inventions. You want some real out-of-sample data to crunch? You want revolutionary disruptive technology? Look to the 19th century:

    Many prices above $100. If you had to settle trades in paper certificates, you would want as few positions as possible.

    A Risk-Free Rate Question, from Jason Schroeder

    I look at the frequently offered definition of government bonds' being risk free and really wonder how that abstraction helps me evaluate other financial products.

    Holding a government bond is akin to one young child's inviting another to his birthday:

    What part of this kind of risk is supposedly free of risk? There is a difference between Zero and the Empty Set.

    The introductory books begin just pricing a bond and proceed to the funkier functions of time and money which I am capable of analyzing.

    What happens when I do not believe what I read? The functions make sense when justifying a payment schedule as a payer. But as a payee, I have questions about the symmetry.

    We Can't Disagree Forever, by Dr. Alex Castaldo

    There is a result in Game Theory called the We Can't Disagree Forever Theorem. As a game is played, the players will learn about the situation by observing the other's move and eventually they will converge on a common understanding or as it is called 'common knowledge': every player knows certain things and knows that the other players know them. This is a difficult area of Game Theory.

    John Allen Paulos gives a complicated and somewhat artificial example involving two investors who have partial and non-overlapping inside information about what is going on at a startup company. By observing whether or not the other has dumped their stock yet, they are able after a few steps to reconstruct the full inside information even though each only has half of it.

    I believe it has no practical application, but is interesting conceptually: people in a market can figure out a certain number of things by watching the market reactions.

    Jim Sogi Goes Fishing

    Three important pilot fish in the last two months:

    1. Apple Computer. The market shakes off some bad news, erasing a nasty gap and propels higher, the S&P follows in similar fashion.
    2. American Express. Chenault's comments at a M#rrill shindig put the markets into a panic. The stock tanks, sellers are all over the place, it is halted. Analyst estimates are too much. The market does not care after it reopens.
    3. Intel. Sellers everywhere earlier today. Now it's up on the day.

    A New Collection of Stories from Bo Keely

    Our Monthly Buyback Update

    Iron, Steel and Trading, by Dr. Rod Fitzsimmons Frey

    The industrial revolution holds fascination for me. The period was one of great inventiveness and entrepreneurial spirit, where a man could, by development of his hands and mind, create a fortune for himself and for the world.

    Even more than that, the industrial revolution was a bootstrapping process. For thousands of years society had existed in a more-or-less technological stasis, give or take a Leonardo or two. As the revolution got underway, a new meme took hold: one of building on ideas; one of unsatisfied ambition; one of desire to progress combined with belief progress was possible. The result was a series of interlocking technical innovations that brought us from plowshare to space shuttle.

    This great societal venture can serve as a macrocosm for the individual process of bootstrapping. There are many similarities between an individual trader's education and society's industrial launch. There is no roadmap for traders, no school program in how to make a living in the market, just as the early industrialists were in uncharted territory. Traders face a society that is uncomprehending of their daily tasks, and even hostile toward them; industrialists challenged aristocracy and peasantry both to accomplish their goals. Ignorance of the role of speculators approaches what industrialists faced in the Luddites and others. And most of all, trading is solitary: the only motivation comes from within, and strength to continue will not come from others.

    I set out to reproduce the major steps of the industrial revolution. My goal is to create an internal combustion engine from scratch. (This goal is considerably less challenging than learning to trade). I initially made several false starts by trying to move too fast. I eventually returned to first principles, and once they were mastered, my progress has been smooth. The principles were:

    1. Harnessing and concentration of energy. I learned to make charcoal, which can be thought of as concentrating the BTUs of wood. That enabled me to melt iron and opened a myriad of doors.
    2. Geometric reference surfaces. Before any progress could be made on actual devices, geometric references were needed. It turns out that a flat plate can be generated to any desired degree of flatness in a completely isolated process. Once one has a flat plate, straightedges and squares can be generated.

    With these two first principles understood, progress has been smooth: I've built a lathe, which can in turn build other machine tools, and the engine will become a reality.

    So what are the first principles for somebody learning to trade? Two candidates that follow (and perhaps stretch beyond tolerance) my analogy are the economic cycle (energy), and probability theory (geometry). But the link from those fields to actual practice of trading is nowhere as clear as the link between charcoal and molten iron. What are some other candidates for "cornerstones" of market participation?

    Heart of a Champion, by Jim Sogi

    I compete for surf with the 20 and 30 year olds in the water everyday, and they don't cut me any slack, and neither do the waves. At 50+, I'm one of the few old guys still out there. My good friend Makalawena Bob surfs at 70. One of things that gave me the most inspiration was age bracket competition and I won the Island Grandmaster division, a local division. No big deal, but it felt just great! A lot of the swimmers do age bracket competition as do the triathletes. The old guys train hard, but still have a chance because the other guys the same age have the same limitations. The young guys give a little respect, not much, but some. They know they will be old one day too.

    It's big wave season now, and your life depends on being in top shape. You can't go out in the 15-20 foot waves with big currents without wind, strength, flexibility, stamina and knowledge. In the bigger waves, age isn't such a handicap as it's not so much about speed, it's more about knowledge, strength, courage. It takes as much guts to drop into a big 20 footer as it does to enter and hold a big position at what seems the trickiest point. Fear is inversely proportionate to one's current level of strength, wind, flexibility, stamina and knowledge. Its good to be in top shape physically as it helps with trading. Both sports and trading can push one to the limits of courage and stamina, so they complement each other in many ways.

    Some Lessons From a Trading Story, by Victor Niederhoffer

    When I was 11, I read a book that seemed good at the time on how to win at poker. The book recommended that you play only low hands because you could win either way with them, in hi-lo games, and that in hi limit games you should only play when your hand was the highest and best showing. I followed this advice and beat my neighbor who was a tenant in my grandmother's apartment out of his rent money which was $20 for the month. I heard his wife beat him up, screaming at him all the while, that he was a no-good gambler and had ruined their life. Shortly thereafter my grandmother told my father of what I had done and he demanded that I never play cards again with the tenant or anyone else for that matter as all gamblers die broke.

    The first thing I learned from that is there is a tendency to lose everything when you gamble. And when I made $20 million on $100,000 in about six months in my first foray into commodity speculation in 1979, and then lost $15 million of it, I remembered the wife screaming at him next door. I stopped before I went under and have always tried to keep that lesson in mind since. It worked many times since that time but didn't in 1997 but that's another story. I hope I learned from that.

    Someone else learned something from that also. It was the boy wonder, Shawn Andrews. He is in with all the big casino owners in Vegas and is invited to the celebratory dinners for the world champions of poker. When the conversation dies down, he tells my story and says "Vic's father says all gamblers die broke, and they're lucky if they don't end up as degenerates like all the system boys he had to carry to the morgue from the Bowery." At first there is great disbelief and disapproval. When no counterexamples are forthcoming, brooding ensues. The next day he invariably gets a few calls, and he has a few new customers.

    I used this story at the recent fund-of-funds conference I spoke at. I told them they should pay me to speak at all their conferences because they could use me as an example of why diversification and vetting and the bear side were necessary. To emphasize the emotional content of the message in a way that mere words can't, I was accompanied by two outstanding musicians playing the piano and singing. My message was a great hit, and I was offered several jobs after the show by risk management firms. I like to make fun of myself because it keeps me humble and helps me to avoid the fate of my next door neighbor.

    A Letter on Poker, the Markets and Finding Success, from Steven Leslie

    A Story on Flat Tires and Loyalty, A Story About Day Trading and On Welding and Trading from Jim Lackey

    "Oops," from George Zachar

    JPM has a chart "showing" that it would take $800 billion in 5y10y swaption straddles to "hedge the vega" of outstanding mortgage backed securities. What does that mean? It means the optionality of the mortgage universe is at an all time high, and along with it, "oops risk."

    A Letter from Don Boudreaux to The Christian Science Monitor

    To the Editor:

    Henry Kaufman and Thomas Johnson wisely support science education, but they go overboard when insisting that "America's economic well-being hinges on our pre-eminence in science and technology" ("Send Future U.S. Business Leaders Abroad", Dec. 8).

    If a people's well-being depended upon their nation leading all others in science and technology, then only one nation in the world, at any time, would be prosperous. More importantly, economic freedom and free trade -- not science education -- are the ultimate keys to economic well-being. Economic freedom unleashes entrepreneurship while free trade allows people in technologically less-advanced countries to benefit from the knowledge and skills of people in technologically more-advanced countries.

    Donald J. Boudreaux
    Chairman, Department of Economics
    George Mason University

    Defeating Failure and Failing at Success, by Sushil Kedia

    Ali is the movie from amongst innumerable ones on the battles of Cassius Clay. What stands out vividly is Clay's/Ali's overwhelming stamina and systematic obsession at defeating failure. The movie captivated me in its portrayal of his failure at handling the subsequent success as well. The movie handled the contrast remarkably but could have spared its lingering at the treatment of the twilight and the transitory phase.

    The fine portrayal of how Ali fought with himself rather than the enemy, ruled the ring with his mind as apart from his footwork and punches, and beat all odds is here to see. The disintegration of a champion, the overtaking of emotions and the ultimate weakness of the achiever, is breathtakingly clear as well. I am preserving the copy I chanced upon a couple of years ago to hand over to my kids as they grow to the age where evaluating and understanding success and failure may be better facilitated with this digital story.

    Rabbit Huntin' and Trend Followers, by J. T. Holley

    We got our first snow of the year in Richmond, VA yesterday early morn. It was a nice blanket though a little slushy. This for some reason got me thinking of going hunting with my Pa Pa for rabbit. This is something of a dying thing hunting for squirrel and rabbit. The hunting seasons of other game are short now that when you do go into the woods you aren't going to waste your time looking for either of the aforementioned. You don't really plan to go rabbit hunting either. It is something that you just get accustomed to after it snows.

    Rabbit hunting is something when I think about it very similar to trying to find trend followers in data. They leave footprints in the snow. They tend to be active in the morning and late in the afternoons most of the time except if it is dreaded cold then they come out in the middle of the day. A good place to find a rabbit in the snow is on the Southern side of a hill like finding a trend follower on the other side of a 10 day or 20 day moving average. Like trend followers placing stops, rabbits when chased out of a burrow seem to come back as if in full circle. That circle or burrow is the average where you can shoot a trend follower too. Rabbits like trend followers don't move much and maintain their positions and when scattered usually return to the point of anxiety, easy prey. The shot of choice is a 20 gauge because they are thinned skinned and easy to kill, much like getting a trendy out of a position!

    Rabbits for those who haven't tasted them are nothing like chicken. You gut them in three parts: front legs, saddle, back legs. Place these in salt water over night then rub butter and breadcrumbs then fry like chicken, but it doesn't taste like chicken! Mess of greens and caramelized carrots are good sides, no puns intended.

    Don't know what a trend follower taste like?

    After growing up huntin' rabbit and squirrel it makes watching ole' Elmer Fudd more of a comedy. You know that it is the foil opposite in real life between the human and the rabbit. For a young man coming of age rabbit hunting is one of the first introductions to the sport of hunting, maybe for counting purposes hunting trend followers and taking profits from them oughtta be the first exercise?

    Remember don't shoot just for fun, respect the game for what it is: nourishment. Equally respect trend followers for what they are: potential profits.

    In Pursuit of the Initiative, from GM Nigel Davies

    I'm not sure how it is for other GMs, but whenever I stretch my position to pursue the initiative I'm painfully aware of the holes I might be leaving in my ranks and the strain put on supply lines. Lasker advised that the attack should be in proportion to the amount of advantage you have, but applying this tenet in practice is fraught with difficulty. First off it can be very difficult to know how much advantage is there, and many games are lost because players overestimate their chances and play far too much aggression for their position to reasonably tolerate.

