Daily Speculations

The Web Site of Victor Niederhoffer & Laurel Kenner

Dedicated to the scientific method, free markets, deflating ballyhoo, creating value, and laughter;  a forum for us to use our meager abilities to make the world of specinvestments a better place.



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February 2005 Posts


Some Variations on Big Cons, by Victor Niederhoffer

  1. One of the tenets of movies about cons is that it's always the con man that gets to eat crow in the end. One sees many variants of this in markets but the losses that the con man faces with his own trading is often to be predicted.
  2. Part of the big con, which always involves a big store with fictitious actors is the staged exit from the store, where such things as bogus policemen are called in to arrest the actors and mark unless they run. This often has the effect of bringing the mark back for more, even after he has lost everything the first time. Again, this reminds me of so many recent events.
  3. The con in con comes from confidence that the con man builds up by convincing you of his integrity and legitimacy. Convincers such as a track record making much money in the first year, when presumably the trades were hypothetical or involved peanuts is a good convincer that we always find in our field. Other convincers are the appearance at seminars with lofty professors, and books and interviews in newspapers.
  4. The con is good at appearing to be wealthy, with limousines, fancy offices, and Odyssian vistas standard props, operating in some cases out of a rented bank, just for the occasion. Wealth in the information age comes from high powered mathematics, rubbing shoulders with Nobelists, and great erudition in seemingly academic articles, and fake humility.
  5. 'You can never con a honest man' is a standard adage of all such books, the classic being The Big Con by linguistics professor David Maurer  (I find it interesting that Maurer sued the producers of the Sting but settled on the Courthouse steps). The larceny in the mark in the market is their desire to get rich with a simple fixed system. It cant be done, and they become easy victims to the inside information con, or the other two big con prototypes, the wire or the payoff.
  6. The big con evolved from a dollar discount store that served as a front and a lure for a three card monte game in the store. Since no one ever won in the game, and everyone lost all their money, the store didn't have to give away too many bargains. The store evolved into the big con where fake betting parlors, stock exchanges, and other elaborate scenarios were enacted. An ironic twist however is that one store became so successful at selling the actual discounted dollar goods that it became the seed corn for a national chain of department stores.

Perhaps some legitimate business will some day come out of the numerous big cons that we are subjected to in the market firmament each day.

Rip Mackenzie responds:

Greatly enjoyed your segment on cons. Episode one in the deal junkie TV series I was commissioned to create is called, "The Fine Art of Deception" and, like all the episodes, descends deeply into the art of the con and the fear of the self-con. It would be difficult to imagine a better time than, if time allowed, six months of all-encompassing, all-consuming research into the art of the con.

Here is an excerpt from Louis L'Amour's The Walking Drum:

"Sometime," I told Suzanna, "I will write about the relationship between piracy and trade. The one always seems to proceed the other, and the most successful pirates have become traders, perhaps on the idea that it is easier to defraud a man than to kill him."

"Trade is much superior to piracy. You can rob and kill a man but once, but you can cheat him again and again and again."

"You are cynical," Suzanna said, "they only sell them what they want."

"If people were sold only what they wanted, there would be little trade, my lady. The soul of business is to inspire people to buy that which they neither want nor need."

Moneyball? How about Money Flicks? by Art Cooper

There was considerable discussion on the List a while back about "Moneyball;" how the Oakland A's Manager used statistics to give him an edge over other teams.

In this same vein, "The Oscar Formula" on p W1ff. of today's WSJ describes a binary probit model developed by Prof. Andrew Bernard of the Tuck School to predict the winner of the Academy Award for Best Picture. The article claims 90% accuracy for the model, which gives "The Aviator" an 85% probability of winning this year.

Unlike the Market, the Oscars Can't Go "Sideways," by Kim Zussman

Hollywood can't let Sideways win best picture since it involves white male middle-aged bookends of complementary human weakness, and was filmed near Indian casinos without naming Sacagewea. Yet the film's popularity may mean at last time has come to sympathize with the reason people indulge the soul with alcohol (it its finer forms) and self-destructive muff-diving: fear....Afraid of aging, dying, or worst of all, irrelevancy.

And yes there is an investment thesis, which forms the basis for counter-trendism. When all is lost and nothing left to hope, suddenly, implausibly, the clouds part and sun floods down just in time to resurrect the parched darkness. Well, at least that's what it says in investment books...

Marketable Aspects to Chess, by Grandmaster Nigel Davies

One question I've continually had to ask myself is whether there are marketable aspects to chess. I came to the conclusion that the best money for a chess master is as a babysitter, running seminars to take kids off parents' hands at the weekends. Naturally this involves a degree of artistic compromise..

What I've found with trading is that it can be just as much of an art as chess, though I don't think either are as 'pure' as music because there is an 'opponent' and competitive elements are prevalent. The main difference is that with trading the prize money tends to be rather better for the stronger practitioners.

George Zachar offers:

The chess coach of a nearby Upper East Side high-end private school charges $85/hour to work with my 10 year old son, Adam. A very gifted and rigorous "old school" professional piano teacher charges $75/hour to tutor him. As I recall, the great multi-generation fortunes immortalized in lists such as the Forbes 400 tended to be generated in two broad categories: Long-term property investment (real estate / Sage-like equity positions), or more importantly, creating/marketing something desired by mass markets at "affordable" prices: Ford/cars, Rockefeller/fuel, Gates/digital tools, Dell/computers.

Piano and chess have proven very important in my son's development, and it saddens me that the devoted men who work with him seem to enjoy only the most pedestrian of "lifestyles" despite their talents and pedagogical abilities. They're most appreciative when I recommend them on to others, and seem embarrassed by the modest (Amazon gift certificate) holiday gifts I give.

Obviously some abilities, no matter how "great" objectively, do not scale in a wealth-producing manner: Why do great tennis players enjoy int'l fame, but not great squash players? Why are Eminem and 50-cent able to conjure huge income streams out the music industry, while thousands of virtuoso pianists, violinists, etc., treat their gifts as hobbies and exchange labor elsewhere in the economy to make ends meet?

I think Mises had it right when he said that in a free market, the consumer is sovereign: both merciless and capricious. Artistic wealth lies in titillating the heart of the income distribution. Artistic beauty often lies elsewhere.

Take Stock of Yourself, by James Sogi

Tim Melvin wrote: How does one gain the same focus and intensity that allows us to perform at our highest and best levels and bring it to bear every game and every day?

"Count." ....Dr. Gerald Patterson, of whom I've written before, broke new scientific ground in the field of psychology by using statistical analysis of coded behaviors diagnosing troubled teenage boys and the behavioral correlations in their environment that lead to their troubles. Dr. Patterson also coded his own behavior and used statistics to analyze and chart them. One of the things he identified with life satisfaction levels was taking some time off. He loved his research, but found if he worked for more than 10 days straight without time off his satisfaction level would drop off.

Statistical analysis of traders, rather than their systems, is a risk management tool. Why not apply statistics to your own trading behaviors and factors that may or may not affect your trading? Many counter-intuitive things turn up in the markets and may uncover things about yourself that you never expected that may be holding you back. Dr. Patterson would code behaviors in the home such as: yelling, fighting, compliments, and place them in a chart then do the regressions on the data. The trader might chart a number of at first random items such as: weather, health, did you jog this morning?, day of week, time of day, season, family trouble, prior win/loss, drinking, indigestion, sex, or any number of factors. They may uncover previously undetected patterns of behavior. Baseball does it.

Andrew Lo's Systemic Risk and Hedge Funds, by Kim Zussman

Andrew Lo details a hypothetical hedge fund, "Capital Decimation Partners," that shows extremely high returns and Sharpe simply by selling OTM S&P puts. Perhaps more salient in that Andrew Lo runs a hedge fund. As such, perhaps different motives to publish than pure academics (such as buttering one's own bread). Pass the toast please, NNT.

Their summary:

A conclusive assessment of the systemic risks posed by hedge funds requires certain data that is currently unavailable, and is unlikely to become available in the near future, i.e., counter- party credit exposures, the net degree of leverage of hedge-fund managers and investors, the gross amount of structured products involving hedge funds, etc. Therefore, we cannot determine the magnitude of current systemic risk exposures with any degree of accuracy. However, based on the analytics developed in this study, there are a few tentative inferences that we can draw.

1. The hedge-fund industry has grown tremendously over the last few years, fueled by the demand for higher returns in the face of stock-market declines and mounting pension-fund liabilities. These massive fund inflows have had a material impact on hedge-fund returns and risks in recent years, as evidenced by changes in correlations, reduced performance, increased illiquidity as measured by the weighted autocorrelation, and increased mean and median liquidation probabilities for hedge funds in 2004.

2. The banking sector is exposed to hedge-fund risks, especially smaller institutions, but the largest banks are also exposed through proprietary trading activities, credit ar-rangements and structured products, and prime brokerage services.

3. The risks facing hedge funds are nonlinear and more complex than those facing tradi-tional asset classes. Because of the dynamic nature of hedge-fund investment strategies, and the impact of fund flows on leverage and performance, hedge-fund risk models require more sophisticated analytics, and more sophisticated users.

4. The sum of our regime-switching models' high-volatility or low-mean state probabilities is one proxy for the aggregate level of distress in the hedge-fund sector. Recent measurements suggest that we may be entering a challenging period. This, coupled with the recent uptrend in the weighted autocorrelation and the increased mean and median liquidation probabilities for hedge funds in 2004 from our logic model implies that systemic risk is increasing.

We hasten to qualify our tentative conclusions by emphasizing the speculative nature of these inferences, and hope that our analysis spurs additional research and data collection to re-neg both the analytics and the empirical measurement of systemic risk in the hedge-fund industry.

Value Beats Growth--Another Wall Street Myth, by Victor Niederhoffer

One of the gravest delusions is that Value stocks beat Growth stocks. And this becomes especially heinous and ubiquitous in years like now when value actually has beaten growth for the past 2 years. Left out of course is that growth stocks selected prospectively over the last 35 years have returned about 30 times more than value stocks cumulatively.

When I presented unobtrusive statistics on this in London the other day, a silver dealer, one of the shrewdest dealers I've ever run into came up to me after. He said "you said that companies selling at below book value are the ones that you never can sell because they stay below book value. Well the same is true in antiques".

I have heard this advice in many forms, e.g. "don't buy commercial stuff--there will always be an abundance of it, but buy the best, the tiffany stuff ". I have found it true in the tens of thousands of things I have bought, but academic studies in the art market like those in the stock market seem to come up with opposite conclusions, due of course to the same kinds of retrospective bias and hatred of business that energizes the Buffetologists.

Tim Melvin responds:

Anyone that knows me knows I consider the chair one of the greatest investors/traders and philosophers that ever walked the landscape...he has been a benefactor, a major influence and simply put, one of the greatest men I have ever known. But at the risk of being ostracized, I disagree. There is no study ANYWHERE that indicates that a price insensitive growth methodology beats a price sensitive value method. NONE. You can't used a managed value line program against a an unmanaged index to prove it...put the best "growth mangers against the best value managers, the value guys win. put the value indexes against the growth indexes, the value guys win. Period. Numbers on the table, value wins, every time, all the time. For the long term investor, price and value matter. the only time I've had bad years were when I abandoned my basic value methodology. I have not achieved a fraction of the chairs success in life or markets, but I'll debate this one with anyone, anytime, anywhere, with numbers on the table. Properly applied a value philosophy of buying quality at a discount beats any other method of long term investing

The Senator Sides with the Chair:

I must agree with the chair on this. Growth outperforms value, and usually hands down. The problem is knowing of growth stocks early on; my experience is once I (we) know they are growth stocks, said growth stops, but had you been able to know in the early stages (the potential for growth) value is beaten. However, value is a much easier approach, very easy to find compared to potential growth stocks.