    Despite my thirty years of competitive chess I can't say I've found an all-embracing solution to these issues. If you play it safe your opponent is under less pressure whilst if you go for the jugular it can rebound. Perhaps the bottom line lies in the kind of tournaments in which someone competes; bold play leads to more ups and downs which are good for Swiss tournaments (many players, few prizes) but less effective in round robin event and matches. But any change in style must also be within one's comfort zone.

    Inefficient Markets, by Prof. Gordon Haave

    Different markets are inefficient for different reasons. Usually, I conclude that the reason for a market inefficiency is that people do not conform to the theoretical ideal of their being rational consumers.

    As someone who enjoys putting thoughts to paper, on my mind this morning is why the market for financial commentary is so inefficient. By inefficient, I mean that bad ideas and writers are seemingly not weeded out over time in favor of good ideas and writers.

    A piece of market commentary necessarily contains two components. The first is the ideas being conveyed in the commentary, the second is the style of the commentary. My comments relate primary to bad ideas being conveyed in financial commentary, which right off the bat suggests that financial commentary consumers might value the style of commentary much greater than they do the correctness of the ideas being conveyed.

    Now, there is always going to be vast disagreement in the financial community over certain ideas, so I am not going to use this space discussing growth vs. value investing, the true value added by hedge funds, or whether or not there is a real-estate bubble.

    Let's use my own situation as an example: I live in northwest Oklahoma City. The area is booming. Just three years ago much of the land around my neighborhood was farmland, and now the developers are building thousands of homes. The schools are good, and northwest Oklahoma City is the easiest direction for future economic growth (due largely to oil prices) to expand to, as the west is bordered by Midwest City, the South by Moore and Norman, the West by Yukon, and the North by Edmond.

    Real estate in my neighborhood is hot. I am going to create investment interests in my house, and you should buy one. The cost? Only $3,500 per Haave housing unit. It does not matter how many investment interests I am selling, how large my house is, or what condition it is in.

    Who here wants to buy an investment unit in my house?

    Why is it that every day the vast majority of investment recommendations (outside of technical investment recommendations) mention the quality of an investment that you should buy without mentioning the price of the investment?

    Possibilities as to why the investment commentary industry does not weed out bad idea/authors:

    Dr. Phil McDonnell replies:

    What this apparently assumes is a definition of efficient writers as being able to predict the market better than their peers. If we accept the premise that most markets are reasonably efficient and by definition unpredictable, then it is only reasonable that financial journalists as a group would have no better track record than random guessing.

    However I think Prof. Haave's point is that the type of logic employed by many financial journalists is inadequate. In a sense I agree. I would always prefer as much information as is reasonable, including the usual financial ratios with respect to price. However I also know the most popular ratios often do not work or even operate in a manner contrary to what is popularly supposed. For more on this see the discussion of the P/E ratio fallacy in Practical Speculation.

    Naturally this leads us back to the random walk. The latest price includes the value of all previously known information. Then the usefulness of a media piece comes down to the novelty of the ideas presented therein. As a reader I look for ideas which I have not seen before and those which represent new trends or information. To the extent that a given media piece does not have new information then I would have to agree with Prof. Haave's underlying point: it is just more random noise on the financial landscape.

    Prof. Adi Schnytzer responds:

    If you are spending 80 hours a week trying to find non-random inefficiencies, why stick to a silly textbook definition of inefficiency? I would define a market as inefficient if I am able, any which way, to regularly get a greater return than the risk-free rate of interest, plus something for the risk, assuming I'm risk-averse. We know that inside information allows such profitability so that part of your search is implicitly for signs that insiders inadvertently provide when they trade illegally. Then there are the frictional inefficiencies that may or may not exist to an extent sufficient for exploitation. Finally, there is the obvious and unquestionable myopic nature of the market. Every time oil changes direction, the market goes nuts. Likewise, when a large firm produces exceptional news, either good or bad, or when something unusual happens in the world arena.

    Can this be used to make money? Sure, if you know how to predict where oil prices, the US economy, the world economy, and I guess the world in general, will be in six months' time. So we are talking about information gathering (easy today) and processing (never easy). Why define inefficiency at all?

    They Held Tightly to the Things They Knew Best, by Victor Niederhoffer

    *See below -- Letter from the President of the Old Speculators' Club Defending Old Ways

    Never at a loss for a reason to be bearish, the chronics are clinging to their old ways and coming up with one reason after another to be bearish. The main themes these days appear to be that the yield curve is close to inverting, the pension fund liabilities are becoming increasingly ruinous, the earnings growth is going to be much worse next year, the bull market has gone on longer than its norm, (or the bear market is confirmed by the absence of a break through of the 2000 high), and consumer debt is going to cause a recession. As the Sage says, "We do not think the general ownership of equities is going to be very exciting over the next 10 to 15 years."

    Now the usual model to analyze those in denial of a failed prophecy is the Keech cult studied by Leon Festinger. Like the chronics, they predicted the end of the world. And when it didn't come, that only confirmed their belief that they were right. Festinger reported five conditions necessary for such a confirmation:

    1. A deep belief was held
    2. Irreversible action must be taken
    3. Events discredited the belief
    4. The evidence is recognized.
    5. Group support is present after the disconfirmation.

    Okay, now the bears:

    1. The chronics deeply believed that Dow 5000 was around the corner
    2. They sold short, bought funds of funds, or stayed in money markets irreversibly staying away from the 10% a year drift.
    3. Events like the market going up some 50% in three years, with the average unweighted stock doing much better than that, have discredited the belief.
    4. This has been recognized by the chronics.
    5. The groups of bears, readers of the weekly financial columnist are still out there, admiring his quips, his sardonic smarmy condescending attitude to those who have made money and have been lulled into a sense of unjustified euphoria et al.

    Yes, but there's a better analysis of it, a better reflection of it all. And as usual it's by a woman of deep insight, one of the greatest observers of human nature in our day, Margaret Mitchell in Gone With the Wind, a book well worth reading as one of the greatest historical novels ever written, rivaling some of the best by Patrick O' Brian.

    Something had gone out of them, out of their world. Five years ago, a feeling of security had wrapped them all around so gently they were not even aware of it. In its shelter (Nasdaq 1000) they had flowered. Now it was gone and with it had gone the old thrill, the old sense of something delightful and exciting just around the corner (Dow 5000), the old glamour of their way of living... Their faces were little changed and their manners not at all but it seemed to Scarlett that these two things were all that remained of her old friends. An ageless dignity, a timeless gallantry still clung about them and would cling until they died but they would carry undying bitterness to their graves, a bitterness too deep for words. They were crushed and helpless, citizens of conquered provinces. Everything in their old world had changed but the old forms. The old usages went on, must go on, for the forms were all that were left to them (the prices are not sticking to the moving averages). They were holding tightly to the things they knew best and loved best in the old days, the leisured manners, the courtesy... the traditions in which they had been reared. They had nursed the wounded, closed dying eyes, suffered war and fire and devastation, known terror and flight, and starvation.

    Now if that doesn't express it perfectly, I'll eat crow.

    Pamela Humbert responds:

    I think it's the aging of the baby boomers (I blame all bad things on them). They are suffering from the realization that:

    While there is no way of testing my theory, it doesn't seem implausible that the bearish meme in the face of otherwise good things is about so many people facing menopause, middle age crises, ennui, and fear of death all at the same time. In my opinion Bill Cl#nton's heart condition had a bigger impact on peoples' outlook than 9/11.

    P.S. I'd like to avoid an influx of emails from 55+ year olds telling me that their s#x life is better than it was when they were 30. And for seniors who feel obliged to share the details of their amazing s#x lives -- don't. It may be great now but the reality is that you'd pay $1 million, if not more, to be 30 again. Viagra does only so much for the experience.

    A Letter from the President of the Old Speculators' Club Defending the Old Ways

    Wrong, wrong, wrong.

    First, you dabble in fiction: "S#x not as good when you're 55+..." There is no s#x after 55.

    Death is further away, not closer. See Ray Kurzweil's The Singularity is Near. Of course, life is not a straight line up. There are too many delightful back alley diversions to even want to adhere to a straight line.

    And you know what's left after the kids are out of college?

    Nothing! We're absolutely flat, stone broke, in debt, and with ever diminishing prospects. Whatever cash assets we had went up the chimney when we clung to the promises of the chronic bulls and held onto our tech shares after the turn of the new millennium. And now that Kurzweil tells us immortality is on the horizon, we learn we'll have to work forever. Of course, if we had put our money back into the market we would have regained chunks of what was lost. But we are a generation that despises risk. We embrace security and a market that always trends up and a guaranteed comfortable retirement.

    Victor wishes us to cast our few remaining shekels into a market that could once again turn into a bonfire. Some of us have done so, but only because we always watch CNBC, "where never is heard a discouraging word." I would love to read the thoughts of the weekend permabear, but I can't afford it. Most of my free cash goes toward purchasing necessities -- thank G-d for low inflation. I used to think I was spending substantially more for food than the government was stipulating. However, once I recalculated my expenditures properly, I learned I had created a straw man. By merely placing meat, fruits, and vegetables in a "highly volatile" category, I discovered my core expenditures were, indeed, almost unchanged. I just don't have much cash - nor do most of my peers -- and that's why we're cranky.

    Why the Chair rants about the chronic bear, the Palindrome, the Sage and others I'll never figure out. Just who does he think is constructing that "wall of worry" that must be climbed? You certainly won't find many contributing builders on Daily Speculations - although they might be quite able to construct a temple to Pangloss. Another item I pass over at the grocery store, which the Chair never foregoes, is the Enquirer. You ask, Why? Well, other than the unnecessary expense, the Enquirer is permanently bearish on people! Admittedly, the celebrities and other worthies who fill its pages may not be the world's finest human beings; but isn't it just a touch vindictive to watch them suffer - and suffer again and again week after week. Appears old-hearted to me.

    So forget about laying the blame off on menopause or ennui. We can tolerate things like that as long as we have a gated community, a good tee-off time, no slovenly neighbors, a convenient Nordstrom's, and good Chinese carryout. But the government won't give that to us. So the market offers our only opportunity. But, forgive us, we're scared to death especially with the resurrection of Goldilocks and "don't worry, be happy."

    We've been down that road and were lucky to get out with loose change. You see, unlike Mitchell's fictional characters, we never possessed fine manners or experienced a flowering. We went straight to seed in the late 60s and early 70s when 420 was cheap, s#x was free, and the only thing exciting around the corner was the draft board office, which we torched regularly. We spit on our wounded, cheered their deaths, and were indifferent to the fire and devastation that the victors visited on our former allies. Gimme Shelter was more than another Stones triumph; musically and cinematically it became our blueprint for life. And we feel betrayed.

    James Sogi avers:

    One of the sad problems is the lack of respect for age, the elderly and their wisdom. There is a pernicious cult of youth. The Hawaiians revere and respect their kupuna (elders) for their wisdom and knowledge (mana'o). Slavish worship of beauty and wealth and their mimicry is a parody that causes dissonance. It is an misguided offshoot of commercialism.

    The are many benefits that come with age and wisdom.... independence, a level of comfort, freedom from many youthful anxieties and self destructive urges. Health can and should be pursued at any age as the top priority.

    Part of the answer is to keep moving and active. Check out Surf for Life, it's a movie about old surfers 93, 84, 70 still surfing, still stoked on life. Health: it's worth a million bucks.

    J. T. Holley rebels:

    Well not exactly my friend. Great book and somewhat good metaphor, but please may I beg of you not to have the Ableprechtuffets compared to my beloved South. Much of the Civil War history is untrue. Like most history it is written by the victor. The Bulls continue to write the economic history of our land and this is based on empirical fact, but the South didn't send its men to War over an issue that affected only 6% of the population, such absurdity is readily made available in text. The deception is there. There was no Union Army fighting for the sake of ending slavery nor was there a Southern Rebel Force fighting to preserve it. After the South declared its independence the Union forcefully invaded, leaving the South no choice but to defend themselves. The South obviously surrendered and gave way to Progress and Industrialization.

    Some would say that the South has become an economic colony of the North used and exploited like Colonies around the World. That might be a little metaphoric to the Bull vs. Bear struggle but it ain't similar at all in the characters and integrities of whom make up the fight? The only similarity is that progress and change are shared in the story and plotline for the sake of economic advancement. The South like the Bears just don't like change! The South at least eventually embraced and is continuing to change, albeit slowly. Chivalry, dignity, respect, individual liberties, and gallantry are what Mrs. Mitchell wrote were Scarlett's feelings and reflections.

    Now Vic, not one of those characters in the Bear Camp possess any of those traits? They have had their brains good and scrubbed to seek total destruction and eventual devastation so that they can say "I told you so", do you think General Lee would have even thought such? Sure Buffets words sound sympathetic, certainly not empathetic, but would you think for one minute he would nurse the wounded or close dying eyes?

    Kim Zussman adds:

    Perhaps in addition to boomer aging, we should consider how much trading is now controlled by 30ish physicists and engineers at quant funds with horizons similar to particles from colliders.

    It's hard to understand how, if trading/investing is approximately zero-sum, everyone can be rich. But of course this is neither the message of libertarianism nor statistics. For there to be rich there must be poor. To be rich you need to be smart or lucky, and usually both. The non-random element after the dice are thrown is intelligence, or persistence at learning, and it is available here and now.

    Here in sunny Westlake Village, there are plentiful queues at tee-time, chock-a-block McMansions, and too many Timmys toning at tony healthclubs. And it is surprising how many are on anti-depressants in the face of such plenty. Maybe it has less to do with absolute possessions than potentials, and the defining moment of age-related depression is the abandonment of hope for a better future.

    Dr. Rod Fitzsimmons Frey offers:

    When I was helping to distribute investors' money to the community by hiring programmers, I had a decided bias in favour of university graduates over technical college grads. Not because one was smarter or more ambitious: rather, it seemed the probability of a university grad's understanding of the importance of "why" versus "how" was higher. (The probability was still quite low, I note.)

    The preference of "how" over "why" seems to be genetically encoded in us. It's easy to see why: in a Hobbesian world of the quick and the dead, they "hows" are well fed and surrounded by little how-asking bambinos long after the "whys" have been eaten by sabre-tooth tigers.

    Like so many traits useful in the jungle, our how-bias is no longer serving us quite so well. Big Macs are so abundant that our jungle-born urge to store them on our midriffs has become injurious. Likewise, prosperity is so abundant that serious attention to the "how" is all that is needed to attain the starter castle and matching Hummer.

    But in attainment, as in all other endeavors, success goes to the "why" askers. Those who know why they want material prosperity are likely to harvest no end of good from it. Those who attend only to the how will meet with disappointment and despair. This is not a revolutionary point: it is repeated over and over by all great religions, all lasting philosophies, and all wise uncles at weddings. Yet by-and-large most people miss it. I'm personally inclined to forgive them: "why" is very hard.

    I know my own "why" for chasing prosperity. I'm turning to y'all for the "how".

    A Ribald Spec adds:

    "There is no sex after 55"... miles per hour! Any faster, and you really do need to concentrate on driving.

    From an Anonymous Contributor:

    Margaret Mitchell would be proud.

    For the poetry version, it's time to chase down a copy of Joni Mitchell's "Hissing of Summer Lawns" album [which I consider her best work, ever], which has this fine track in it. Grafting in the trading analogies is a straightforward exercise.

    Joni Mitchell, Shades of Scarlett Conquering lyrics:

    Out of the fire like Catholic saints
    Comes Scarlett and her deep complaint
    Mimicking tenderness she sees
    In sentimental movies

    A celluloid rider comes to town
    Cinematic lovers sway
    Plantations and sweeping ballroom gowns
    Take her breath away

    Out in the wind in crinolines
    Chasing the ghosts of Gable and Flynn
    Through stand-in boys and extra players
    Magnolias hopeful in her auburn hair

    She comes from a school of southern charm
    She likes to have things her way
    Any man in the world holding out his arm
    Would soon be made to pay

    Friends have told her not so proud
    Neighbors trying to sleep and yelling not so loud
    Lovers in anger Block of Ice
    Harder and harder just to be nice

    Given in the night to dark dreams
    From the dark things she feels
    She covers her eyes in the X-rated scenes
    Running from the reels

    Beauty and madness to be praised
    'Cause it is not easy to be brave
    To walk around in so much need
    To carry the weight of all that greed

    Dressed in stolen clothes she stands
    Cast iron and frail
    With her impossibly gentle hands
    And her blood-red fingernails

    Out of the fire and still smoldering
    She says A woman must have everything
    Shades of Scarlett Conquering
    She says A woman must have everything

    (repeated refrain) A woman must have everything

    Low Tax States and Stock Performance, from Dr. Alex Castaldo

    Performance of stock indexes for 6 low-tax states since 1999:

                   Start   StartDate     Cur   CurDate   PrcChg  PrcChg
    Arizona         229.94 12/31/1999  514.94 12/05/2005 123.95% -13.90%
    Nevada          Not available
    North Carolina  100     1/02/2002  125.70 12/05/2005  25.70%   9.56%
    South Carolina  100    12/31/2001  148.33 12/05/2005  48.33%  10.19%
    Florida         100    12/31/1999  131.82 12/05/2005  31.82% -13.90%
    Texas           178.89 12/31/1999  347.52 12/05/2005  94.26% -13.90%

    All five available indices have substantially outperformed the S&P.

    Data: We used stock indexes provided by Bloomberg that track the performance of each state. The companies are headquartered in the state (or have a substantial portion of their operations there) and have a minimum market cap of $15 million. We used 12/31/1999 as a start date or the first date the index is available. The indexes include from 45 to 400 companies and are price-weighted indexes.

    A Cantankerous Spec Reads the Newspaper, a Continuing Feature

    Quadriga's Baha Comments on Performance Outlook for Main Funds
    Dec. 7 (Bloomberg) -- Christian Baha, chief executive of the Quadriga Investment Group which has $1.6 billion under management, comments on the outlook for the performance of the company's main funds and assets under management. He made the remarks in German in a television interview scheduled to be broadcast tomorrow.
    On the performance outlook: ``For 2006 we are expecting 20 percent to 30 percent growth for our three main funds. That's the long-term average. With the more aggressive Superfund C statistically we could even see up to 40 percent growth, especially because this year wasn't that great. ``I'm not worried about a negative year, it's a good time to start buying.''
    On funds under management: ``These will rise to about $2 billion to $2.5 billion, with a bigger part coming from our performance -- $400 million to $500 million -- and the rest from new clients.''

    When Rastfarianism was in vogue, I remember reading about studies of people who smoked every day, a lot. They lost the ability to discern the difference between reality and their dreams, and developed a religious belief system that included the notion that dreams and reality were not all that different.

    A Methodological and Romantic Note from the Assistant Webmaster

    "How do you combine the large number of contracts traded for a particular futures market into one series?" is a hearty perennial. I think 'best practice' is to save two series: 'raw' prices, simply concatenated, one contract after another, and 'adjusted' prices, with all the data till contract i back-adjusted, difference-wise, by the rollover amount from contract i to contract i+1. The 'adjusted' series preserves correct point-wise/dollar-wise changes, and to get correct %age changes, you can use 'change in adjusted' as the numerator, and 'raw' as the denominator.

    The question of when to roll from contract i to contract i+1 is complex; Prof. Corso (who runs APL on his cellphone) has written about this. It doesn't matter much for financial futures but can be important in energy/metals/ags/softs.

    An alternative is to keep just the 'adjusted' data, along with the rollover dates and amounts in a 'footnote' database, to be used when/if %age changes need to be calculated. This takes up less space than two full series, but is harder on the brain.

    The splicing of futures contracts is usually handled automatically by the many vendors of realtime and/or historical market data, typically with many methodologies (including several that are "wrong") for contract rollover offered as user choices. E.g., on Bl##mberg: PDF(Go) 2 (Go) 13 (Go) brings up:

       Generic Futures Rollover:       Roll     Include Serial
                 Type Day(s) Month(s)  Adjust?  Futures?
    Price        :  B     0      0         N          N

    Individual share data are another issue entirely. "Fixing" splits/spinoffs/dividends is straightforward, but the big problem is finding survivorship-free universe information "as of" a date in the past. The realtime vendors, (including Bl##mberg), are unsatisfactory as "research" databases for this reason.

    Prof. Miller points out that his peers don't worry about such things, but instead assume the existence of clean, accurate data. I'd suggest this is because the "plumbing" work is handled by the grad students under their tutelage (the students insufficiently comely to serve as romantic prospects, that is).

    John Lamberg contributes to the Dept. of Scientific Breakthrough

    It sounds like science fiction: a brain nurtured in a Petri dish learns to pilot a fighter plane as scientists develop a new breed of "living" computer. But in groundbreaking experiments in a Florida laboratory that is exactly what is happening.

    Diffusion of Innovations, by Victor Niederhoffer

    The diffusion of ideas, markets, industries and companies that involve innovations is one of the most fruitful areas for the spec-investor to study. The approach should start with a good book on methodology and in this context I have found the 86 page book Models for Innovation Diffusion by Vijay Mahajan and Robert Peterson very helpful. Another outstanding resource is the website of Roger Clarke, devoted to all manner of research on how technology, ideas, artifacts, and techniques "migrate from creation to use."

    The basic model is drawn from the spread of epidemics. A germ or idea is unleashed. Its diffusion is related to the number of susceptibles (S) in the population. But this number keeps getting smaller as the number exposed accumulates through time.

    N(t+1) - N(t) = A + B ( S - N(t) ), where N(t) = cumulative number infected at time t.

    The above equation is a good difference equation model of the process that leads to many insights for the non-random diffusions. A basic part of all such theoretical and empirical models in innovation diffusion (ID) is the familiar S-shaped curve with growth starting out slowly, speeding up at the ~20% of susceptible point and then leveling off at ~50%, with usually a symmetric descent to a 0% growth rate as the number of unexposed susceptibles approaches zero.

    Preliminary study of the subject reveals a gold mine of applications with applications to predicting the whole stock market, industry rotation and impact studies of patent and research spending jumping right off the Googled pages on the subject. More generally, every day in the market there is some idea that seems to have the mojo. The idea gets adopted with a slow or fast start and then it either levels, explodes or recedes. Where does the pitch in the pinch come in?

    Such thoughts revolve and enliven the creative process while sleeping and trading but are still very preliminary and I call on my readers for insights and lines of approach in this area.

    Sushil Kedia Responds:

    The number of shares held per shareholder, or shareholding density, might be an interesting variable to evaluate the idea diffusion of owning a stock. High density would be visible in either low floating stock companies or those that have a universal or near bearish outlook consensus. Similarly a low density of shares per share-holder would be a case visible in large floating stock companies, or where a universal or near bullish outlook consensus exists.

    Low and High density are descriptive terms. Maybe a beginning point is a study that evaluates a correlation between shareholder density, (over a reporting period), and returns over the same period.

    If meaningful correlations are found on certain stocks then this indicator can be exploited further, even if leading to dangers of curve-fitting by identifying shareholder density ranges that have turned out to be bullish and bearish consensus territories. Instead of using these ranges as a trigger to trade or invest, it might be useful to have these at the back of the mind as the coming change in bias.

    Alternatively, and possibly for the better, one could study the same data-sets to identify between what levels of share-holder density the most rapid move in prices happened, such that those levels would roughly correspond to 20%-50% of the idea stage. That would take care of blocked shareholding such as owned by managements or investment managers who never knew how to sell.