Tim Melvin retorts:

WAIT A MINUTE! I find myself in disagreement with two legends of our business. I should back down at this point but no one has ever accused me of refusing to do something stupid.

Senator, how can you make that statement when your last book espoused low price to sales ratios, high yields and the darlings of the Dow strategy--all value oriented strategies?

The Senator explains:

I have great value for value. The problem with growth is I cannot assign it or find ratios that catch it early enough for me to profit thereby. So my point is if you could find that, then it beats value. Until I know how to find growth (that lasts) I stay with value. This was more of an academic point.

Pam van Giessen reasons:

My pea brain has a tough time with the whole value versus growth thing. A good buy is a good buy whether it's spicy or sweet, no? Why this obsession by investors with the flavor of the thing? And who cares really? Bogle pointed out in Common Sense in Mutual Funds that for the 60 year period from 1937-1997, growth funds returned 11.7% and value funds 11.5% (p. 232). I know investors want every fraction of a percentage point gain they can get but the whole growth versus value debate seems more an exercise in intellectual masturbation than an uncovering of real profits -- at least for most investors (though perhaps not specs).

Anyway, in my view, I wonder why investors would limit themselves one way or the other. Making the distinction even seems weird to me but then again I like both spicy and sweet foods, as I know Chair does too.

GM Nigel talks Value vs. Growth in Chess:

There is an interesting chess analogy to growth vs. value issues in chess, i.e, in dynamics and structure. Structural advantages are things that are immediately visible (material, pawn weaknesses, bishop pair etc) whilst dynamic features (piece activity, time etc) are much harder to assess, especially for beginners.

It's interesting that players who value structure, the chess Buffets and Grahams, seem to enjoy a much better reputation than dynamic players such as Alekhine, Tal and Bronstein. Even when the structuralists lose there's the suspicion that it was 'just tricks' and that more sober times are just around the corner. In this respect it's interesting to hypothesize that the tricksters' methods may be even more frowned upon when people are afraid. But perhaps that's exactly the time they are most likely to succeed.

Rudof Hauser examines the subject.

Vic's contention on growth beating value raises some interesting questions. The general assumption is that markets are reasonably efficient. Naturally for any given past period one would expect one group to come out ahead of another. But does that mean it should continue into the future? If markets are reasonably efficient over a longer time interval then risk adjusted returns for all assets should be equal.

The first question is how would one define a growth company versus a non-growth company?

I prefer Joel Stern's definition that says a growth company is one that has a return on investment in excess of its cost of capital, that is the return the market requires for the level of risk involved with regard to the company. One would expect investors to bid up the price of the stock relative to its economic book value (not historical cost) to the point where the future returns are no longer in excess of its cost of capital. If a company earns less than its cost of capital, one would expect the stock price to decline relative to the economic book value until it is priced so that the stock yields (total return) the required cost of capital in the future.

Whether all non-growth companies would be called value companies or only those selling below economic book value depends on whether one divides the universe of stocks into two or three categories. The only time one should earn excess returns in the market is if one buys before the market fully recognizes the current nature of the company or if the relation of the companies returns on investment over its future life changes. To the extent that those latter changes can be expected, one would expect an efficient market to do so and to be reflected in the current price. To expect current growth stocks to always outperform non-growth stocks over longer periods would assume that growth companies are more likely to have more upward than downward changes in expected future returns on investment relative to what the market expects than non-growth companies do – and all this continuing to be the case because of some bias in the reasoning ability of investors.

Given the ability of investors to envision great future returns based often on no more than a promising idea and that most people tend to be risk adverse for smaller risks but a good number are willing to risk some capital for potentially very high returns (like playing the lottery or gambling where you know the odds are in favor of the house) that bias does not seem all that intuitively evident. But is that what you are assuming Vic, or on what basis do you make your claim? And if you assume this bias exists, do you have any assumptions on the nature the sub-conscious functioning of the human brain that explains it?

Yishen Kuik chimes in:

Perhaps it is useful to define growth very loosely as companies that are experiencing growing revenues. Whether it is because these companies have succeeded in producing newer products, better products or cheaper products, they are getting more sales - the ultimate vote of confidence in what you are doing from the economy.

It seems that investing over the long term must be about hopping from one island of growth to the next, before the previous one sinks, the inevitable victim of changing tastes, loss of touch with what the economy wants or technological obsolescence.

A 100 year look-back at the composition of the Dow Jones Industrial Average tells you that entire industries tend to wax, wane and eventually completely disappear. So it seems to me that over the long horizon, there can only be growth as one tries to keep up with what new thing the market demands, for it is always demanding new things. If it happens to be your new thing that the market decides it wants next - the market will tell you in your sales growth. Eventually and inevitably though, the market will move on to the next new thing, and unless you are among the very few companies who possess the ability and luck to change correctly with the times, the market will pass you by, just as it has the scores of DJIA components who have long since faded away from the Big Board.

If my premise has merit, and growth is about really about trying to figure out what society will want to purchase tomorrow, then it is a difficult thing to try to wrap numbers around - which might explain why the foremost seekers of growth, the venture capital business, is entirely qualitative.

"I prefer Joel Stern's definition that says a growth company is one that has a return on investment in excess of its cost of capital, that is the return the market requires for the level of risk involved with regard to the company."

I respectfully challenge Mr. Stern's definition as more useful as an example of a failure of market efficient models (i.e. return greater than risk) than providing us with any insight as to what growth is really about - the future.

J.T. Responds:

I know that I have previously mentioned my love of baseball card collecting and the love of math it taught me as a youngun' studying stat figures on the backs of cards. This is by far one of the greatest examples of free markets that I know of today that is UNREGULATED, NONGOVERNMENT, NONTAXED and has one company Topps Inc. dominating a oligopoly of small players Upper Deck, Donruss, Fleer and the likes.

eTopps is the "electronic" version of older paper cards- you hold in street name at eTopps and they have IPOs, EBay is trading floor.

How does this relate to value vs. growth? It both supports the 6 percent return of IPOs, and the fact that people pay premium for whatever definition of Growth you want to throw out there vs. whatever definition of Value you want to throw out there. For example, when a player breaks into the Big Leagues he has a "forward looking" card created. These cards are the IPOs and in high demand which create premiums vs. the other already seasoned players that have been in the leagues for awhile. Future star cards, rookie cards are all highly sought after! Who wouldn't want to purchase a pack of cards for 2 bucks that has the next Henry Aaron or Mickey Mantle inside? If one is inside then you might have an immediate 500 percent return on your hands. Delmon Young, Felix Hernandez, and Kendry Morales are Topps 2005 hot rookies, these are immediate 15 buck cards, have you ever heard of them? Have they pitched a no hitter yet? Have they swatted 50 hrs? Won any Golden Gloves? Answer to these is no, no, and no! But you can be your sweet tail that my son and I will be opening up packs and looking for them not Greg Maddux, Barry Bonds, Pedro Martinez (Value Guys). My son just turned five and this is the first year that he wants to start collecting (trading) cards! I bet a nickel on a doughnut that he'll understand the growth vs. value argument by the end on the season! Once you see that Barry Bonds is worth 2 times less than those up and coming HIGH PE, HIGH PEG types it kinda defines itself. It ain't always peaches and cream though; for example, Joe Charboneau was a hot rookie with Cleveland Indians and was Rookie of the Year in 1980 he smacked 24 hrs w/ .289 avg in 453 at bats. His card shot up and then fell straight down when he got back problems and only basically had a 2 year career! I was holding 10-15 cards that were worthless and at an est. 80% loss - I was only 9 year old. I did corner the Rickey Henderson market with his 1979 As card - I had about 100 of these and they went up to 200 bucks a piece in 1991 (that's right 12 yr holding period) when he broke Lou Brock's stolen base record, as I unloaded and don't have a clue what I used the money for being a sophomore in college.

On etopps in 2003 the LeBron James card came out (you want to talk about Growth!) Etopps did the IPO w/ only 10,000 cards, I was part of Dutch Auction and landed 1 card at $9.50 and it is worth roughly 27.50$, the Dewayne Wade came public at 6.50 and is now 42.50 and they only had 1208 of these at IPO.

Give me Growth or give me Death!

James Morin Responds:

It occurred to me there are many other parallels to card collecting and the markets; I remember in the early 1990s there was a significant increase in the popularity of card collecting across all ages. I am sure many folks who had collected over the previous 30-40 years finally got their big payoff, at the expense of all those rushing to get rich quick etc. It was a valuable lesson as I know many friends that accumulated expansive collections in the hopes one or 2 cards will be that magical one that goes from .10c to $1000 in their lifetime....I wasn't interested at the time, rather I continued to simply collect a few cards of the players I admired, specifically Jose Canseco (I was a teenager, he was a larger than life heroic figure!) and continued to do so...I have accumulated hundreds of cards of his, hoping someday his "unique" career would payoff. Things are looking better now, having cost no more than $50 to accumulate this collection, it could be unloaded to the right buyer for well over 10x that amount...but that is the key I suppose, the right buyer would make an emotional purchase well over the actual value of the investment, perhaps as I did initially.

I think I will hold a little longer, lets see how this steroid saga will affect baseball's history.

Vic Calls Upon the Don to Sum Things Up:

The very pleasant discussion that has been engendered by my thoughts that the unobtrusive evidence is that growth beats value, a thought consistent with the raison d'etre of the stock markets role in an enterprise system, an exchange system where entrepreneurs with ideas as to how use  capital more productively and urgently desired reward investors who have their money committed to less urgently desired areas brings to mind chapter 4 of Don Quixote.

The Don demands " let all the world  acknowledge there not  in all the world a maiden more beautiful than the empress of La Mancha."  A merchant wag  says " sir knight, we know not the lady you refer to. Discover her and if she proves as beautiful as you say, with pleasure and without reward, we shall acknowledge the truth of your assertion. "   The Don immediately says "Should I show you her, ' what profit in the acknowledgment of a truth so  obvious? The thing is without site of her you must acknowledge and believe it, affirm, swear, and defend it or fite you unnatural and presumptuous louts".

What reminds me of this is the remonstrations of the value people who without data demand that the wisdom of Ben Graham who found the market overvalued  at  a p/e of 10 and found individual stocks overvalued  when  cash was less than twice liquidating value and whose fund the Rea-Graham Fund was one of the worst performing funds of all time, be accepted without evidence.

Enclosed below are the actual results year by year with value stocks versus growth stocks as chosen prospectively by Value Line each month for the last 40 years. Value stocks are those with the lowest 10% of price sales, or price book or price earnings as of the end of month in the Value Line universe   using the latest available reported results as of the time ( without retrospection or deletions or additions from the big retrospective file)

Year by Year Performance of Stock Market strategies studied by Value Line. Each year, for each factor, they form a portfolio of most undervalued 10 percent of companies within their universe


A Good Strategy is Hard to Find, by Charles Pennington

A good strategy is hard to find, and it doesn't always hang around. From the data that the Chair posted, below is listed the percentage outperformance of Value Line 1-Rank stocks over the Value Line Composite.  There was clear, obvious outperformance before the 1990's, but now it's dramatically not there anymore.

YrRank OnesYrRank OnesYrRank Ones


Ross Miller: Adventures in Retailing Part IV: Woodbury Common

With Presidents' Day Weekend giving me the first opportunity in over a month to get ahead of the curve in my teaching, it is time to get back to retailing with a visit to Woodbury Common. Though it might sound like a socialist utopian planned community, Woodbury Common is a "premium" outlet mall situated immediately off the Harriman exit of the New York State Thruway not far from Bear Mountain.