    Two other similar variables of study on this paradigm could be defined as:

    1. The number of fundamental analysts' upgrades/downgrades on widely held and analyzed stocks. The better alternative here again would be to identify ranges that would correspond best with the 20%-50% range, since there may be some analysts and some investment banks that never know how to write a sell.
    2. Investment Newsletter/Advisory opinions. Again, identifying the 20%-50% range is better.

    The beauty of the approach of diffusion of innovations appears to be the S curve that encapsulates roughly the 20% to 50% of the susceptible population.

    The equation in a single expression harbors the aspirations of the trendists as well the contrarians. Turn either S or Sum of N(t) to zero and you have contrarians lapping up the situation while the trendists' endeavor remains to ride the 20% to 50% range of susceptibility.

    Letter of the Month Award

    The material on this website is provided free by us, and by our colleagues, friends and readers. Because incentives work, each month we reward the best contribution or letter to the editor with $1,000 to encourage good thinking about the markets and augment the mutual benefits of participating in the Daily Speculations forum. Prizes are awarded at the end of each month by the Chair and the Collab.

    November's winner is Exploring Fama-French in R: Visualizing the Difference between Traditional CAPM and the Fama French Three-Factor Model in Estimating Cost of Capital, by an Objectivist researcher who requests anonymity, Nov. 23.

    Crazy People, by Nigel Davies

    It's a mistake to assume that crazy people are absolutely wrong about everything. Often they've got some great ideas but are missing balance and perspective. And they're always more interesting than sane people.

    As for a crazy person with perspective, then you have genius.

    An anonymous contribution to Bear Corner

    Credit Card Minimum Payments Set to Double Beginning January 1, 2006 Monday December 5, 4:15 pm ET

    San Diego, December 5th: , from PR Newswire. City Mortgage Services, a California-based independent brokerage offering a full variety of mortgage products to the public, today announced that recent changes in credit card payment regulations could drastically affect consumer budgets, making it impossible for some families to keep up with increased minimum payment requirements.

    Credit card companies will be increasing minimum payments right after the holiday as a result of new credit card lending guidelines set by the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision. This new guideline, which should potentially double minimum credit card payments, could drastically affect many household budgets.

    "It's easy for people to sign their life away on credit cards but there's a price to pay at the end when the bill comes," said Don Marginson, President of City Mortgage. "For many that price is going up. In the past, most credit card companies required a minimum payment of 2.5 percent of the balance. The new regulation requires that amount to double. For example, if you have revolving credit card debt and the current monthly payments are approximately $300/$400 per month on a $15,000 debt you're soon to be looking at a payment of $600 to $800 per month. As a result, credit card and mortgage payment delinquencies are on the rise and going up daily. I am advising my clients, and indeed, all consumers, to act now to reduce their outstanding debt before this new regulation affects their credit standing."

    Bank of America and MBNA have already raised their minimum payments, and Capital One is currently sending out their notices. Most companies will follow suit beginning this January. "This is going to cause people to take a look for alternative ways to get out from under their credit card debt," said Marginson. "One solution is to think about refinancing their home loan or perhaps arranging a line of credit, and paying off their credit cards and getting back on track with their finances."

    Do Rates Matter? Doubtful, from Prof. Mark McNabb

    While the body of research on rates has found extensive and exhaustive evidence of trends, economic impacts, etc there are numerous 'exceptions' to the rules.

    For the non-debt traders:
    Why care if the yield curve inverts, if the consumer is still financed at 5-7%?
    GMAC still at 5%.
    Why care if capital returns 8% or more in SE Asia?
    Why bother if your trade horizon is intraday?
    Why bother if your industry group grows at 15% and has low or lagged correlation to the spread?
    Why bother if energy replacement occurs at an increasing price curve? It does permit Mr. E. to tantalize the weaker with the prospect of the grail....

    Most of the rate relations are built on 25 year old externalities and outliers that will not matter one bit to the semiconductor group in the next 2 quarters as they outperform, or to consumer driven data storage and video gamers with demographics independent of crusty old men wearing green eyeshades.

    If one wants to look at credit factors and the market as an investor, (not a trader), look at its availability to industry not its cost when it is historically low. The new Fed governor little B is a non-factor unless the Fed reasserts its role in bank supervision. For example, if the yield curve inverts in 2006 and the long end remains cheap, the real estate game continues. The real banker in this economy should look at the musical chairs director in the Japanese-Hong Kong-Sino finance game.

    A greater challenge in the future for dual-homeowning yuppies will be to whom and at what price do they unload the second home, when factors such as the ease of credit, (as opposed to price), don't support growth. Look at families in Midwest that hold on to the house of every dead relative and rent them for less now than a year ago, as populations dwindle. Families end up with several unwanted wasting assets, (even if owned outright), in that economic environment vs. seeing real estate double and rents increase along the coasts. Take away the availability of credit and willing buyers, the coasts will go to the plains.

    Rudolf Hauser adds

    There is little question that, as mortgage finance depends less on depository institutions that borrow short and lend long, the prospect of a yield curve inversion does less to impede mortgage financing. The crucial question should be of expectations as to future long-term rates. Why would anyone want to lend long if short-term rates were higher unless they expected long-term rates to decline in the future to a level equal or below that of current short-term rates, other than to the degree necessary to hedge their assumptions given the odds that they could be incorrect in that forecast of flat to rising long-term rates. After all, the sensible case would be to invest short until rates decline and then switch over to the longer-term instruments. As to yield curve interpretations see my earlier posts on this subject of some weeks ago.

    Football and Speculation, from James Fee

    Among our friends there may be an aversion to the writings of Michael Lewis, who irresponsibly penned an awful review of EdSpec years ago. However, here he writes exceedingly well about a deeper understanding of sports, which can be applied to diverse other fields.

    Victor Niederhoffer muses:

    This offense at all times approach is a very interesting discussion point for specs. How to mix up the offense without suffering ruin? The optimum amount of leverage? Three times leverage for S&P futures?

    Will Huggins adds:

    This immediately brought to mind my "hero", Miyamoto Musashi, whose utter disdain for defensive postures was based on the precept that defending was simply an attempt to hold off your own defeat, while the possibility of victory lay in attacking (echoing Sun Tzu but more extreme in his view, and completely opposing Carl Von Clausewitz's ideas about "insurmountable defense" that probably spawned the trench-wars of WWI). Seizing initiative was a "key success factor" in executing any strategy as far as he was concerned; might not be true in trading, but it certainly was when one was fighting an opponent with a 3-foot razor blade in hand.

    Martin Lindkvist says:

    I think the optimum amount of offense/leverage depends not only on the edge one has, but also on psychology. When leveraging one's position heavily it is easy to get scared out, even if statistically one is on safe turf. Perhaps one could use sand sprinting, as Leach had his players do to strengthen their ligaments for their offensive play. For the speculator the equivalent of sand sprinting could be to leverage way beyond the normal, but with a small purse, to get used to fast percentage swings in equity.

    A European Reader comments:

    It is misleading to infer too much trading strategy from American football, because of weaknesses in the structure of the game. Offense and defense are largely unconnected and discrete, compared to European football where an overly aggressive offense (excessive leverage?) can leave one overextended and vulnerable to attack (the squeeze). Hence the perhaps insurmountable problem of amplifying the 1.5 million percent-a-century negative bleed while avoiding gambler's ruin, as with leverage.

    A Little Nugget from Bo Keely

    The packrat standard is gold where I live. Seven-inches long (with tail), the half-dozen around my desert property trade trinkets and metals for foods such as pasta and nuts to carry and store in their burrows under my trailers. They never take anything without an exchange that is daily. however, sometimes they steal an item to trade for something else. I found my glasses and business card from the office in the pantry in the oatmeal. Each 3" diameter portal to a packrat burrow has a 3" thick plug of cactus spines, bright metals, nails, paper clips, etc. to block snakes and thieves. My neighbors, the Quick family, trail packrats to search for gold in the plug or burrow. Their successes are secret but ma Quick describes each track with a gleam in her eye. Likewise the packrats that I watch through the wire of my personal burrow reveal nothing. Humans covet gold and one day I'll look for a Fort Knox beyond the wire and in their holes. The packrats value nuts higher than anything else.

    Five Variations on the Economics of Location, by Victor Niederhoffer

    1. Pioneers of location theory: The study of where and why trees, firms, illnesses, crimes, cities, satellites, and prices locate opens up lines of inquiry useful for gaining insights into markets and other phenomena. Such studies start with Johan Von Thunen's description of  the types of economic activity in rural Germany as forming concentric circles based on the cost of transporting various kinds of goods into the city. In such a model, the most productive uses of land with the highest yield relative to cost, or the highest transportation cost, would tend to cluster around the center. In an agricultural economy, vegetables would be closer to the central city than wheat, which would be closer than cattle. In a more modern economy, the central city would have department stores and financial centers, and concentric circles of intensive farming, forests, and ranching would branch outward. Amazingly, this model applies to modern cities of today, and gives insights into many location decisions of firms. A variant developed by Ernest Burgess describes cities like Chicago as having a central business district where transportation is most propitious, surrounded by concentric circles of factories, workers' residences, residential zones, and commerce zones. The key variables in the Burgess model are the commuting time to work, which is lowest in the central district, and the quality of housing which is greatest the further you are from the factories and noise of the central business districts. A discussion of site selection as it relates to the stock market is contained in the work of the Spec Duo and David Hillman, and the extensions of the central business model to the decision where to locate commerce and residences may be found in a summary on the Economic and Business Geography site The Four Classical Traditions of Location Theory.
    2. Regularities and clusters: Central to any studies in this area is a proper method for classifying locations. Such descriptions attempt to classify clusters of similar entities, as well as regularities in the characteristics of the entities such as their averages and variabilities. An excellent area here with well developed applications and methods appropriate to all fields is forestry. The paper Point Process Methods in Forestry Statistics provides methods of analysis based on spatial patterns, descriptions of variability, correlation methods, nearest neighbors, growth models, point process models with complete randomness relative to the density of points, and linked processes that treat the bivariate distribution of points classified by two main characteristics. One of the characteristics of trees is that they show clustering at the beginning of their life cycle and regularities at the end. At the beginning stages trees "show clumping caused by environmental heterogeneity, seed dispersion and competitions with other species, that are sometimes called environmental, morphological, and sociological causes." But as evolution proceeds, the regularities dominate. "This can be mainly explained by competition among neighboring trees and by dependence of mortality on local population density. Also, environmental variables such as ground cover vegetations, light conditions, microclimate, soil characteristics, profile and ecological history of the forest area play an important part." The application of these concepts and conclusions to markets is quite direct and useful.
    3. Methods of study. The main way of studying location data is to compare the characteristics of the distances between points to random distributions. Most studies start out with the density of the trees or stocks in a unit area. One variant is to look at the distance of each point in a area to its nearest neighbor, and then calculate the variance of these numbers. One approach is Bitterlich sampling, which is based on the mean of the sum of all cross-sectional areas at breast height divided by the area of the stand. A variant is to count the number of trees that can be seen in an angle larger than some small number like pi/36. The standard for measuring concentration is Ripley's K function. It's calculated in many statistical packages that contain spatial relations modules, but is difficult to tally by hand even for simple diagrams. It's defined as "the mean number of points in a disc of radius r centered at a typical point in the sampled area centered at a typical point which is not counted." If you draw a circle around each point in the area samples and calculate how many points there are at various small distances from it, and compare this to an identical calculation for points randomly placed in the area by simulation, you come up with a good practical estimate of K. Another statistical technique that is useful for extensions to markets is the coefficient of segregation. What's counted here is the number of times that each of two stocks (or trees) A and B have a return or price that is closest to itself, or to the other one, relative to the total number of times that it's nearest to any of the other stocks in the sample space. All these fancy statistics merely serve to refine the analysis. The basics of any study of location data are the mean distances from the points in one area to another, and their variabilities.
    4. Applications to markets. The cities for markets tend to be places where they cluster or reach milestones. One milestone for stocks are the round numbers of $100 or $50 or the price of $5 where stocks become marginable. Stocks may be envisioned as traveling to the cities of $100. How far away are they now? Are the coming or going? Do they tend to show an affinity for the cities based on their nearness? Another approach was suggested by Brian Haag: are stocks affected by the central business district of the market factor itself? Concentric rings from the market might be formed by low idiosyncratic volatility companies such as GE and KO, while the farthest rings would be highly idiosyncratic stocks. Burgess hypothesized that there is a tendency to move from an inner circle to an outer circle. Is the same true for stocks? Academic papers have applied Haag's ideas to the study of the degree of idiosyncratic volatility in DJIA stocks during periods of important news announcements.
    5. Location of companies. Companies in the old days chose their location based on where their raw materials were, where their customers were, and where the costs of transportation and communication were least. Modern companies choose their locations based on the ease of entering into transactions, or their ability to find superior ideas, educated employees or cutting-edge innovations. I remember when one-quarter of the companies in the Fortune 500 had their primary location in New York. Changes in the degree of envy, and the belief that companies  were static entities with resources that could be exploited at will, like oil reserves, led the authorities to tax them into areas where they could keep more of their output for their stockholders' and employees' wealth, future growth, and current stability. A line of studies that relates company performance to geographic location vis-a-vis the tax rate has been inspired by Arthur Laffer, who applied his theory that the lower the tax rate, the higher the revenues that government will receive relative to the performance of individual companies. Ten years ago, I saw data that showed superior returns to companies headquartered in low-tax states such as Arizona, Nevada, North and South Carolina, Florida, and Texas. Numerous studies show these states are growing much faster than the high-tax states, but no one has updated the Laffer results to modern times. Ironically, since it's against its leitmotif, Bloomberg provides ready data on this by calculating the daily performance of companies classified by city and reporting them each day.

    Dr. Alex Castaldo adds:

    Performance of stock indexes for 6 low-tax states:

                    Start   StartDate     Cur   CurDate  PrcChg  PrcChg
    Arizona           100  12/31/1994  514.94 12/5/2005 414.94% 175.55%
    Nevada            Not available
    North Carolina    100    1/2/2002  125.70 12/5/2005  25.70%   9.56%
    South Carolina    100  12/31/2001  148.33 12/5/2005  48.33%  10.19%
    Florida           100  12/31/1994  131.82 12/5/2005  31.82% 175.55%
    Texas             100  12/31/1994  347.52 12/5/2005 247.52% 175.55%

    Four out of the five available indexes outperformed the S&P over the same time period.

    Data from Bloomberg LP.

    Kim Zussman speculates:

    1. Better, more adaptable companies move to low tax jurisdictions.
    2. Low-tax states provide advantageous low overhead and higher profit margin, goosing the stock.
    3. The number of in-state companies is far less than SP500, and the higher return is due to greater risk.
    4. All of the above.
    5. Sacajawea.

    Andrew Moe notes:

    One problem is that the K function is based on circular measures. The benchmark is K(t) = pi * (distance)^2. We deal in "flatland" by comparison, as our ranges only go up and down.

    But an adaptation may be to count how many points (say closes) occur within n points of a given trigger day. For example, how many closes occur within 10 points of a new 20 day low? Or how many within 10 of a round number. Then compare that to random. Lots of variations here.

    Another adaptation would be to take expiration into account. Instead of saying how many cases within n days, you keep on counting instances until x number of days have passed since price has been in the study range. I have this nagging feeling that somehow this count should supplant pi in the K function, but no real clarity on the matter yet.

    Jim Sogi comments:

    "Universal Geometry of Circles", Chapter 11, gives the formula to compute the diameter and chords of circles in quadrance (distance squared) thus avoiding use of pi. as well as the spreads. The use of the xy coordinate would be apt for charts of prices and time in respect to the circles and clusters of spatial geometry. The quandrances can be analyzed statistically for significance of clustering as in Ripley's K, but with simplified computations. Not sure if this refers to chart formations or actual geography, but would work on lat=long as Cartesian.

    Kim Zussman comments:

    The cost of transport would seem to relate to historical location of centers of commerce adjacent to shipping: ocean ports, lake ports, and rivers. Later, this was supplanted somewhat by railroads, and eventually highway and airport hubs. Locations of transport for industrial goods attracted manufacturing and trading enterprises, which brought opportunities and jobs so populations swelled.

    Most of the great cities are on advantageous harbors, but this is based on heavy industry. The recent trend is on informational commerce, which does not dictate particular geography and can be accomplished, with the aid of low cost mail and shipping, more remotely than in the past. Thus a trend toward many industries locating away from port cities, to areas attractive for employee family life (examples include Google, Microsoft, and Amgen).

    One investment thesis is that the gradient between coastal port city real estate prices and that in suburbs/rural areas should decline over long periods. Of course cities serve numerous other social purposes, including facilitation of s#xual commerce, which will likely preserve much of the premium.

    What about prior inverse-radial advantages of the denizens of Wall Street? Whereas in prior eras there were great informational advantages to physical association with the machine, now stat-arbs everywhere have easy access to market data. The only barriers now are delocalized desire, the ability to find discrepancies, and willingness to take your chances and test your strength against all the other maniacs. Nature abhors a gradient.

    Dr. Alex Castaldo adds:

    Additional details are found in:

    Economic clustering and urban form: The case of Hamilton, Ontario

    {We want] to consider the firm population of a [geographic] sector and to test for firm clustering, considering complete spatial randomness (CSR) as the alternative hypothesis. Using as input the location coordinates of the firms, the method commonly used for such analysis is to estimate an empirical univariate K-function. Intuitively this function provides the number of firms within a given distance of a randomly selected firm. The estimated K function is then compared to a set of simulated K functions for the same number of firms that are constructed under the CSR assumption. The test is simple in its conception but computationally intensive. Details for the estimation of the K function are provided in Bailey and Gatrell (1995) and Cuthbert and Anderson (2002).
    While the univariate K function provides an explicit test for the spatial dependence among firms of the same type, it is not useful in studying the co-location of firms that belong to different sectors. An extension of the univariate K function is the bi-variate function, which tests for interdependence in clustering between two patterns in space. The function provides the expected number of points of one type from a randomly selected point of the other type within a specified distance. For a more detailed description see Bailey and Gatrell (1995)

    Sushil Kedia adds:

    Investing involves transporting expectations and risks of the future to the present moment.

    The rent is the cost of investing. Cost of invested capital, or the opportunity cost of the invested capital, is the rent. In any economic enterprise, so long as the cost of the enterprise is less than the incentives of the enterprise it remains viable. Opportunity cost of investing is the amount of risk one undertakes in the venture of a particular investment.

    Thus the analogous economics such as Von Thunen's Economic Location Theory brings about layers/concentric circles of risk (volatility) organized farther and farther consistent with an optimality with the cost of investing, which could be a function of the cost of transacting (commissions, slippage, impact cost, average contango etc. etc.) the investment.

    High transportation cost /quickly perishable trade-generating high-frequency trading programs, or the day traders, are closest to the city centre.

    The view-based counting-oriented speculators' bets of a small time frame -- a few days -- are next in the circle.

    Medium-term 'trend-seeking' specinvestors' bets form the next circle.

    The lowest cost, lowest volume-producing investors' bets are farthest in the circle.

    The optimal rent of a particular layer would be deciphered from time to time by a function of the amount of risk perceived and the amount of drift/move in prices that one expects to capture from a particular pool/shoal of stocks. Say for example, if the optimal rent estimates were highest for the coal producing companies during the FWW or if it was the steel companies near the SWW or if it was the Software/Tech producing firms towards 1999-Y2K and the Oil companies in 2002-2005 it is essentially a similar reflection as the Economic Theory of Location of Von Thunen. Sectors getting the highest rent (allocations/attention), not necessarily highest rewards is but a function of the perceived maximum optimal point of cost of investing and expected returns. By a similar set of tautomerisation it is possible to see that sector rotations over shorter time frames are also running on the theory of Economic Location.

    Dave Whitesel comments:

    Two interesting modern-day examples where this theory is applied is Blockbuster and Starbucks. Blockbuster seems to be a magnet for Starbucks; where you see one you will often find the other within line of sight. Recently "The Undercover Economist" did a study on Starbucks with respect to rents. Interesting study though not very complete. The primary goal of these placements is surrounding ingress and egress points to specific populations. Therefore you might find two Blockbusters or Starbucks very close together. These placements are not random; they are targeting known paths of trafffic, with a goal of surrounding destinations.

    Rob Fotheringham remembers:

    About ten years ago I was working for a retail auto parts chain (about 650 retail stores in the Western U.S.), that had a real estate department dedicated to finding and securing optimal store sites. They studied demographics and traffic patterns and other indicators but could not predict successful locations better than their competitors could (i.e. AutoZone). So they did the logical thing and opened up a store right across the street from a newly opened, very large AutoZone, and it quickly became their highest volume store. Imitative behavior in this regard seems common. For example, a couple of years ago, while trying to attract a grocery store chain to our small city, we were told that by several major chains that we did not have sufficient population density to justify even a small store (35-40k square feet). Soon thereafter Wal-Mart declared their intent to build a superstore on the same site, whereupon Home Depot inquired about the land across the street, and the major grocery chains developed interest.

    Quote of the Day: Prof. Frank Harrell's Philosophy of Biostatistics, via the Assistant Webmaster

    A Directional Trader adds:

    Note that Prof. Harrell has contributed major packages Hmisc and Design for R, allowing him (and others) to practice what he preaches. And he throws in a free 308 page ebook to serve as a guide! I salute his professional magnanimity.

    Spec Songs by Kevin Depew Chet Baker's "Let's Get Lost"

    *slightly adjusted for financial consideration:

    "Let's get alpha, alpha in each of our trades
    Let's get alpha, let them send out brigades
    And though they'll think us just a rube
    Let's tell the world we're in that crazy mood.
    Let's defrost all the bearish myths
    Let's get crossed off every doomsday list
    To celebrate this difficult endeavor, mmm, let's get alpha

    [horn solo] [piano solo]

    Let's defrost all the bearish myths
    Let's get crossed off every doomsday list
    To celebrate this difficult endeavor, mmm, let's get alpha
    Oh oh, let's get alpha"

    Johnny Cash sings "Walk the Line"

    *but some Specs sing, "The Bottom Line"

    I keep a close watch on this stock of mine
    I keep eyes wide open all the time
    I set a loose stop in case a big decline
    I hope you mind, the bottom line

    I find it very, very tempting to sell you
    I find myself alone in owning you
    Yes, I'll admit, I paid too much for you
    You didn't mind, the bottom line

    As sure as value is dark and growth is light
    I keep you on my watch list day and night
    And since momentum says you are alright
    I will not mind, your bottom line

    You've got a filing to show me what you hide
    You give an earnings call to plead your side
    And yet your stock price will not turn the tide
    Because you're mine, I curse my pride

    I keep a close watch on this stock of mine
    I keep my eyes wide open all the time
    Oh Lord, I fear a very big decline
    Who cares about, the bottom line

    Quote of the Day, from Dick Sears

    Debbie made a wonderful observation today. The word "correction" is never applied to a rise in stock prices, only a reduction. Doesn't that tell you all you need to know about the people who use it?