I was inspired to write about this mall when I noticed on a recent visit that I was apparently the only patron whose spoke English. Some of my fellow patrons were familiar from my days back in Houston when I would visit Neiman-Marcus purely for entertainment--at the end of the Disco Age, academic salaries did not go very far at the city's high-end retailers. Back then, certain customers from foreign lands would pay from their purchases with crisp $100 Federal Reserve Notes peeled from rolls that barely fit into their pockets.

I travel in circles where plastic is the coin of the realm, so after witnessing two transactions where money (in big bills) did the talking, I had an epiphany. Although the items being purchased would undoubtedly be whisked away to distant shores within days, I did not expect that any trace of them would appear on our country's balance sheet as exports to offset our gaping foreign-trade deficit. A back-on-the-envelope analysis, however, demonstrated that unless the number of alien visitors willing to "underdeclare" the value of the goods leaving the country was on a par with our indigenous population, such transactions could only explain a small fraction of the trade deficit. Still, given the difficulty of accounting for anything these days, one has to wonder just how much faith some be placed in government statistics that implicitly assume a world of honest people.

With the topic of international finance (about which I know nothing) out of the way, I will address the mall experience at Woodbury Common itself. I discovered Woodbury Common in its early days when it was still small and outlet malls were the new, new thing in retailing. Woodbury Common is an outdoor mall with stores arranged to resemble a retailing "village' rather than a series of adjacent, yet askew, strip malls, which is what the mall really is. In theory, the mall is built on concept of selling luxury goods at ridiculously low prices. In practice, there is more schlock than luxury and more rip-offs than bargains. I do not intend this remark to be viewed as disparaging, just an objective observation or what my old colleagues in the economics of industrial organization would characterize an optimal strategy in the price-quality state space. If one understands the game that is being played in such a mall, shopping can be profitable as long as one enjoys the process.

Basically, shopping in an outlet mall is like being a fund manager; if you don't know what something is worth, you are going to pay too much for it. The optimal shopper enters the outlet mall with a mental shopping list and a target set of prices. When shopping for good sold by mainline retailers, such as the Coach Store, it is wise to visit the flagship store first to know what the true retail price is. Some stores, such as Brooks Brothers, have special lines of merchandise that sell only at their outlet stores and very little of their "good stuff" makes it to the outlet store. (With Brooks Brothers, the best bargains are to be had at the semiannual sales at the flagship stores and through their catalog.) Some stores, such as the Sony Store, actually have the temerity to sell many items at their full retail price. (In the Sony Store's defense, it has some great "refurbished" items that beat the best prices available on the Internet. I wonder how you say "caveat emptor" in Japanese.) My visits to the footwear outlets are driven not so much by price as by the superior selection afforded to one with outsize feet.

I should mention that after one serious misadventure on Memorial Day Weekend, I never visit Woodbury Common on a weekend (Fridays included). I even go out of my to avoid its stretch of Thruway, which can back up for ten miles, during prime shopping hours. The best time to visit the mall is on weekday mornings in the dead of winter--the colder, the better. While the locals around here think nothing of wearing short in subfreezing temperatures, many of the visitors to the mall come from climes where significantly negative Celsius is cause for a national emergency. A bargain is not a bargain is you have to wait in line for half an hour to cash it in.

For a mall that purports to be premium, the edibles are rather pedestrian. A big fuss was made several years ago when the mall added an Applebee's--the McDonald's of sit-down dining. (The real McDonald's is available in the food court along with the usual suspects.) Before I lapse into a restaurant review, it is worth noting that those insidious Dippin' Dots have long been a feature of this mall.

In my assorted travels I have stumbled across other outlet malls, but I must give the nod to Woodbury Common for general atmosphere--the mall does resemble a village, albeit a tacky one, at the base of a wooded hill that is sometimes quite beautiful--and because some luxury items (by my standards, not Sarah Jessica Parker's) do manage to find their way to the mall at attractive prices. (When Manolo Blahnik sets up shop in an outlet mall, can the final day of reckoning be far away?)

Woodbury's competitors seem a mundane lot. Gilroy, California has diversified its economic base to outlet malls, but its setting has much more of a strip-mall (not to mention, garlic) flavor to them. The Jersey Gardens outlet mall benefits from the local tax breaks to be found in Ikealand-by-Newark-Airport, but is decided downscale and fully enclosed. It had a good Asian restaurant--a real restaurant, not a chain--but my sources tell me that it has closed. The very existence of Jersey Gardens is evidence that the salad days of the outlet mall had passed.

I will resume this retailing series once I get a chance to visit the Wal-Mart SuperCenter that recently opened to the north of me where mobile homes run free. I am beginning to have second thoughts about my tilt toward Target as repeated visits to their stores indicate inventory management policies that leave much to be desired.

The next few commentaries will focus on things that I have run across while gearing up to teach finance course for the first time in fifteen years, which is like an eternity in financial time. (This gearing-up process is what has been making me more sporadic than I had planned.) My first installment in this new series is called "Outlaw Financial Calculators."

Style Investing, by Bruno

It seems that the concept of style investing is relatively recent. So does it make sense to study the performance of styles over long periods? No investor in the 1920's or 1940's would think of himself as a value or growth investor. So there is actually no track record for style investing. Except perhaps the one from VL that Vic mentions, but it is only from the 60s. This paper about stock valuation history also seems to show that valuation methods evolve from recent market behavior. In a prolonged bull market, people will focus on the future and growth-oriented valuation methods prevail. After a severe bear market, people go back to caution, and value-based valuation is back in fashion.

The "IBD 100", by Charles Pennington

Investors Business Daily each week publishes a list of 100 high fliers called the "IBD 100". The paper is cagey about whether it's actually recommending those stocks, and even if it did it would tell you to wait for some vaguely defined price pattern to emerge. Also the list changes weekly, and I'd guess that a stock's typical lifetime on the list is perhaps one to three months. The characteristics of the stocks on the list include rapid growth in earnings and sales, high profit margins and returns on equity, good recent performance of the share price, and institutional ownership. I don't know exactly how all these things are calculated.

Nevertheless the list is there to see, and in fact this website provides the list as it stood each week, starting in December of 2003.I took the list as of 12/27/2003 and looked at the price changes of these stocks from 12/31/2003 through 2/18/2005. It turns out that as a group they did quite well, with an average return of 27% and standard deviation 49% for the 98 stocks for which I could easily find price data from yahoo. There were two stocks for which I couldn't find price data. Assuming that went bankrupt with no residual value would knock the average return down by 2%. During this time the price change of SPY was only about 8%.

A word of caution thought--if you had bought only the highest 10 rated stocks in the IBD 100, you would have lost about 10%. Also many of these stocks have low market caps, some less than $100 million, so it would be difficult to buy them in quantity. Nevertheless it's a little evidence in favor of the high fliers, and a very good argument against shorting them.

Feedback from California, by Jean Paul Schmetz

I am attending a small conference with the greatest minds of our time here in Monterey (Venter (genome), Watson (DNA),... but also Brin, Bezos, Doerr, etc...). One of the consensus here is that the petro-chemical industry is doomed in its present configuration. It seems also (acc. to Venter) that this may happen much sooner than previously thought (the talk is 5-10years or even less if a lucky break through is achieved). Venter (financed by Moore of Intel fame and the DOE) circled the globe in his luxury yacht and collected water to identify 2000 new genes involved in photosynthesis (light --> Hydrogen) and is starting to build bio-tech power plants that can reproduce. He is also working on organisms that convert CO2 into methane. The whole process seems to be much more efficient than electronic or chemical means of producing/recycling energy. Nothing to trade on but the prediction is that there will be an oil crash sometimes during the next ten years (note also that the announcement of this possibility can come anytime during the period -- as soon as Venter creates the first self-reproducing power plant, it will be a media event even if it takes ten years to implement in practice).

Statistical Musicology, by Victor Niederhoffer

The area of statistical musicology is a gold mine for improving one's understanding of art and markets.

Musical pieces may be considered a time series consisting of an open and moves by favored intervals above and below  the open occurring at various speeds and durations, with other time series from other instruments (or markets) creating the harmony.

I was particularly intrigued by a study that attempted to quantify jumps in consecutive notes in melodies according to the 11 intervals in the chromatic scale. A four-interval jump corresponds to a major third, and a five-interval jump is a perfect fourth, etc.

The bivariate distribution of consecutive jumps, i.e., a scatter diagram of how often a jump of a given magnitude is followed by another, is a very fruitful area in understanding music. Jumps can be considered on an algebraic or absolute basis.

I particularly enjoyed looking at scatter diagrams of Bach pieces, because they corresponds to much to consecutive changes in the stock market with jumps of 4 and 5 intervals being most common. These are almost invariably being followed by jumps of 1, 2 or 4, in descending order of frequency. The jumps down of 4 or more are invariably followed by a much greater frequency of up jumps. And this is because the composers are much more likely  after a decline to write notes that are higher than notes  that are lower.

The music of Mozart is much more evenly divided in the four quadrants, and Scriabin is wild like the derivatives expert says that the market is.

I found some new ways of analyzing markets by considering these jump distributions and I will illustrate with some work and charts and examples  that the I did not have the chance to present during my lecture, accompanied by Laurel at the piano, at the Feb. 23 student investment conference at the London Business School (the reason for our silence last week). A good link to the literature>>>      

An After-Talk Photo at the Royal Chinese:

L. to R.: GM Nigel Davies, Laurel "nanny" Kenner , Professor Elroy Dimson, Chair,"stache" Mustafa, and Patrick Boyle.

James Sogi responds:

The Blues: it's emotional; it's simple; it's powerful. The simple 1-4-5 progression evolves emotionally with the context of the progression using a repetitive pattern. Try play the basic 8 bar blues, 1-4-5, 2 times: EAEB, EAEB, four beats each. Its the same thing on paper twice but the second time on the second B there is an emotional resolution when heard in person. The song cycle is typically played 3-4 times through with final resolution at the end sometimes an octave higher. The songs are often distinguished by their rhythmic signature which is a whole level of communication which does not appear in standard music notation, and which oddly is also missing from your regular time series bar chart. African drum rhythms are able to communicate meaning. Rhythmic fluctuations would be fruitful area of study in the market in addition to price. Counting is done by tapping (or stomping) the foot. The foot itself contains the rhythm.

Price bars have no more intrinsic emotional content than quarter notes on a music chart, but WE know better....they are packed with emotional intensity as fortunes are made and lost. Look at 2/23-25 SP chart. Its a perfect blues progression starting on the downbeat Tuesday night. A repetitive 1-4-5, each day and the climax today. A move, small pullback, mini resolution top at the "5", a turn around, repeat. Same notes, same chords, different context and different emotional resolution. Seems to be a fairly distinctive and repetitive pattern. Don't forget the obligatory overextended guitar solo or drum solo in there this morning.

Spin-offs, by Alex Castaldo

While Prof. Pennington has been making great progress in estimating the performance of spinoffs during the past few years, I have been continuing to review the academic literature on spinoffs. Here are two articles:

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Desai, Jain: Firm performance and focus: long-run stock market performance following spinoffs Journal of Financial Economics 54 (1999) p75-101

Examined 155 spinoffs between the years 1975 and 1991. Divided them into "focus increasing" and "non focus increasing". Examined the long run performance (up to 36 months) as well as the short run.

Three alternative measures of focus (1) Using data on sales revenue for individual business segments, compute the Herfindahl Index. A spinoff is a focus increasing spinoff ("FIS") if there is an increase in the Herfindahl index of the parent from the year before the spinoff to the year of the spinoff (i.e if sales revenue is more concentrated). (2) A spinoff is focus increasing if there is a decrease in the number of segments reported by the firm. (3) A spinoff is focus increasing when the two digit SIC code of the subsidiary is different from the two digit SIC code of the parent.

>From the full sample of 155 spinoffs, 111 are classified as FIS and the remaining 44 as NFIS. (In about 90% of the cases the classification is insensitive to the measure of focus used.)

-Quote Our results are as follows. Similar to Daley et al. (1997) the 3 day announcement period abnormal returns are significantly larger for the focus increasing spinoffs (4.45%) than for the non focus increasing spinoffs (2.17%). However we show that the superior performance of FIS persists in the post-spinoff period. In particular the abnormal returns (based on size and industry matched control firms) for the FIS are statistically significant 11.12%, 20.77% and 33.36% over holding periods of 1, 2 and 3 years following the spinoff [this includes both the parent and the subsidiary]. The corresponding abnormal returns for the NFIS are statistically insignificant -0.96%, -7.66% and -14.34%. [ ] The results are robust to the use of alternative definitions of focus and to a number of alternative benchmarks for computing abnormal returns.

[For the subsidiaries only of FIS (i.e. leaving out the parents) the abnormal returns are 22%, 47% and 54% for 1, 2, and 3 years. All are statistically significant.]

Cross-sectionally, the change in operating performance is significantly positively associated with the change in focus. [ ] Thus the stock market results are corroborated by the operating performance results. Also, we do not find any evidence of disproportionate transfer of debt from the parent to the subsidiaries through a spinoff. We show that the firms that undertake NFIS are spinning off poorly performing subsidiaries. -End Quote

Abnormal return is computed using a matching firm methodology (i.e. a firm chosen at random that is close to the sample firm in market cap and is in the same two digit SIC code). Alternatively, the CRSP EW and VW indexes were used, with similar result.

In summary, from an investment point of view, the subsidiaries from FIS (focus increasing spinoffs) are preferable.

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Krishnaswami, Subramaniam: Information asymmetry, valuation and the corporate spin-off decision, Journal of Financial Economics, 53 (1999), p73-112

Prior academic research considered 4 reasons for the gains from a spinoff: (1) improvement in focus and elimination of negative synergies, (2) transfer of wealth from bondholders to shareholders, (3) tax and regulatory advantages, (4) recontracting benefits after the spinoff. This article instead looks at mitigation of information asymmetries as the reason for the spinoff. In layman s terms the spinoff somehow makes the parent and the subsidiary more understandable to financial analysts and investors.

Sample includes 118 firms in the period 1979 to 1993. This study looks at the return at the time of the announcement only, not at the longer term return.

Five measures of information asymmetry were used: (1) Analyst earnings forecast errors (from IBES) (2) Standard deviation of analysts forecasts (3) Normalized forecast error (defined as the ratio of forecast error to the variability in earnings of the firm). (4) Volatility of abnormal return around the earnings announcement (specifically the standard deviation of 3-day abnormal return around the quarterly earnings announcements of the last 5 years). (5) The residual volatility in the firm s daily returns, i.e. the unsystematic volatility

Empirically these measures are found to be higher (before the spinoff) for the firms doing the spinoff than for the control firms.

Also, these measures are found to decrease from before to after the spinoff. For example the earnings forecast errors decrease significantly (by 78%) after the event.

The measures are also found to be related to the size of the abnormal return at the time of announcement. For example, using the forecast error measure, the mean two-day return for top-quartile firms is 4.11%, while it is 2.28% in the bottom quartile. This difference is significant at the 5% level.

-Quote Stock analysts typically have industry preferences and tend to track firms in one or a few specific industries. When these analysts encounter firms with divisions in different industries, their valuation of the unfamiliar divisions is likely to be less accurate, leading to higher forecast errors for such firms. -End Quote

Because this study looked only at returns at the time of announcement, the practical application for investors is not clear. If the results hold for long term returns as well, then one should buy spinoffs of firms with large analyst forecast errors before the spinoff. But this study is more concerned with "why" firms spin off than with what investors should do.

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One disappointment in these studies is that the data used is fairly old.


It's Good to be Admired, by Charles Pennington

Every year Fortune magazine posts a list of the "Most Admired" companies in the U.S.  This year the 10 most admired are DELL, GE, SBUX, WMT, LUV, FDX, BRK, MSFT, JNJ, and PG.

Contrarians might guess that these are stocks to be avoided.
However, a year 2000 paper by some scholars at the Federal Reserve Bank of New York suggests otherwise.

The authors looked at the results of buying the top decile of "most admired" companies as rated by Fortune each year and holding for one year.  Their purchases well after the list was published in Fortune.  They found that the top decile of most admired companies outperformed the overall market by 3.7% per year over the years after portfolio formation, and outperformed the "least admired" decile by 5.3% per year.  The study covered the years from 1983 through 2000. (Time for an update.)

I looked at the 10 most admired companies, as rated by Fortune, for the years 1995-2003.  The list is typically published in February, but I waited until the end of the calendar year to form the portfolios. *I didn't include dividends.

Here are the results:

list year      investment period    perf (%)  perf.SPY (%)  diff
1995            1996                45%          20%        15%
1996            1997                25%          31%        -6%
1997            1998                39%          27%        12%
1998            1999                20%          19%         1%
1999            2000                -1%         -10%         9%
2000            2001                 0%         -12%        12%
2001            2002               -26%         -23%        -3%
2002            2003                28%          26%         2%
2003            2004                 8%           9%        -1%

Summarizing the results:

--The "most admired" clearly do NOT systematically underperform, as a contrarian might have expected.  They outperformed in 6 years and underperformed in 3.

--During the 3 bad years (2000, 2001, 2002) SPY lost a cumulative 45% (I know, I know, I should consider compounded results.), and the "most admired" lost only 27%.

--For the past three years, there has been little difference between the "most admired" and SPY.

--The biggest embarrassment in the list was LU, which showed up in the year 2000 list, and lost 53% in 2001. And note...there is about 10% in statistical error associated with looking at just 10 companies, with standard deviation of the 10 company returns' typically being about 20 or 30%.  

Investments, A Review by Russell Sears

I hesitate to give a review of a book I am still in the middle of reading, and probably always will be. Due to its depth, I found that I never really finished reading the 3rd edition of Investments, by the time I progressed to the latter chapters, I had already found myself constantly referring to the book earlier chapters.

Often the world of investments are full of jargon and complex subjects. Investment professionals throw out not just a language but usually a philosophy intended to beat your thoughts into subjection. I consider it a great benefit that my intro into Investment was through this early book. It explained these complex concepts in simple enough language that I could understand. Simple, but comprehensive, I have yet to pick up an investment book that has come close to explaining the range of concept of this one. Further, it presents the philosophical concepts with at least an effort to present both sides. Yet, I detect the authors inclination to index, at least for the masses, rather than actively manage a portfolio. But the 6th edition presented active management in a better light than before.

A caveat to the numerically challenged, this book probably is very difficult reading for those without a basic statistical knowledge. While the texts does review the concepts of standard deviation, covariance, regression etc. it is probably not the easiest way to learn these concepts. As the text assumes you have mastered these ideas fairly quickly. Yet personally, coming from a math background with only basic stats knowledge, I found this book to be an excellent way to solidify a better understanding of stats. Learning stats for a grade lacks motivation incorporate it to long term memory, and the meaningfulness of practical numbers. And what could be more motivating than the hope of increasing your wealth. I would recommend this book for concurrent reading for a beginning stat student.

The sixth edition is definitely worth the purchase if you have not updated your edition for a while. This edition makes extensive use of the Internet. With purchase you obtain access to a web site with power point presentation of each chapter, a glossary of term and quizzes. There also are Excel application on the website for students that want more complete look at a concept than a normal text question.

Both the book and website contain links to relevant websites for each chapter. Like the book itself many of these sites are well known by most connected investors. The website also contains news feeds, by chapter. While often I did not see the direct relevance to the chapter. This I suspect rather is a reflection on web news. Also the site has "power web articles" which appears to retain the most relevant and often the current think on the topics in each chapter. I found this site valuable for the few chapters I have referenced it for. This living updates makes this edition a step ahead of most textbooks, not just investment textbooks. Finally a trial subscription to market data is available for free. But I must confess I did not bother with activating, since I have access to Bloomberg at work.

The sixth edition has done an excellent job of updating topics that have become more relevant recently and keeping up with the best ideas on the current thinking of academic research on the markets. A good summary of recent scandals is given in chapter one for example. And the regulation environment that has grown to meet them. Another example, that caught my imagination, is research by Jaganathon and Wang. This research uses a 3 beta factor model of value weighted market, spread of high grade to low grade bonds as proxy for the business cycle and the cost of human capital. They find "that the significance of the book-to-market and size factors disappears once we account for human capital and cyclical variation of the single-index betas" (Chapter 13 page 425.) Small caps are dominating large and China India and outsourcing are large influences on the cost of human capital. Spreads on junk bonds are tighter than I can have ever experienced. Such concepts invariably divert my attention from the book. This version I again will never complete, and that is a good thing.

You Can't Navigate the Market Ocean If You Can't Recognize the Chop of Her Seas, by James Sogi

After watching the ocean for 35 years and intraday market data for half a decade, there is chop everyday, uneven short period surface conditions, different than the long ocean swells or rogue waves we've discussed before. There are many names for the ocean conditions, many types, many causes for the chop: Beaufort Force 1-10, describing calm blue seas to violent hurricanes; Cat paws, small ripples caused by puffs or gusts of wind showing as a black shadow across the surface of the ocean; Squall lines caused by a thunderhead and front coming through strong enough to knock a boat down; Whitecaps, small white spray as the tops of the wave briefly feather in the wind; Ocean breakers, blue water breaking waves in the open sea enough to fill and sink a small vessel; Wind chop, small choppy 2-3 foot waves that splash, Storm seas with 15-30 foot confused breakers in many directions, with breakers; Whirlpools, swirling eddies that can swallow canoes in the Northwest passages near Juneau; Glassy, calm conditions when the blue skin of the sea sparkles like diamonds. These phenomena are caused by wind, currents, undersea formations, continental and island land formations, sun spots, the rotation of the earth, tides, the moon, and environmental effects.

The intra day markets have moods like the ocean, and everyday there is the constant chop. Some days are quiet with slow movement, other days with huge breathtaking drops, or powerful up surges, sometimes lurching up and down, some days flat with violent breaks with the entire days move in half an hour. Many make money working the chop, the constant up down motion of the bars. Some consider the daily up and down mere chop in the weekly and quarterly moves. Eskimos have over 27 names for snow. The Hawaiians, who live and die by the wind, have hundreds of names for different winds as they pass over the water: makani 'olu'olu, the fair wind; Moa'a, the trade wind; makani palua, the daily diurnal wind; hau'oki, the icy wind; Ulu, the rising wind; Ehukai, sea spray, all responsible for ocean effects. Speculators need better names for different market conditions. /George has names for his bond work such as "classic firming" , "forward trajectory assessments", "rate back-up out the curve", "convexity". This might lead to better quantification and better profits or different systems. Newton had to invent the names for mass, velocity and inertia to formulate the laws of physics and quantify them. Accurately naming market conditions and what is generically referred to as 'chop' might help speculators frame their hypotheses better.

Checkers Anyone?

Please Enjoy the Wisdom of the Incomparable Tom Wiswell.  To view His Spectacular list of Proverbs(which has been recently augmented). Click here.

A Daily Run, by Kim Zussman

This morning's trail jog through the hills was an intrepid one snatched during hiatus in recent centennial record southern California rainstorms. My new running shoes ran slower than usual since they were worried about the mud. However, the hills were splendid; ablaze with deep green celebration laced with bubbling brooks by the hundreds. Curiously, the usual areas of mud and mire were quite passable at the behest of numerous firm sandbars which were easy to hop. It seems the heavy rains washed away the finer, lighter clay particles, leaving heavier sand to stand. The volatile deluge taketh and giveth anew in rebirth.