    Jim Sogi on Aggression Theory

    Regarding the Chair's post on aggression theory, I recommend Coercive Family Process Vol 3, by Gerald R. Patterson, a study of aggressive children in the family context. The author asks, why are children aggressive? The method is based on observable behaviors of clients, counting events, such as 'number of bites' (obesity), 'out of seat' and statistical analysis thereof. He was the pioneer in such studies. He found in the 50's as he began his career that the best was not good enough. The theory is based upon performance, what people do from a bilateral or interactional perspective, rather than underlying neuroses or a person's characteristics. He looked not only to the patients but also the behavior and effectiveness of the therapists and their results. This latter point is interesting to traders who might improve understanding by counting and tracking their own behavior and trading results in reference to the methods. The author makes extensive use of statistics and tables. Many of his studies seem to focus on the point at which ramping up of low scale factors led to coercive action, and parallels the all important "break point" in market movements.

    "Direct observation of behavior can be the key for identifying how actual behaviors are elicited, maintained and organized." Description and explanation are different. Breaking down behavior into 6 second intervals led to analysis of the effect of the environment on behavior, and bilateral effects. While simple frequency count was the preferred dependent variable in the 1960's it was too clumsy to describe relations between events. Patterson found conditional probabilities; given one behavior, what is the likelihood of behavior by another to be workable.

    What is aggression? It is both aversive and contingent. A dentist is aversive, but not contingent on certain behavior. Dr. Patterson found patterns of cursive behavior, when a child displays one member of such a subset, he is likely to perform others as well. This is the clustering idea. Patterson describes cursive behavior as occurring in bursts. Dr. Patterson used 29 category codes of variables in homes of aggressive children, coding the most obvious events. He counts base rates for various behaviors. Aggressive behavior appears consistently across setting and time and tends to continue. It is worthwhile to identify subsets of market behavior, gaps, intra range reversals, continuous up days without x point pull back bars, ranges, etc and find the related responsive behavior or other clusters. Range reversals usually occur in groups or bursts. Big run ups like at the end of November come in a "burst" of up days. Down days, drops like October, came in bursts of 8 days down in a row. Both the psychologists and the market find these statistically significant. He talks of the cursive events being chained together. The measure of behavior includes duration and latency periods. Timing is important in the market and measurement of duration and latency is predictive, important and under utilized.

    Our culture is programmed to reward many kinds of aggression. Look at sports and war. Football players are highly compensated. In ancient times soldiers were amply rewarded. Roman Centurions were granted 100 hectares and exemption from taxes. Television displays several violent episodes per 1/2 hour. The markets can be viewed as a form of aggression. Entering the market by an affirmative act one takes from another participant at the bottom tick or hits the offer, then anticipates a large run up, at which point the position is sold to another participant at the very top, when the market should fall, taking money out of the other participants. This can be characterized as aggression in the essence of taking from others. It is reinforced. Being nice is not reinforced in the market.

    "At the crux of the interactional stance is the idea that each member of a dyad changes the ongoing behavior of the other." Extrapolate to larger numbers and we see the development of S#ros' reflexivity theory as an outgrowth of behavioral psychology! Synchronicity and reciprocity encompass the functional relation between the behavior of one person and another embedded in larger structures. A prime example of synchronous action is turn taking during talking. Another example is chess. On the higher order political scale the doctrine of equality in response to combat action, such as Israel's policy toward Palestine, an eye for an eye and a tooth for a tooth. In the market on a micro scale is the flipping of transactions at the bid and ask, then there is the up down action from bar to bar and then at a higher level the structures we seek to catalog and predict; of interaction between buying and selling groups. The offshoots from Synchronicity are ripple effects. Actions reflect back with growing cycles of reflexivity. This has application to markets, the bouncing repeatedly in ranges, the multiple surges of a trend, the current expanding range cycle, triangle patterns. Action tends to be mirrored in the response. The overall theory is that the study of micro structure will lead to the explanation and understanding of larger structures.

    Personal Finance Department: The Best Retirement Account Ever, from Dan Grossman

    Enacted in 2001, the Roth 401(k) goes into effect on January 1st, 2006.

    Under a Roth 401(k), an employee, including an owner-employee of a one-employee business, can contribute $15,000 per year ($20,000 if the employee is over 50) to a retirement account regardless of how high the employee's income, something not true all these years for Roth IRAs. The employer, (which can be your own single-employee company), can also make a matching contribution up to 25%.

    While contributions are not pre-tax (i.e., not deductible from income), all gains and earnings in the Roth 401(k) account are tax free, and all distributions out of the account starting at age 59 1/2 are also tax free. So if you're reasonably successful over the years in self-directing your best investments in the Roth 401(k) account, the miracle of tax-free compounding could easily result in an account of a couple of million dollars all tax-free on payout.

    The one fly in the ointment, somewhat surprisingly, is that I have not yet found a plan administrator ready to set up a simple and inexpensive Roth 401(k) plan. Perhaps a reader knows of one, or is himself or herself a plan administrator or works for a firm that does plan administration.

    Vanguard and other companies I have spoken to say they do not know if there will be sufficient demand so they will not be offering Roth 401(k)s on Jan 1 (they are wrong -- the demand will be there), and those that are offering it are doing so as an option to a conventional 401(k). That is, employees in a conventional 401(k) will now have the option of making their particular contributions either pre-tax or Roth after-tax. This makes for very significant record-keeping and administration expense in a combined conventional and Roth 401(k). Exactly the opposite of what was intended in the Roth 401(k) law and regulations which speak of simpler and less-expensive administration than in a conventional 401(k).

    So it's the best retirement plan ever for successful investors. But I ask readers' help in setting one up.

    Blue Planet Oceans, from Jim Sogi

    The Blue Planet : Seas of Life: Open Ocean - The Deep from the BBC is a fascinating DVD about the varied life in the oceans. It is a rare case of a movie being better than the book. The ocean predators eat the bait fish in dynamic and sometimes explosive activity reminiscent of the markets where it is a matter of life and death. Some live and some die, and that is their niche. Rather than characterize the feeding as aggression, survival is more apt, as there is no anger or ill will involved. Predators eat other fish to survive. The bait survive by their numbers and by the general plenitude productivity of the oceans. Like Luca Brassi the mob hit man, says in doing his job, "No hard feelings, its only business."

    As in the competitive undersea world, Speculators cannot afford anger or hard feelings going about their job of providing and allocating capital. Survival must be foremost, as danger lurks for the unwary. Fish have hundreds of methods of deception to lure the unwary, to escape the dangers, decoys, specialized appendages, special eyes, techniques of hiding and hunting. Birds swim underwater, fish fly in the air. All develop niches in the ecosystem. Some fish rely on other fish, such as Ramora fish riding on sharks, or the tube worms on the volcanic vents relying on the bacteria. Some eels and prehistoric sharks wait on the seabed for the dead to float down. The animals on the sea floor out number life on the surface as the area size is so much greater under water than on land. We know less about the seabed than about the surface of the moon. Over 60% of the planet is covered in water over a mile deep. Scientists find new undiscovered Bizarre creatures and new life forms in the depths over 1-5 miles deep every hour. Some live without sunlight relying on a bacteria which fixes hydrogen sulphites from volcanic vents.

    There are many ways to profit from our diverse markets, undiscovered angles, methods to distinguish the background from the profits, to lure out sources of sustenance, create unknown dangers and deceptions to trap the unwary - the bait. We can band together for mutual hunting and protection and sharing of ideas and morsels, as the porpoise and fish do.

    Some market S&P mechanisms, (December Mini):

    Deception. Gig gap up 11/29; then reversal hard down 2 days. A big fake out. 12/1 Big gap up and straight up.
    Startling. Fed minutes, then 2 weeks straight up.
    Predatory behavior. Late November run up with no down bars, no pull backs, just sold attack until they couldn't eat any more. The same effect but different group in early October drop down. If you are not feeding and eating, best to hide or run. They feed till the bait ball is gone in a frenzy.
    Play dead behavior. 11/3 - 11/10, Friday 12/2.

    The technique of eminent behavioral psychologist Dr. Gerald Patterson was to quantify behavior and use statistical analysis to discover causal relations rather than speculate about theories of oral fixations. He would go into homes of troubled teens and observe and count yelling, hitting, verbal demands made by parents, and mark them down and later count them. One thing he found was that parents that make the highest rate of demands on their children had the most non responsive children ... they simply cannot keep up with the high demand rate. Come here!, don't do that!, clean your room!, turn down the TV, comb your hair, tuck in your shirt, help your sister! ... etc etc. By the way, a wonderful book he wrote is called Living with Children. I give it to all my young friends with young children about raising children with a system of rewards. See also Parents and Adolescents.

    This is the scientific approach that works in the markets: catalog the various market behavior types: aggression, startling, play dead, etc and place them in their proper context in the market. Quantify and test. The difficulty is that we are watching the tracks of the animals on the ocean floor, we can't see them in action in real time. It is like the Indian guide looking at the tracks of the horses and droppings who says, "Three horses passed, two days back, one without rider, riding at gallop." So we have to dig two layers deep, and interpret the action from the evidence of only the tracks. Its like the movie the Invisible Man, we just see footsteps.

    A good way to bridge the gap is to consider the motivations of the actors in interpreting their tracks. In legal cases it is always good to be a step ahead of the opponent, to consider why and how the opponent would act in a given situation. What are his motivators? What in his history shows how he will act given his propensities, his normal human reactions, his specific needs. The news gives a reflection of the the reaction to the situation, and might be quantified as a variable, (good news or bad news), (trading news, market up bad news, down on good news 2x2 table), this helps anticipate. At different times in the market different groups, different types of animals, are involved, and so its good to identify who is in the markets? Who is the opponent? This is an issue that comes up in the intelligence and counter intelligence field, where it is not clear who ones opponent is and what his motivations are. See The Great Game, Hitz. Many times they are very basic motivators, money, greed, revenge.

    Notes from Abroad: Merry Christmas from Singapore, from the Senator

    The streets are aglow here with holiday signs, lights and such. The word Christ has not been taken out of Christmas, here in a country that is about one-third Christian. No one minds, protests or files lawsuits. Each religion gets to fully and publicly display its holidays. There was a very large Christmas sign and cross in the Indian restaurant where we dined today. Each culture allows the others to enjoy their holidays, and the gummint foots the bill for lots of it. A very pretty site, here.

    Back home it's still the same rag-tag group trying to do away with any references to religion, saying it's about freedom from religion, which of course stops freedom of religion. Singapore, full of "strict laws," allows more religious freedom than our own, formerly freedom-loving, country. Increasingly I see more personal freedom in countries outside the US, a stronger distrust of government, a passionate hatred of communism: something I have rarely seen stateside.

    Risky Regression, by Kim Zussman

    The Stigler paper on regression to the mean (kindly offered by Doc) describes the repeating exam analogy:

    "Verbally, we may consider a stochastic time-varying phenomenon, where two correlated measurements are taken of the same person or object at two different times. For example, we might consider the scores recorded on two examinations taken by the same individual at two separated times. Suppose the first score is exceptionally high near the top of the class. How well do we expect the individual to do on the second test? The answer, regression teaches us, is 'less well', relative to the class's performance. And the reasoning is clear: there is a selection effect. The high score on the first occasion is surely due to some mixture of successes in two components, to a high degree of skill (a permanent component) and to a high degree of luck (a transient component). The relative bearings of the two components of skill and luck on the first time score would require measurement to pin down, but the fact that we expect both to have, on average, contributed to the exceptional first outcome is intuitively plausible, even obvious. And on the second occasion we expect the permanent component of skill to persist (for that is the meaning of permanent) while the transient component of luck will, on average, not be present (for that is the meaning of transient)."

    So a student taking numerous equivalent exams should have a mean score which approaches measurement of skill, since luck is a random component averaging zero over many tests.