All the creeks tumbling dutifully downhill; off one cliff a roaring waterfall. Gravity will always let you down. And it pulls water along with great energy to strip mountains of aged skin and over millenea creating a new land, eyes cleansed with tears to face the sky.Gravity preoccupied Einstein 100years ago this year as he began his seminal work on relativity and heuristics.

Got to Have Faith, by Nigel Davies

Dr. Zussman asks the great question: "Can faith steady nerves when the going gets rough?"

I suspect it depends on the faith. A belief in divine intervention on your behalf must surely be extremely dangerous, and the faith will (or should) be shattered when the protector fails to appear on cue. But faith in your methodology must surely be a very positive thing, provided of course that the methodology is sound. Personally speaking I find that my wife and son help a lot in dealing with the pain of both chess and trading, mainly by putting things into perspective. Good health matters more than money, and being a good father is more important than winning lots of chess games. But if you don't have other things in your life, losing can be very hard.

Red Fingers, by Kim Zussman

Dad was an artist who was a successful car salesman working for Jim Moran in Chicago in the 1960's. Moran started as a teen mechanic at a service station. Often customers asked if he could sell their cars for them, and over time the inventory grew. He saved enough to buy the station, and as his service/sales business expanded Moran acquired property and eventually developed what became the largest Ford dealer in the US.

Besides initiative and hard work, Mr. Moran's success evolved from innovation in advertising. He was a pioneer in selling cars using the new medium of television. Moran sponsored "Friday Night Fights", a program where cameras cut between rounds to Jim's live descriptions of gleaming beauties driven past spotlights by salesmen. Even before the boxing was over customers lined up at the dealership eager to buy that fancy TV model or even a better substitute.

As a boy I used to watch the fights on the flickering black-and-white rabbit-ear with Dad. We had a tradition of eating pistachios while feinting and dodging, promising Mom not to drop shells on the floor. The old-style nuts were dyed red, as were our fingers once the show was over.

What would I give for just one more of Moran's shows cracking nuts watching with Dad!

How to Use & Interpret Logistic Regression, by Professor Tony Corso

Binary Logistics Regression & Industry Modeling shows how to use logistic regression to properly frame the kinds of questions the Chair and Professor McDonnell are constantly encouraging us to ask: "If this, what are the odds that.. ."

Its examples are industry effects, but extensions to other sorts of questions are obvious.

Makes me want to go and break out some old regression code from 5.25" floppies and my tattered Schaum's Linear Algebra.. .

Dick Sears Weekly Commentary: Another Dreary Week

Humphrey-Hawkins, deconstructed by Roger Arnold and George Zachar


Ron Paul from the 14th district in Texas has made challenging all aspects of the Fed his own crusade. And Greenspan's continuous condescending treatment of him right on television! When that happens you have to ask yourself what the Chairman is thinking. He knows he's TV; he knows that an elected official is questioning him. And he smirks when Ron Paul questions him EVERY TIME! It's like watching a kid stick a hornet's nest with a stick!


Ron Paul and Greenspan are friends "off stage," as are Greenspan and Sarbanes. The Fed may be "corrupt" when measured by a historical yardstick that encompasses the true 19th century gold standard, but now it is best modeled as a semi-independent bureaucracy with the standard attributes of mission creep, survival bias, and organizational/political competition/threat response.


Yes, it is obvious that the interaction between the two of them is not adversarial and that there is a mutual relationship of some kind there. More like watching a theatrical production than a congressional hearing. I was referring more to how the lay-audience perceives that interaction. Greenspan does not seem to appreciate that, or perhaps he is just letting Ron Paul have his fun. But I would think that he would play his part too, by taking the questioning seriously.


A Greenspan appearance on Capitol Hill is a goldmine of material for rhetoricians. The questioners have a very wide range of intelligence, and a veritable checklist of political motives, both local for their specific constituencies, and specific for inside the beltway. In this, they could not be more transparent.

But Greenspan is speaking to the national and financial press (his conduit to the great unwashed), and to the markets themselves. This accounts for the awkward discontinuities in what looks like a Q&A, but are really alternating speeches to different audiences.

These "players" are all frighteningly far removed from the day-to-day lives of the populace. I do worry about the momentum Washington has in eroding our freedoms. Vic's eloquent posts on medicine and regulation are the classic example.

Sector Rotation, by Professor Mark McNabb

Interesting how S&P 500 subsectors flip from the top 10% of returns in the market to the bottom 10% in a short period of time:

Top Dozen Subsectors
2002                   2003                   2004

Bottom Dozen Subsectors 
2002                   2003                   2004

Charles Pennington responds:

By my count:
1 of 2002's top dozen is in 2003's bottom dozen
3 of 2002's bottom dozen are in 2003's top dozen
2 of 2002's top dozen are in 2003's top dozen
1 of 2002's bottom dozen are in 2003's bottom dozen

It looks pretty random to me. What am I missing?

"As Predicted," Certain Companies Involved in the FDA Hearings Showed Rises of 6-10% After All the Bad News Was Out

This brings to mind the following observation of Mr. Cutten:

With stocks driving higher during the last few months following each downward reaction, the situation was ready made for Livermore. The Street stories are that he went short of a large line of issues such as:– United States Steel, Montgomery Ward, Simmons Co., General Electric, American and Foreign Power and half a dozen other of the markets pivotal issues. He then started his familiar hammering tactics under which the market first faltered, then broke

Cutten, the Fishers, Durant and others of the group known in Wall Street as the “Big Ten” were large holders of these particular stocks and have seen their plans and pools wrecked by what were natural economic developments, coupled with much shrewd short selling.

One of the tales started and circulated in the financial district yesterday, was that Livermore had the backing in a bear campaign of Walter P. Chrysler, who was said to be piqued because he suspected that the Chicago-Detroit group had hammered at Chrysler motors in the market, driving it down below 55 from its high of 135 this year.

The outstanding Bear leader appears to be Livermore, who has regained a tremendous fortune through adroit short selling, and who, temporarily at least, is regarded as being exactly “right” on this market. Cutten, who started as a grain trader, has amassed an estimated 100 million or more, in the stock market during the last three years of bull markets. Cutten is the leader of the bull faction and is temporarily at least regarded as “wrong” on the market.

Mr. Cutten was in New York and watched the market from the office of the head of the stock exchange. His expressed opinion to friends is that much of the selling had been hysterical, and that he believes good stocks should be held for higher prices. He has not changed his formerly stated position about the long distance outlook.

Source: New York Times, quoted by Stock Market Solutions

It also brings to mind the following quote from the 1874 "Bulls and Bears of New York", by Matthew Hale Smith:

p 69: "Milking the street". This is a combination to put the price on the Street down so that parties may buy. The stock is then Bulled by the holders who instantly sell out. ... In the excitement the combination reap a golden harvest. They have milked the street"

Alex Castaldo offers:

Nathan [Rothschild], knowing that information is power, stationed his trusted agent named Rothworth near the battle field.As soon as the battle was over Rothworth quickly returned to London, delivering the news [of Napoleon's defeat] to Rothschild 24 hours ahead of Wellington's courier. A victory by Napoleon would have devastated Britain's financial system. Nathan stationed himself in his usual place next to an ancient pillar in the stock market. This powerful man was not without observers as he hung his head, and began openly to sell huge numbers of British Government Bonds. Reading this to mean that Napoleon must have won, everyone started to sell their British Bonds as well. The bottom fell out of the market until you couldn't hardly give them away. Meanwhile Rothschild began to secretly buy up all the hugely devalued bonds at a fraction of what they were worth a few hours before.

Hedge Fund Vigs, by Tom Downing and Victor Niederhoffer

In order to determine the extent to which fund of funds (FOFs) further add to fees charged by hedge funds, we carried out the following experiment: Given the number of hedge funds that an FOF buys and the correlation structure of the funds within the FOF, what is the corresponding expected return and volatility? The results are below:

Simulated Annual Fund of Fund Returns:

Correlation Structure
2 Funds-0.19%-0.2%-0.23%-0.25%-4.51%
4 Funds-0.26%0%0.05%-0.31%-4.6%
8 Funds-0.2%0.02%0%-0.04%-4.54%
20 Funds-0.17%0.05%0.11%-0.05%-4.45%

Simulated Annual Fund of Fund Volatility:

2 Funds10.82%6.22%8.86%12.21%9.16%
4 Funds9.83%4.37%6.23%12.49%6.61%
8 Funds9.45%3.07%4.36%12.45%4.71%
20 Funds9.04%1.95%2.72%12.36%3.02%

Expected Return: 5 percent
Expected Volatility: 15 percent
(except in case of 'Mixture', where Expected Return is 0)
Fee Structure:
Each Hedge Fund charges 2% mgmt/20% perf
FOF takes 1% mgmt + 10% of net

Correlation Structures:
POS: All hedge funds have expected correlation of .5 with the other hedge funds in the FOF.
NEG: Separate funds into two groups (A and B); funds in A are correlated .5 with each other but correlated -0.5 with each in B and vice versa.
ZERO: All funds have expected correlation of 0.
PERFECT: All funds nearly perfectly correlated.
MIXTURE: Half of the funds have expected return of 10 percent and the other half have expected return of -10 percent, and all are ucorrelated.

A Philosophical Question, by Philip J. McDonnell

Much of my research has recently focused on developing methods to predict shorter term market moves on the order of one to 10 days. In reviewing the results a curious pattern emerged. The variables with the highest correlations with the market seemed to show weaker results when tested as trading systems. By contrast variables with near zero correlations often showed dramatic results when used as threshold variables.

A threshold variable would be something like:

If the S&P yesterday was up more than 1% use the actual value otherwise use zero (ignore the data)

In this case the threshold value would be +1%. One way to view this oddity is that the high correlations indicate a strong linear relationships. The threshold variables may indicate a non-linear relationship or possibly one which only comes into play when a threshold is surpassed.

One theory as to why this may be happening is that the rise of all the statarb shops has milked out most of the excess profits from simple linear correlations. Corresponding to this is that linear relationships are the easiest to understand and identify because the statistics are universally available. By contrast the threshold variable methodology may be little used and certainly requires a bit more thought as well as deciding on or "fitting" a threshold value.

Another theory is that the market is fundamentally non-linear. If so, attempts to predict its behavior with linear models and techniques will at best prove weak. This may explain why the market appears so random to its linear thinking human participants. To the extent this theory applies then the most fertile ground to hoe will be in the area of non-linear models.

Nullius in Verba, by James Sogi

As the Temple of TA comes tumbling down at Smith Barney and the high priestess is banished, what better time to look at the history of the speculative sciences. Nullius in Verba, was the 17th century Royal Society of London 's motto, Don't take anyone's word for it. The society had such distinguished members as Newton, Bacon, Hook, Halley who celebrated the scientific method, sought to deflate ballyhoo, and rejected appeals to authority. They lived in a time when the European languages lacked words or concepts for some of the concepts they were developing. Descartes suspected mechanical demonstrations of hyperbolic and elliptical functions such as sails, or the line traced by a pencil in a circle as it rolled, or the ellipses drawn by a string on two foci. He lacked the conceptual framework and the mathematical concepts to grasp what was before his eyes. Their math did not allow use of the infinitely small. Science in the early 17th century lacked the language or the mental framework to understand the heavenly phenomena before their eyes nightly as their concept of velocity was just beginning with a knot line tossed over board a sailing ship.