    In a changing-cycle paradigm of trading, investors weigh various parameters to continuously change their position. Success (and failure) in such trading over various time periods should also attribute both to a luck and skill component. Over time, the luck component converges to zero and skill is demonstrated. However the problem with markets would seem to be sticky luck. Persistence of various regimes favor certain "skills": momentum/growth in the 90's, value/small stocks in the 00's, bullish bias 1946-69, 82-00, and bearish 1929-50, etc., as well as the un-announced change in regimes which are obvious only in retrospect.

    Was Mr. Hill, who bought VL1's from 1970's-00 and sold out with millions, a skillful trader, or was 20 years too short to eliminate luck from the test? To him and his family, during an investment lifetime, he was genius. Perhaps the persistence of luck in markets, coupled with useable investment lifespan, makes it less an SAT than a game of chicken with risk.

    Quote of the Day from Larry Harris

    Dear Vic,

    I suspect that many people use limit orders for the same reason they spend a few dollars in gas to obtain a dollar better price across town. In the case of limit orders, few realize that they are paying for the gas.

    Best regards, Larry

    Trader Types, from Mark Mills

    I've had the following list of trader types hanging on my wall for several years:

    Thus, I found your comments on trader types of great interest. Bobby Bluffer wasn't on my list. After spending some time comparing your comments to my trader types, I noticed my list ignored strategy styles. After parsing your comments, I came up with the following:

    Strategies with regard to one's own motivations: one can either follow whatever emotional reaction one experiences or follow a single emotional reaction and never change: "I am bullish, always bullish, particularly whenever someone asks."

    Strategies with regard to others: one can either actively encourage weak traders to play losing strategies, quit the game and abandon one's stake, or passively take advantage of weak traders who play losing strategies, and the inefficient market structures they exist in.

    At this point my own emotional imbalances interfere and the project of defining trader types looks pointless. At another level, I'm tempted to add another type: Charlie Counter.

    Green Eyeshades, by George Zachar

    The revision to the September data now shows no absolute decline in employment nationwide, despite the hurricanes:

                        Nov.   Oct.   Sept.
                        2005   2005   2005
    Nonfarm employment   215     44     17
    Previous estimate    n/a     56     -8

    Pangloss: "Wow!" Cynic: "Yeah, right, sure." Interestingly, the "bad" employment news seemed to concentrate in the "part-time" sector:

                        Nov.   Oct.
                        2005   2005
    Unemployment Rate    5.0%   5.0%
    Full-time workers    4.9%   4.9%
    Part-time workers    5.7%   5.3%

    Martin Lindqvist Asks:

    How do you approach the question of which time periods to test your hypothesis on? Do you randomly chose a cutoff date? Do you use as much historical data as possible (possibly saving some for out of sample testing)? Do you qualitatively chose a time period which resembles the one you are in for the moment, for example the last rate hiking period, or a period when volatility was low? Do you test for stationarity a la Dr Steenbarger, carefully choosing a time period which have the same means and std deviations? Non of the above? - then what method do you use for choosing the time period to test? Pros and cons for different methods are welcomed.

    Dipping My Amateur Big Toe into the Yield Curve, by Charles Pennington

    One would guess that the two major stock-picking camps, the cigar-butt value camp and the go-go growth camp, would have different relative performances depending on whether the yield curve is flattening or steepening. After all, the emphasis of the cigar-butt school is on what's in the coffers right now, while the emphasis of the go-go's is on cash flows off in the distant future.

    So a reasonable guess is that the go-go camp outperforms during periods when the yield curve flattens, i.e. when distant future cash flows are being valued higher relative to near future flows than they were previously. The cigar-butt camp would outperform during periods when the yield curve steepens.

    This hypothesis is only predictive in the sense that it makes a prediction about what the outcome of a little historical research would be. It doesn't appear to have any money-making value, which is in keeping with my position as Minister.

    To test the hypothesis, I pledge to do the following: I will use something like Tweedy Browne American fund as a proxy for the cigar-butt school (unless Tim Melvin suggests another), and I'll use Fidelity Aggressive Growth as a proxy for the go-go's. I'll then look at their relative performance during the last few periods of steepening and flattening.

    Predictions are welcome.

    The Senator Interjects:

    Copper has been inverted, at a premium. I know, I know, this is not an interest rate instrument, but future traders must be aware of inversions, as opposed to knowing about head and shoulders formations and such. It is very unusual for the nearby commodity (a natural resource) to trade at a premium over the next months out. There is only one thing that can cause that: the commercials want the product so bad they bid it to a premium, hence a commercial bull market. Fundamentals matter. Markets move for reasons. You gotta figger 'em out. And inverted, premium, commodity markets are hugely important. Technical analysis, by and large, stinks.

    Prof. Adi Schnytzer Responds:

    I plead ignorance and would like to understand this point. An inverted yield curve as applied to interest rates is weird because rates are the cost of waiting and the inversion tells me that there is a premium on waiting! OK, so now copper, for example. I assume that inversion means that the futures price is less than the spot price. Aside from the weirdness of implied negative storage costs, what else is unusual about this? Don't commodity prices go up and down all the time? Or is it unusual to see futures prices lower than spot? Sorry for my ignorance. And what does inversion mean in this context? That there is pessimism vis-a-vis the economy?

    Prof. Gordon Haave Comments:

    I have studied these cycles extensively. The problem is that growth vs. value cycles in relation to the yield curve is that growth versus value cycles really don't last very long (with the exception of the late 90s). So when you are talking about long periods of flattening, there is plenty of time for the cycles to adjust. See this growth vs. value graph. There are of course a million variations on how to measure this. The graph that I have linked to is just one way of measuring it as part of something else that I happen to be working on, but the fact that growth/value cycles don't last long should be clear. Perhaps a better way to look at it would be some measure of what happens in the one year preceding and following a change in direction of the flattening/steepening of the yield curve.

    Allen Gillespie Adds:

    Another common problem, which the chair has addressed, with the growth v. value debate is constructing a growth index prospectively rather than retrospectively like all the value studies do which simply use trailing P/B as an indicator of growth. In fact, this is why S&P, et al (with the exception of Russell) have changed their calculations for their growth indices in the past 12 months. They have realized they are failing to adequately capture the returns to growth stocks like GOOG, AMGN, DNA, CELG, EBAY, MSFT, DELL, CSCO, etc. The Russell indices also have some quirks in that a stock may be allocated in proportion to both indices.

    Finally, I have never seen a stock, growth or value go up and to the right on a chart with time on the horizontal axis without growth in earnings. Just look at any old Babson chart, now published by Securities Research Corp to see that this is true. Flipping through these books one will also learn that the slope (Growth) of the earnings line and its persistence are critical and that the market sometimes anticipates and sometimes lags these changes in value. I speculate the lags are frequently a result of:

    1. The general speculative conditions.
    2. Neglect - stocks with no analyst coverage (which is more common now that brokerage have consolidated their market making operations). If I had the data I would test insider buying at stocks with no analyst coverage.
    3. Underestimation of the value of the future and its ability to be different than the past or present.

    Certainly, however, it goes without saying that the lower the multiple you pay for that future growth the better your return. Take the homebuilders over the last few years, classic low P/E, Low P/B stocks but one's who earnings were going up 15-20% per year because of favorable demographic and interest rate factors. Should these stock automatically have been classified as value stocks during their run? What about a cyclical who earnings rebound to new high levels like PD? Oils stocks?

    The Frustration Aggression Hypothesis, by Victor Niederhoffer and Alex Castaldo

    Neal Miller states a famous and influential theory of behavior from the 1930s as follows: "Wherever there is aggression, one presupposes the existence of frustration, and frustration always leads to some form of aggression."  The theory has been applied to explain every form of behavior that harms others ranging from chicks to humans. For example, chicks not allowed to peck bite their neighbors when freed, and a little brother allowed to play with a doll that his mother takes away from him will smash the doll to pieces. Anthropologists apply this theory to explain the behavior of primitive tribes that accept pain as an inducement to achieving some goal. As Bateson (the Palindrome's second favorite philosopher) puts it, "The thesis fits the Latmul perfectly. But they have added one wrinkle. They have invested aggression with pleasure. For the Latmul, aggressions must be regarded as a self rewarding action series, self reinforcing regardless of whether it ends in injury to some other persons."

    The theory is often used to explain violence, with hard economic times leading to the frustration of not having goods that others have, and the constant observation of those with more goods, leading to such aggressions as murder and revolution. The case of the voter who backs the losing candidate or the athlete who doesn't win the very important game is often used as a archetypical case of frustration that we find in normal people. Psychoanalysts use it to explain dysfunctional behavior with the frustration that occurs when some normal behavior has not been allowed, leading to displaced and dysfunctional activities of all sort. A typical case is the daughter who doesn't receive enough oral stimulation from her parents becoming a great and highly sensitive writer. I think that some of the great women writers like Emily Dickinson developed their inordinate sensitivity from such childhoods.

    Like most psychological theories the predictions from the theory are not often precise and indeed can lead to opposite conclusions. Many people when frustrated grin and bear it. Dollard and Miller would say that the cause of the frustration continues to exert its impact in such situations and it will manifest itself later in some other area (displacement)

    I have always felt that the frustration aggressions theory is a variant of the conservation of energy. In a closed system, any input of energy must increase the energy of the system. If it's not allowed to express itself, then it remains as potential energy. Many of the early experiments that led to the development of the steam engines worked because the heat that was released from the burning of coal was used in relatively closed systems to raise the potential energy of a fluid, which would cycle back to its initial state by performing mechanical work to move a piston.

    The question is how does the frustration aggression theory express itself in the stock market. Aggressive behavior can come from bullish or bearish activity, and it would seem to be measurable by the extent of an inordinate move. The situation that would seem to arise the most frequently occurs when you hold a stock and wait for it to announce something good, and it turns out bad. The most common disappointment is the bad earnings report, one considerably less than forecast. Another typical situation is the company that doesn't have its product or patent approved by some regulatory agency such as the FDA, or a court's invalidating the patent.

    A frustration that we always find particularly noteworthy occurs when a certain well known spokesman for the tech industry, a folksy man from West Virginia, moves to center stage to talk about his company and his industry. There is so much hope surrounding such appearances and reports, that almost invariably whatever he says seems to lead to aggressive selling amidst disappointment. Indeed it seems after some of these reports that the entire frustration that investors have felt with the technology and Nasdaq bubble of the oughts is hurled at that small but doubtless well meaning West Virginian.

    Extending this to the field of markets, any stock that fails to break through an important threshold would seem to be prone to frustrated behavior. Gold recently broke through $500 overnight, a 23 year high, but failed as of yet to close above $500 and this would seem to be frustrating to gold bulls. The Dow recently flirted with 11000, getting up to 10969. but as of yet has also failed to achieve the break through the round number.

    I believe that frustration with the inapplicability or unprofitability of some commonly accepted ideas about markets are at the bottom of many exacerbated moves in markets. I call on readers to set forth hypotheses in this area, and we will try to refine more of our own and put some quantitative touches on these speculations.

    Dr. Brett Steenbarger contributes:

    When it comes to the frustration-aggression link, my mind always returns to Artie and his seminal insight that delinquency among male youth stems from a thwarting of the drive toward manhood. Delinquent behavior and gang membership are the enactments of manhood among those who lack better channels through sports and careers. Having spent time in male-dominated trading rooms, I can vouch for the degree to which market setbacks also are experienced as cuts to one's manhood. A trader who reduces his size after losing big is said to have lost his mojo, and he generally looks like a man who has lost his size. One trader likened the experience of putting on trades when he was frustrated by losses as "hitting" the screen--as if his orders were jabbing at unseen assailants. Sadly, the aggression born of such frustration does violence only to the traders' accounts.

    The phrase used by traders when they impulsively make frustrated trades after losing their capital is "revenge trading". The Mafia exacted revenge when they as leaders--and their territories--were not treated with respect: to be a man of respect was paramount, and a slight to one's standing could only be met with revenge. So it is with revenge trading. Losses are measured not only in dollars, but social standing and must therefore be avenged.