We see many obvious things in the market each day, but struggle to make workable hypotheses and tests to advance the speculative sciences. Do we possess sufficient concepts to understand the market? It took over 1000 years to deflate Aristotelian ballyhoo. We still cannot explain what gravity is. Are speculators like ancient mariners believing the world is flat? Are we missing obvious explanations of market machinations for lack of an adequate conceptual framework. The work here is an advance and will carry forward. The answers need not be exact as rocket science, for even Newton only sought to calculate "pretty nearly". Time is the father of truth. The testing of market hypotheses will continue. The results will remain suspect until disproved according to the scientific method.

Victor Niederhoffer: An Interesting Hypothesis...

appears in a recent Merrill Lynch report titled "The Economics of Volatility". Their main point is that volatility is the price that investors demand for providing insurance, i.e. risk capital to the market. They go through some charting mysticism to predict that an increase in short term yields leads by 2 years an increase in volatility. Since short term interest rates rose one percent from June 2004, they predict a spike in volatility in the near future and recommend buying long term volatility now a la the expert, albeit his recommendation is for all times and if he's wrong he tends to put the blame on the demand schedules of his clients. But that's not the point. The authors state "when risk capital withdraws, riskier investments tend to be liquidated first. Emerging markets generally slot in that category quite well". Thus they predict that shortly Asian equities will fall and that volatility in Asian markets will rise. Of course, this is untested. But like everything else it deserves to be tested. I hypothesize that Asian equity markets lead US equity markets and that turning points in the former occur earlier than the latter. It's a good and useful thing to test and I might recommend the Henry George type of analysis that we used to test similar relations between real estate prices and equities in Practical Speculation as a related phenomenon and template.

Dr. Alex Castaldo Responds:

Aussitot dit, aussitot fait.

Using quarterly data from 1997 through 2004. The correlation between the % change in MSCI Emerging Markets Index Free and the subsequent quarter's % change in the S&P is -0.075 with 31 observations. This seems to be statistically indistingushable from zero.

The correlation coefficient multiplied by the number of observations is 2.3, which is less than the threshold of 10 that Henry George would consider "useful".


Kim Zussman Responds:

A former physics professor who manages money uses what he described as mathematical models of the stock market. With a book of charts he quizzed me on spotting repeating patterns among individual names and sectors, with the desired revelation that there are wave patterns in channels which are predictable.

Instead I noticed that stocks making waves waved up over longer periods. I did not have time to tell him that this is how markets work and why they go up (who would take this from a periodontist anyway): Volatility is risk, and the pain of volatility shakes out the weak to feed the strong (or patriotic). One is compensated for enduring this, and it can be profitable only since not everyone can endure it. If no one felt pain there would be very little buying (in hope) and selling (in fear).

Puts act as insurance against disaster, albeit at a cost too dear. Historically volatility mean reverts after spikes in profitable ways while low volatility doesn't. Yet how gratifying it was to have such protection at 2005 inception; and so too must it have been in '87, '97, and 9/11.

Recalls the patients who ask for Vicodin by name. This highly-abused narcotic is a favorite of the pain-intolerant. What price will you pay for pain reduction (it reduces physical as well as other pain)? Labeling? Addiction? Constipation?

Perhaps puts are too expensive because most are too weak. The strong sell this narcotic at a steep price yet sleep well even with 1000 airliners aloft every night.

Is this what Ayn was saying?

Bruno adds:

Liquidity Black Holes, edited by A. Persaud, deals with this concept, among other things. They make the interesting point that the prevalence of VaR for institutional risk-management could lead to herding behavior. That's when similar risks models all indicate more or less simultaneously that some positions should be liquidated. VaR people will liquidate riskier investments first because that the easiest way to get back within their risk limits.

There are actually a couple chapters in the book that test for herding behavior (looking for Granger-causality). They find evidence of this type of behavior, but don't show that it is linked to the widespread use of similar risk models. There are other explanations. VaR-induced liquidity black-holes, starting in the most volatile markets or instruments, look more like a scenario for possible future crises than the reason for past ones.

Another Reason to Distrust Finance Academia, by Ross Miller

I was in the process of preparing my first derivatives exam for my poor, unfortunate accounting graduate students, when it hit me that something was really screwed up with standard textbook treatment of options. I am used to finding little errors and inconsistencies of every variety left and right, but this is a more serious one that affects every treatment of options that I have ever seen. To Continue:

The Inefficient Stock Market by Robert Haugen, reviewed by Philip J. McDonnell

I must confess to a certain affinity for outspoken rebels. Robert Haugen, the author of The Inefficient Stock Market, is an academic rebel who is willing to confront the established aristocracy of academic finance. For that reason and more I enjoyed reading his book and can recommend it with a few reservations.

Haugen is a Professor of Finance at the University of California, Irvine. He is the author of several books and papers and is probably most famous for his popularized work on the January effect.

Key points of the book include:

1. The book takes issue with the standard business school beta model, where beta is used as a measure of non-diversifiable risk. Empirical evidence is presented that the return to highest deciles for beta are uniformly below the returns to the lowest beta deciles. Additionally the beta based decile rankings are substantially in the reverse order which is predicted by theory. Hence the market does not reward increased non-diversifiable risk contrary to the last 35 years of business school teaching.

2. The author takes issue with the factor models of the 1990's. In particular the Fama-French (FF) (3 or 4 factor) model is disputed. In substitute he offers a 51 factor (!) model in which he shows that the variables used in the FF model are quite weak when other correlated variables are explicitly broken out. For example the book value factor used in FF becomes weak when explicit earnings variables are used because book value is essentially an accumulation of earnings over time.

3. The major model presented in the book attempts to predict the future returns of 3000 stocks and thus, is of fundamental interest to investors. The model shows a substantial 42% annual return differential between the best decile and the worst decile over a period of more than a decade.

4. The most important factors were: 1 month excess return -.72% 12 month excess return .52 Trading volume/Market cap -.20 (2) month excess return -.11 Earnings to price .26 Return on equity .13 Book to price .39 Trading volume trend -.09 6 month excess return .19 Cash flow to price .26

No risk factors such as beta or historical volatility made the top factor list. Four price change, four value and two liquidity variables made the top list. All 51 variables were included in the regression.

5. Mean reversion in the one and two month time frame is reported, which is attributed to correction of "market error". Serial correlation in the intermediate 6 month to 2 year time frame was found which was explained as corporate exploitation of competitive advantage. Mean reversion was again found in the 2 to 5 year time frame. The book explained this as the time frame for competitors to react to any temporary competitive advantage. Furthermore the assertion is made that the markets routinely overestimate the length of time for which a competitive advantage will be sustained.

6. The author considers and effectively refutes most of the usual biases and flaws in such historical studies. Included in the list are survival bias (manually addressed), look ahead bias (3 month post publication delay and use of actual data files after 1987), data mining (the 51 variable model was the first one they tried) , counterfeiting (real time test with real money by a Norwegian fund). The author pleads guilty to data snooping which is the practice of reading other people's published reports and papers and then using variables which they found successful.

7. One of the amazing findings of this model is that the best performing deciles routinely had lower risk as measured by beta and variance. The worst performing deciles had the highest risk flying in the face of accepted CAPM theory.

My reservations include the following:

1. The model uses 51 variables fitted with ordinary least squares (OLS) regression. Because of the endemic cross correlations between financial variables I am very dubious of the quality of the confidence estimates of the individual regression coefficients. Given the more than 2500 possible cross correlations it is certain that the 99% confidence levels claimed by the author are specious. However I do find the overall results quite convincing simply because the deciles nicely line up in their expected rank order.

2. The study used Compustat data which is notoriously flawed for the purposes of historical testing including issues such as retroactive adjustments etc. After 1987 the author saved the original data releases and used only data available at the time with an appropriate lag. Although I don't trust the results before 1987, they appear to be in good agreement with the results after 1987 which are more trustworthy.

3. The book was published in 1999 and the factors must be updated before being used.

I especially enjoyed the author's irreverent tone, which is quite unbecoming one who professes in finance. He refers to the established big names in finance as the College of Cardinals and defenders of the Holy Temple of the Random Walk. His model is part of what he has termed The New Finance, which he admits is ad hoc and has little or no theory to support it, but does offer much better predictions with respect to future returns. His style makes for an easy read and motivates one to go out and seek his Super Stocks and avoid the Stupid Stocks.

Keeping Count of Your Counterpart's Count, by Leonard Kreicas

Thorp's idea of betting with odds that are "rich" is intriguing for counters. In the game of Hearts, for example, by knowing how rich in suits the opposing player is, the player knows that certain suits will come out. This analogy might be fruitful in the market when the counterpart is "rich" in a holding he will eventually have to dump or cover.

Bond Grey-Beard humor, from George Zachar

Q: What is the most frightening phrase on Wall Street?

A: There's a problem on the mortgage desk.

Sunspot Cycles, by James Sogi

Climate change may have destroyed fisheries. The Aleutian low pressure system is the dominant meteorological winter feature in the North Pacific and helps stir up ocean water, bringing nutrients to the surface. (and brings 50 foot waves to Hawaii) This climatic phenomenon is called the Pacific decadal oscillation because a review of past climatic data shows that the low pressure system seems to shift with near decadal periodicity. The fairly regular oscillation may be a response to an 11 year solar cycle of sunspots. The eruption of solar flares with a near decadal frequency increases the heavy solar particles(atoms), which take approximately 6 months to reach our atmosphere. Solar particles reacting with the upper atmosphere may lead to higher atmospheric pressures, which may intensify and displace the Aleutian low pressure system to the east. recent oceanographic research has shown that Pacific decadal oscillation is part of a greater cycle defined as near century oscillation on the order of 70-100 years. From Islands of Refuge, Rauzon. (about the northwest Hawaiian Islands.)

The waters are so wild up there, my fisherman friend tells me, that humans cannot go in the water. Schools of 50 or more 100 pound Ulua (trevally) attack divers. A friend tells of schools of ulua hitting the flashing spinning props of dual 200 horsepower outboards running at full speed causing the outboards to jump in their mounting. Seals and sea birds cover the shores. It is dangerous to put your hand into the water.

Reflections, by Victor Niederhoffer

The hearings on pain killers at FDA will be held during the next three days. And it will be good to study the kinds of statistical errors that are made in weighing the results of one study with a percentage of heart attacks that varies about 1% a year from expectation with the base figures as this will enable one to see better the kind of randomness that fools the mystics in our field. Of course, with us, it’s just money.

Every now and then a number of forces come together that crystallize the million wrong things that emanate from the idea that a human does not have the right to his own life. Such is the case with the tests, propaganda and hearings associated with the well publicized side effects of the pain killers. The main thing that's wrong with such hearings is that every patient should have the right to decide for himself whether he should be taking the drug after assessing the benefits and costs. The related main problem is that there is a total emphasis in the controversy about whether there is an increased risk of heart attacks and strokes without regard to the benefits involved in pain reduction and cancer prevention.

It turns out that the risk of heart attack in the most frequently cited studies by the "take it off the market group" goes up from 1% or 2% a year to 2% or 3% a year for people in the 50 year old bracket. That's what they're referring to when they talk about the doubling of rates. But compare that to the approximately 100% reduction in pain the drugs cause and the approximately 50% reduction in polyps that the drugs cause, with many estimates of about an 80-90% conversion of polyps to cancer.

But that's just the first of the problems. The whole subject is junk science at its worst. The drugs themselves have been used for hundreds of millions of patient-years. And they have been tested for efficacy and safety in double blind studies in hundreds of studies. They have numerous spillover benefits in all sorts of off-label uses. And indeed at the time they were pulled hundreds of studies were going on as to their efficacy for such things as prostate, breast and colon cancer, and stroke. Of course, one of these studies with a hundred patients or a thousand patients is going to show a increased rate of disease of 1% a year. That's guaranteed to happen with randomness. As a benchmark, consider that the variability of a proportion is of the order of 2% with a study of 100 patients.

Regrettably the problem runs into the tort system. Lawyers using junk science have an industry in suing companies whose products have side effects. In a typical such study, the patients get 100 bucks each and the lawyers get 50 million. But politicians benefit because the tort lawyers are one of their biggest contributors. While the litany of abuses runs deeper and deeper, all stemming from the idea that people are incompetent to make choice, the drug companies, or big pharma as they're known in the industry, should not be absolved. The outcome of all such hearings is to preclude competition, reduce their permitted level of expenses, and make it harder for other companies to bring out competitive drugs. Think of the tobacco settlement as an example here, with restriction on entry into the industry by companies that didn’t participate in the settlement. Multiply such witch hunts by 1000 fold, and think of all the molecules that don’t get invented, and all the patients that don’t get treated, and the delays and restrictions in the drugs that do go through the pipeline, and you can readily estimate that the average life span of all of us would be increased enormously, say five years, within five years of the abolition of the organization that likes to think of itself as a proper noun, with benevolent influence, FDA.

George Zachar adds:

1) Amen.

2) I actually read the public treatise Hillary used to promote nationalizing healthcare a decade ago, and the only possible conclusion one could draw was "they're trying to kill me". She even advocated racial quotas for training/hiring in each medical sub-specialty!

3) A simple way to project the logical outcome of current trends in government/legal medical meddling is to visualize health care a few decades hence as the auto manufacturing business looks today: A creative dead zone where zombie firms crank out fill-in-the-blanks products, with engineers in thrall to regulators and lawsuit generators.

4) I am pessimistic about slowing the "big trend" toward stifling innovation and freedom in health care. It is far too easy for rent-seekers to rig the information, legislative, regulatory and legal dimensions.

5) Innovation and freedom is likely to manifest at the margins of US society, in off-shore facilities (India's booming surgery tourism for example), and in smuggled pharmaceuticals produced outside the increasingly suffocating American regulatory framework.

6) I expect to see a black market in medicinal pharmaceuticals develop in parallel to the existing one in recreationals.

Victor Niederhoffer rejoins:

The omniscient libertarian bond trader George Zachar has developed the meta frame "your own man" to help understand the multitude of occasions liberals try to spin pro agrarian reform measures. I pointed out that Alan Dershowitz noted the same phenomenon at Harvard where he was unwittingly put on committees that were going to come up with anti-Semitic choices for important faculty and admin posts at Harvard so they could say "hey, your own man was head of the committee."

Such would seem to be going on with FDA hearings on pain killers today where Curt Furberg is on the committee. He is the proud author of the paper that showed that Bextra tripled heart attack and stroke risk in heart bypass patients. Recall that that study raised the risk to about 3% a year from 1% versus placebo, which had less than 0.5% a year risk versus the population of 50's which seems to have about 3% risk. Furberg's hobby horse is "many studies compare Cox 2 Inhibitor with other NSAID's instead of a placebo."

There are so many things wrong with the statistics of the placebo study that Furberg did, as well as the reasonable idea that people who are in pain wish some relief so a placebo shouldn’t be given, and there is a balance between pain relief and heart attack relief, that one almost wouldn’t dignify the professor's hobby horse. But he's on the committee. Why? He's obviously biased and should recuse himself. Is it a case of   "your own man" or is FDA truly a witch hunt forum where the lead member of the southern contingent on the committee shows where they want to go?

I vote for Zachar's "your own man."

Michael Stallings adds:

"Universal Health-Care", as Hillary sees it, is not DOA, but on life-support, to be revived when she's elected President. The Dems couldn't get it through on her husband's watch, as she was his wife and not the leader. But heads-up if she's elected to the big job.

Dr. David Brooks writes:

So it strikes me there are basically two issues:

1. Should pharmaceuticals be allowed to pitch their meds to the public through the same mechanism as Coca-Cola and Walmart, and

2. Are the Cox-2 meds better than standard aspirin or NSAIDs at the appropriate dose in preventing polyps/cancer?

I believe the answer is "no" for the first (and this goes for erectile dysfunction meds, cigarettes, statins, etc) because I do not believe that the public has the sophistication to parse through the various claims of pharma. You, Vic, review the studies to determine their efficacy; 99% of the others believe that anything they see on TV must be right or it wouldn't be there.

As for #2, if they are better (and so far as I know there are no studies comparing the two head-to-head) then let's use them. If not, they should be reserved only for people with a bleeding diathesis.

Pam van Giessen says:

With all due respect to the good doctor, I disagree with his answer to #1. Doctors are the barrier in place to protect the completely idiotic through which we all have to pass to get a prescription for just about everything. I also disagree that 99% of the folk believe all marketing that comes at them (which is pretty much an insult to the hoi polloi but a typical attitude among health care professionals).

What is so bad about people hearing the marketing for drugs that might give them relief from whatever ails them, and then engaging their physicians in discussion about that drug? That's not the same as "believing." It's about learning about a product for which they may have use, and then turning to the gate keeper of that product to find out if it is right for them. Good gatekeepers will explain the pros and cons to their patient/clients who will then take the guidance from their trusted medic. And even if we break down the doctor/prescription-giver barrier, the market will quickly take care of bad companies promoting bad products. Companies with products that may help us shouldn't be constrained from promoting their goods to us just because the product may not be right for everyone, or even if their product is a lemon. In today's hyper-connected world, no company will be allowed to get away with selling lemons for very long before the news gets out to millions, and it would be easy enough to put penalties in place that would make releasing bad drugs not worth the short term gains (though the market penalty will be harshest). Personally, I would never take a drug without discussing with my doctor but I've been well indoctrinated. Doctors, in the form of the AMA for instance, could easily do outreach campaigns promoting the value of having one's doctor review drugs before ingesting.

Unfortunately there is an attitude among many health care providers that they should be the conduit through which all (or any) information passes to the masses (or maybe it's the same bunker mentality every profession under fire feels), and it can be very frustrating for patients and their families. You would think that a daughter of both a nurse and a doctor would not have doctors playing these games with them, but I've personally experienced it twice, the first time being devastating for my family. Pain being a great teacher, I learned a valuable lesson about taking responsibility, doing research, then following up with the doctors to ask intelligent questions. People should engage in their and their family's health care, with their providers, and if that comes about by drug company marketing, so be it. Doctors should rejoice in even modestly informed, engaged patients.

We have created a weird health care system in this country where doctors and patients are at great distance from each other (instead of neighbors or long-time family caregivers as they once were, and with 3rd party payments further separating them), and so patients act like dogs at the vet, dumb and almost afraid, or blathering idiotically. And then there is the ever pleasant exam situation whereby the annual (if that) conversation between patient and doctor is usually had while patient is stripped, on an uncomfortable table, covered by a napkin, with cold instruments or fingers in uncomfortable places. When asked by the medic (who one sees but once a year) and whose fingers are poking and prodding in places usually reserved for no one or intimate partners only "and how are you feeling? Any problems?" most of us do sound a little stupid in the ensuing conversation (likely because our brains are saying "I'll be fine once you remove your fingers from my x').

Further, the economic incentives for doctors have changed so much that they are overburdened and hardly have time to ask "how do you do?" during regular exams, and likely resent discussion about some drug they heard about on TV. My father often saw that his patients were not very forthcoming during exams, but at the school picnic and other events, they would disclose, and he would learn more about their problems, and could effectively treat them because he was engaged in discussion with them when they felt comfortable. He lived among them. Not so any more. You get your 15 or 20 minutes and that is that. I think my vet spends more time with my dogs than my doctor does with me. But then again I am paying my vet cash money, at rates he sets, and not dictated by insurance, and if I don't like his rates or his demeanor or his treatment, I can go elsewhere easily -- not so when one and one's employer combined pays thousands of dollars for insurance every year and choices are limited. I also have the power to get just about any drug my vet may prescribe from mail order sources (and often no prescription is needed). I even have the power to give my dogs their annual distemper shots (which I have done). My dogs have not suffered because I took their health care into my hands. Not even when I used the (medical) staple gun on my pointer when he slashed his leg.

Direct marketing to consumers by drug companies, and doctors promoting the value of consumers *paying* doctors for a professional vet of their drug choices could be beneficial to everyone and the entire system if it gets people to take more responsibility, and brings about a more competitive marketplace whereby the value of health care professionals outside the insurance system is increased -- in which case everyone benefits.

The Good Dr. Brooks answers:

In general, I agree with the vast amount of what she says. And I would be the first to acknowledge that there is a considerable amount of paternalism in the medical world. That said, I for one, do not have the sophistication to prescribe, for instance, a specific statin, a specific ACE inhibitor or a specific beta-blocker and can't imagine why I should leave the decision of whether I need that medicine to the marketing department of Pfizer or some such company. And yes in an ideal world, the physician could be a gatekeeper and discuss these issues with the patient, but if you have ever tried to tell a patient why you believed that he/she didn't need a medication or procedure you will know that that is a fool's mission. It's easier to acquiesce.

Furthermore, as any MD reader of NEJM knows, preliminary results are often just that and need to be viewed with a skeptical eye. We talk over and over again about evidence based medicine when in fact we often accept received wisdom as the coin of the realm. Since I do not believe that I (with a small degree of medical sophistication) can interpret many of the new studies that are published each year, I fear for patients who are easily swayed by marketing. Look at the Fen-Phen diet drug.

It's instructive to look back at the situation in the latter half of the 19th century when patent medicines were routinely available and sold to the unwitting without any oversight. A generation of hucksterism and a class of scoundrels preached the wonders of these drugs across the West. Furthermore, as a surgeon who deals regularly with cancer I can assure you that the number of people "out there" touting unproven cancer cures is horrifying. People with advanced cancer will do almost anything if they think there is even the slightest chance of cure. Coffee enemas, shark's fin, eye of newt. While there is much arrogance in modern American medicine, we do at least make a supreme effort to subject our medicines (if not our surgeries!) to rigorous controlled trials. I would refer you to my colleague Jerry Avorn's book Powerful Medicines: The Benefits, Risks, and Costs of Prescription Drugs as well as the one written by Marcia Angell, The Truth About the Drug Companies: How They Deceive Us, and What to Do About It, portions of which deal with just these issues. (Though Vic would enjoy Malcolm Gladwell's slamming of the Angell book in his New Yorker review)

All good issues to debate, and perhaps there is a good common ground, but having the fox watch over the well-being of the chickens may not be the best.

Victor Niederhoffer responds:

There are biological theories that underlie and illumine the efficacy of various treatments and molecules, there are economic principles that play a similar role in the issues you raise about leaving the fox to judge. The main economic principles are what are called internal and external controls on a business, the importance of reputation, and the power of competition. Perhaps it's easiest for you to place this debate in the context of sail boat racing or tennis play, something your family is knowledgeable about.

People like you and me are quite exert on various things. Others seek us out. Certifying agencies and consumer reports and advertising come into play. Competition from the external world talks about the virtues of their own product and the defects of bad products. People evaluate this and generally, like Unlucky Jim, are able to do a much better job in doing this then the altruistic bureaucrats who don’t have specialized knowledge.

That's the external controls. The internal controls are the fiduciary responsibilities of the companies and their directors, and the incentive they have to deliver a good product to the customer so they can maximize shareholder value. You see how these things operate in fields like tennis and racing where the competitive element keeps improving the product and the quality of the results. David, the same thing has been at work in the computer industry where people know as little as they do about the body and sailing.