    The greats channel the aggression from frustration toward their own betterment. Dan Gable was no doubt the most successful wrestler in history. As a high school wrestler, he won his state championship three times and was undefeated in sixty-four consecutive matches. He proceeded to win 117 consecutive matches at Iowa State University, and he was the national champion twice. He was an Olympic gold medalist, and as a wrestling coach for the University of Iowa, his teams went 340-20-5 in dual meets.

    After his 117 consecutive wins and two consecutive national championships, Dan Gable lost his final match of his collegiate career. Frustration brought him to tears as he stood on the stand in the place reserved for the runner-up. "Bottom line is that match helped me," Gable later related in the book A Season on the Mat. "I needed to get beat. Because it not just helped me win the Olympics, but it helped me dominate the Olympics. But more than that, it helped me be a better coach. I would have a hundred times rather not have that happened, but I used it. I used it."

    It is difficult to predict who will use the aggression from frustration to rebuild themselves and who will become defeated or delinquent. Galton found that the essence of genius was:

    ...a nature which, when left to itself, will, urged by an inherent stimulus, climb the path that leads to eminence and has strength to reach the summit—on which, if hindered or thwarted, will fret and strive until the hindrance is overcome, and it is again free to follow its laboring instinct.

    The greats are frustrated when their drive for mastery is thwarted, but the aggression fuels the overcoming of the hindrance. Maybe the great markets thwart their obstacles as well, and this might be one way of distinguishing eminent markets from merely mortal ones.

    John O'Sullivan Adds:

    When a new paradigm becomes generally accepted, there is a period of rapid extension and clarification. But Kuhn describes practitioners converging on a single paradigm by a variety of means, and I question whether there is such an accepted single paradigm in finance. With technical and fundamental analysis, the efficient markets hypothesis, behavioral finance and others it seems unlikely that theorists and practitioners will accept a single account for price action any time soon.

    Mehmet Urcu Offers:

    Caglar Tuncay, physics scholar from Middle East Technical University introduced an original method, assuming potential and kinetic energy for prices and conservation of their sum is developed for forecasting stock prices...He also showed its connections with Zipf's Power Law. The power-law behavior in the tails is characterized by the exponents and the exponents found in different stock markets very much resemble. Power-law behavior (Zipf plot) is decorated with log-periodic oscillations in his study.

    From Dr. Phil McDonnell:

    The phrasing "decorated with log-periodic oscillations" is a rather unique expression which I have only seen in Didier Sornette's book "Why Stock Markets Crash". Before our Turkish friend (or others) spends his time and money on that book it might be good to read my review published here.

    Sornette is a geophysicist at UCLA who studies earthquakes using similar methodology based on power laws, fractals, critical points, "decorated with log-periodic oscillations", and tails of distributions. He seems to spend much of his time using his theories to predict stock market crashes. Before getting too far into this stuff ask yourself two simple questions. When was the last time anyone made a successful earthquake prediction? Why would I want to use that methodology to risk my money?

    For a far better look at conservation laws and the stock market one should read the chapter in "Practical Speculation" by Niederhoffer and Kenner. It is a straight forward discussion of conservation laws without the unproven mumbo from chaos theory.

    Russell Sears says:

    I have found this hypothesis some what counter to the spirit of the speculator.

    First, is the unspoken assumption that aggression is basically a counter-productive force an the goal of studying this should be to eliminate the aggression. As an athlete and capitalist I find this attitude counter to my nature. Competition aggression tends to reduce the causes of frustration, and often is productive. I get up most mornings very early to aggressively run, this tends to make the days minor frustrations go smoother. Now at my age when my best athletic performances are behind me, this is generally the motivating force.

    Second, is the implicit assumption that the individual is not responsible for his actions, especially with-in a frustrated group. I believe it is these two reasons that I am drawn to the parallel in the works of John Steinbeck, a contemporary of Neal Miller. Particularly his 2 most famous books, "The Grapes of Wrath" and "Of Mice and Men". In Grapes of Wrath" he tries to use the F-A hypothesis as it applies to group behavior to exonerated the individuals actions. In "Of Mice and Men" he implies that all individuals as animals are as incapable of controlling their frustration-aggression as the mentally handicapped tragic figure.

    In short both implies that authorities, the parents, the winners and the successful are responsible for any tantrums of self destruction aggression for revenge, not the individual committing them. Now I do not have the talent or the resources of Mr. E to predict when I will be trading against a frustrated immoral, pacifist, socialist. But hopefully I can recognize this at least currently, instead of retrospectively when incidents like 9/11 drop in equities or New Orleans spike in oil. For now my best advice is to assume frustrations will occur, run, exercise aggressively and routinely have productive competitive outlets for those frustrations. So you are not the one throwing a frustrated self defeating tantrums when the trading games goes against you.

    Trading Lessons from Jason Giambi, by J. P. Highland

    This past MLB season I followed Jason Giambi with special interest, I was among the few that still believed that Giambi was a good guy and that if we able to be 75% percent of what he was he could be a useful player for the NY Yankees. So I picked him for my Yahoo! Fantasy team.

    The beginning of the season was not very promising, the guy was producing nothing but a number that gained my attention was his Walks, despite the fact that Giambi was not batting he was walking more than anyone else in the team, thus his OBP was high. Giambi was being very selective at the plate, instead of making the mistake of widening the strike zone, what must slumping players do, he shrunk it the most he could, leading him to take a lot of walks.

    I told that to Rob Neyer (former disciple of Bill James) and he considered that there was hope, that even though his numbers were poor he was not hurting the team and that he might eventually rebound. Giambi turned around his season, Viagra awarded him for the comeback player of the year, while keeping a small strike zone, finishing the season with 108 walks and 109 strikeouts, which is a great ratio.

    Being selective is the lesson I learned from Jason Giambi, don't swing at everything and only swing at those pitches in which I think I have a better chance to make contact. Decide when to trade or not is one of the few advantages that I enjoy over the house. As a reminder of this approach I put a picture of Giambi on my monitor.

    Dept. of World Affairs: New Orleans, by Roger Arnold

    My partners and I have finally been forced to carry our New Orleans property at zero value by our creditors. Not even the land the improvements were built on is given any value as collateral for other projects. Without going into detail I will simply say for us that completes the vicious cycle started earlier this year. I don't know how much of an impact this is having on others or the market in general or even how others in the area are dealing with it. What I do know is that New Orleans is still a disaster area. Much of the money that initially rushed in expecting to capitalize has already decided to skedaddle. Those choosing to remain are living in a kind of suspended animation with no clear signs of what the future holds.

    It's an almost surreal experience. And this involved a scenario that was known well in advance. The fact that there was no apparent preparation on how to address the situation once it was realized is very disturbing. We've spent 200 billion of our own money in Iraq on Iraqis and will probably spend another 300 billion of our money rebuilding their infrastructure but we can't figure out what the financial responsibilities are in New Orleans between Federal, local and private dollars. They can't even decide whether up to 50% of the city should be rebuilt. A couple more delusional masochistic peaceniks go into Iraq, get taken hostage, and we respond with the hostage rescue teams while 150 US citizens are kidnapped from Laredo Texas by Mexicans and we can't even decide whether or not to close the border.

    Tim Melvin on College Football

    What a year it's been so far for college football fans. That is it's been a year full of surprises, returns to glory, disappointing years, spectacular plays, close games and blowouts. We've seen Charlie Weiss work his Magic and bring Notre Dame's Fighting Irish (so near and dear to my Irish catholic heart) back to prominence and a BCS bowl berth. I mean did you see the Notre Dame vs. USC game this year? I won't say it was the greatest collegiate game ever played but it is on the list. For the record, no way Leinhardt crossed the line and if he did Reggie Bush pushed him in. No way God let her favorite team lose like that unless chicanery was involved.

    Speaking of USC, these guys are the real deal. They could line up Sunday and beat many if not most of the parity plagued NFL teams. They are THAT good. Alabama began what seems to be a return to glory, Tennessee dropped out early, Joe Paterno and the Nittany Lions of Penn State blew cheerful raspberries at those who said he was washed up, out of touch and too old to coach. Way to go, Joe.

    The Ole Ball coach, Steve Spurrier, returned to the college ranks at South Carolina and turned right around, beat Florida his first year back and got an unexpected 7-4 record, good enough for a bowl bid. speaking of bowls, the state university of New Jersey is going to a bowl. The Scarlet Knights of Rutgers have their first 7 win season since 1992. We have a three way Heisman Trophy race, with two of the contenders on the same team (USC naturally.) From the SEC to the Pac 10, the WAC to the Ivy League (speaking of the Ivy League did you see Ryan Fitzpatrick step in, take command of a shattered St. Louis Rams team Sunday and throw for 300+ yards and 3 touchdowns in the comeback win. When the Rams name him the starter this week, he will be the first starting QB with a Harvard degree in the modern era of the NFL) and the non-stop football frenzy of late December, early January.

    And there's more to come for the college football fanatic. We pigskin obsessed couch jockeys, stadium seat and bar stool adorners have this weekend's conference titles. including a great USC vs. UCLA match-up and Georgia vs. LSU also on the slate. But most importantly the game of the year kicks off Saturday in Philadelphia. I have written in pervious years of the many traditions of service academy football but this one is the granddaddy of them all. It's Army vs. Navy time again. The long grey line against the brigade. It looks to be a great game with Navy under Paul Johnson continuing to be impressive, while Army under Bobby Ross has won 4 in a row and appear to be turning the program around.

    But this is more than about the game. For the seniors on both sides it is likely to be the last time they play the game as ahead of them is service in a war time military, not glory in the NFL. Both sides of the stadium will be filled with young men and women who signed on post 9-11 and believe that god, duty and country mean something. In spite of a first class education, it will be some years before they talk to the recruiters of Wall Street and Madison Avenue, if indeed they ever do. Many of them will serve a full career in the military and go on to be among the top ranked military and government leaders of our nation. Some of them will fall in battle and never achieve their dreams. They CHOSE to be here and to serve. The academics are strenuous, but even the football players have to pass economics, physics and military subjects in a grueling schedule as well as performing other duties. But they are here and will go on to be the core of the United Sates military's officer corps. For 3 hours or so on Saturday, all that is set aside as the clash on the field in pursuit of honor and glory, and this year the commander in chiefs trophy. The safety from army blitzing Navy's QB may well be calling the guy for sir support in a year. Today they are the fiercest of rivals. After, they are brothers in arms in the service of the United States. Make no mistake, it is the game of the year.

    There are no losers on either sideline. However: Go Navy, Beat Army!

    Steve Ellison adds

    I was well acquainted with hoodoos as a result of growing up as a sports fan in the Boston area. In winter, the hoodoos glided on ice, wearing CH on their sweaters. In summer, the hoodoos wore pinstripes and NY on their caps. Strange and unexpected things happened when a championship was on the line.

    The Montreal Canadiens beat the Boston Bruins in 18 consecutive playoff meetings from 1946 to 1987. The Bruins had a star-studded team that won the Stanley Cup in 1970 and 1972. The 1971 Bruins were statistically the best team of the era. Phil Esposito scored a then-record 76 goals, and the top four scorers in the NHL were Bruins. Unfortunately, the Canadiens eliminated them in the first round of the playoffs. Esposito was very superstitious and thought that crossed sticks brought bad luck. Wrong - bad luck came when CH jerseys appeared on the ice.

    In very different circumstances, an underdog Bruins team had the clearly superior Canadiens within 60 seconds of elimination in the deciding seventh game of the 1979 semifinals when the Bruins were assessed a penalty for, of all things, too many men on the ice. The Canadiens scored on the power play to tie the game and won in overtime. It was only too predictable, coming seven months after the Bucky Dent home run.

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