Nay, this process writ large over many years is what gives us our incredible standard of living, our personal freedom, and yes, our increased life span. I don’t expect to convince you with all these arguments but there are principles behind all these. And the books of Mises, Hayek, and Milton Friedman cover the principles involved, and almost all the current generation of economics teachers and text books cover them the same way the modern biology books cover the " new knowledge " and principles from DNA.

Art Cooper adds:

I'm sure you'll be interested in the Op-Ed piece 'Unlucky Jim' on p A14 of today's WSJ. The author, physician Robert Oldham, describes how his patient (Jim, who died Monday) was unable to obtain promising new drugs to treat his kidney cancer because of FDA regulations:

"Jim remained protected -- unto death -- from the potential toxic effects of these drugs....Jim was like thousands of cancer patients each year who want access to new drugs. But by restricting access, we elevate OUR caution above THEIR lives."

Dr. Oldham's parting: "Goodbye Jim -- you fought the good fight. I only wish I could have given you more weapons for your struggle."

Dr. Brooks's response to Mr. Cooper

This is a slightly different issue - and I can see the argument on both sides: effiacy vs safety. Don't know what's right though I think when it's immediate life or death we should err on releasing too soon. Sort of the way I felt when I used to do trauma and felt that there was virtually no way I could make the patient worse.

On the other subject, another example of how the public misreads medical info is what has happened to childhood vaccines. Because of a few well-publicized deaths, the number of children receiving vaccinations has dropped off despite the overwhelming evidence that the lives saved way outweighs those lost, by orders of magnitude.

Dan Grossman offers:

While agreeing with Vic's analysis, we need a proposed solution with some chance of being adopted. If our only solution is total abolition of FDA control of drug approval and marketing, all of us will be long dead and buried before that happens. Perhaps the following type of proposal has a chance:

Two categories of prescriptions drugs would be permitted. The first would be drugs as we have now, approved by the FDA after hundreds of millions of dollars and many years of testing in accordance with FDA requirements


What procedures would be required of drugs in this second, non-FDA-approved category? Perhaps testing in accordance with guidelines issued by some private testing association, along the lines of Underwriters Laboratory for electrical devices. Perhaps approval of the drug by a foreign FDA in a scientifically-advanced country, such as Japan, Canada or any of the countries of Western Europe. Perhaps just disclosure by the drug company of the testing the drug has undergone, provided the company has a required level of net worth (so it can be sued if it's disclosure is not accurate) and perhaps a required number of years of experience in drug testing and development.

Addendum: Back 30 or so year ago, Japan was not considered creative enough to do drug research, but they duplicated American big pharma quite well and many of the leading drugs sold by Merck, Pfizer and Squibb were invented in Japan. it was the US drug approval and marketing process that kept the Japanese pharmaceutical companies from becoming big in the US like their electronics companies.

Firm Behavior and Industry Evolution, by Alex Castaldo

"The Impact of Financial Markets on Firm Behavior and Industry Evolution" PhD Dissertation by C.J.Kock, 2003, University of Pennsylvania

(1) A rise in a firm's stock price allows the firm to raise money and invest more ("equity enabling effect") (2) A rise in the firm's stock price tells the firm that what it is doing is good, and that it should keep doing it ("direct alerting effect") (3) A rise in the stock price of OTHER FIRMS tells our firm that it should consider imitating the other firms ("indirect alerting effect")

The author claims to be the first to study (3), while (1) and (2) have been looked at before.

Generally speaking firms have two choices when they seek to expand their activities: "exploitation" means expanding in existing products and markets, while "exploration" refers to the more adventurous choice of trying new products or markets. The author theorizes that when the firm's own price goes up (direct alerting) it will prefer to do more "exploitation" than "exploration", and vice-versa when the prices of firms in a different area of business go up our firm is encouraged to overcome its inertia and "explore" a new approach to doing business.

Furthermore large firms have more "inertia" to overcome than small firms and firms where executive compensation emphasizes stock or options are likely to be more sensitive to stock price effects. That's the theory.

In Chapter 2 the author tells the story of the retail brokerage industry as an illustration of these effects. In the 1970's retail brokerage was dominated by large firms (ML, etc.) that offered full service. Gradually (1980's) "discount brokerage" firms such as Fidelity and Schwab developed, that offered lower prices but no trading advice. The large firms did not adopt the discount approach, since it would have threatened their existing way of doing business. In the 90's another change took place: the development of "online brokers". The stock prices of E*TRADE et al soared and this caught the attention of the discount and full-line firms. This time the change spread quickly throughout the industry, with most firms adopting the online approach. This illustrates a powerful "indirect alerting effect" of stock prices.

Since one anecdote is not enough, in Chapter 3 the author does an empirical study using regression. It is difficult to know whether a particular firm is using an "exploration" or "exploitation" strategy, so the author has to use proxy variables that hopefully are correlated with such things. For example the author thinks that an "exploitation" firm would increase advertising spending while a firm pursuing "exploration" would increase capital spending. So ad spending and capital spending are thrown into the regression, together with a number of other variables. It is all a bit artificial and unrealistic, but not uncommon in testing these academic models. The author concludes that his model is supported by the data, although there are some surprises, such as the difference between small and large firms is not as expected.

In Chapter 4 the author builds a simulation model on Cournot duopoly lines, to see how two firms would behave if they followed the theory the author developed. At his point you are probably losing interest , as I did also. After a fairly lengthy and convoluted discussion of the simulation results, the thesis concludes.

It is all presented as an academic exercise, but as readers we can ask ourselves about the investment implications. Are there any, as far as you can see?

Best to Start on Right Foot, by Nigel Davies

One of the most difficult areas for an improving player to address is how to correct errors in thinking, long standing beliefs about how chess should be played that have become ingrained. This difficulty is particularly noticeable amongst players who grew up in a relatively weak chess environment and then tried to improve later in life. Despite all efforts to 'do the same thing, only better' they find themselves continually frustrated.

In order to make serious progress a paradigm shift is usually needed, but how does one achieve that? From my own experience I know it is very difficult, and even today I don't consider myself 'cured'. From the days when I occupied only 3 ranks and had a fianchettoed king's bishop (Modern Defense and King's Indian Attack era) I 'progressed' to taking more space, though still with a fianchettoed bishop on g2 or g7. The biggest problem was when I started to exchange my darling bishop early on with the Nimzo-Indian, but perhaps it was through this I made the greatest progress. Little by little anyone can make progress (my advice often varies according to where they are), though the extent to which they can move their game depends largely on time, dedication and the willingness to acknowledge that there is a problem to begin with. Of course it's much better to start out on the right foot in the first place, but in the West very few of us have this luxury.

In "Close Range" of the Mistress, by Victor Niederhoffer

Stem-and-leaf of the S&P range, 6/10/04 to present:




Yesterdays' low to high range of 3.8 from 1204.1 to 1207.9 in the S&P appears to be a minimum for all non-holiday trading days since 6/10/04, and this has much significance for the market ecology, especially after a similar observation last week. And again, as mentioned, such an observation makes me seem much more sapient than I am.

George Zachar Responds:

Trading sessions prior to what are anticipated to be major Greenspan presentations, pivotal FOMC meetings, or unusually critical economic releases are often lethargic, at least in debt land.

Tomorrow is the Fed Chair's penultimate monetary policy presentation to Congress, and the research channels are stuffed with buzzbuzz about what he may or may not say.

In the interest rate universe, the bets have all been laid, and though the parimutuel windows remain open, it's just clock watching until Greenspan's testimony transcript is released Wednesday morning.

Intuitively, the narrow ranges in capital market assets reflect this dynamic.

Are they predictive of volatility ahead? Given the uncertainty about how Greenspan will characterize both the economy and the likely trajectory of Fed interest rate policy, a volatile session Wednesday was already expected. The counter-trend UPtick in debt implieds makes that clear.

Perhaps a study examining both ranges and implieds will reveal something the Mistress would rather keep to herself.

The Fountainhead, by Laurence Glazier

The Fountainhead by Ayn Rand was recommended to me many years ago by an engineering colleague. Wherever you are, Tamir Ilan, I am eternally grateful. Her book gave me the confidence to go into business, and to reject the avant garde in art and music. And of course her philosophy makes clear the nobility and morality of trading.

Philosophically, A = A is fine, though not all of reality is measurable with the instruments of science. I work in music from the assumption that the emotional effect of harmony is an empirical truth, but who can measure harmony? Creating a predictable emotional effect with harmony is as much engineering as building a bridge. I think Rand found it harder to deal with art than science and logic.

This may or may not be relevant to trading, but I found the use of phi-bonacci to structure music a very useful tool, though when I tried using Elliott the music got into a tangled mess.

Check out "Ayn Rand" in Special Collections Section for all Ayn Rand posts.

Ask The Senator, a continuing series

Q: I notice the MSN StockScouter system uses a high price/sales ratio as an independent, positive indicator!?

A: I have so much data on this ratio (only in large cap stocks) and assure you stocks with high p/s numbers flat out do not outperform the market. They are the most dangerous of the Dow.

Send queries for the Senator to senator<at>dailyspeculations<dot>com

Spin-offs, by Victor Niederhoffer

I have examined about 100 papers on corporate spin-offs in the last day, my conclusions are as follows:

1.This is a fertile field where the results of the original studies are completely outdated and desperately need contemporaneous update, an effort which my good colleagues are working on.

2.The original study by Cusatis, Miles and Woolridge showed that from 1963-1988  returns of 10 percentage points a year better than the averages for the three subsequent years to the announcement. All attempts to replicate this have been failures. Indeed, the best studies I have seen on the subject, by Sebastian Ruta, 2001, shows that from 1990-1999 the spin-offs show returns of about -30 percentage points relative to the market in the period starting six months after announcement and ending four years after announcement.

3.The type of management involved in the spin-off seems to be key as ably analyzed in a study by Wruck and Wruck Restructuring Top Management: Evidence from Corporate Spin-offs. They find that a spin-off does better with a division head and a big honcho from the parent company in the driver's seat after the spin-off but that all spin-offs do worse than their peers.

4.There is substantial evidence that carve-outs, a public sale by a parent and then a spin-off, do worse than the market and the same is true for tracking stock. See The Market Performance of Tracking Stocks by Matthew Billett and Anand Vijh.

5.Another factor that seems to affect the relatively lackluster performance of spin-offs is the degree to which the spin-off was in a separate industry from the parent -- an increase in focus. Thus, Desai and Jain in "Firm Performance and Focus" conclude that from 1975 to 1991 "long run abnormal returns for the focus increasing spin-off are significantly larger than the corresponding abnormal returns for the non focus increasing spin-offs."

6.The book You Can Be a Stock Market Genius by Joel Greenblatt has some excellent intuitive ideas, including the hypothetical influence of better incentives on excellent spin-off performance after the spin-off, but it seems good that Greenblatt got out of the hedge fund business in 1995 as his strategy does not appear to be working.

7.There appear to be about 15 spin-offs a year that make it to all the samples involving CRSP and Compustat data with security research data being a key.

8. I have a complete contemporaneous up-to-date sample which will be subjected to counting and refutability and prospectiveness.

More on Spin-offs, by Victor Niederhoffer

"Spin-offs that Expropriate Wealth from Bondholders" by Maxwell and Rao is at once an example of the value and the worthlessness of academic research. The worthlessness is apparent in that they are able after going through extensive data collection to find a complete enumeration of 72 companies that fit their criteria from 1974 to 1997. Thus, there were able to come up with only three a year and this includes apparently all of Nasdaq as well as NYSE and AMEX. Obviously there are so many small companies involved, there are so many missing data, there are so many divergences in the companies that have full data on bonds, and the data are so out of date, that all conclusions are completely worthless and behind the form.

Yet the ideas that the professors consider are very suggestive, i.e. that there is a transfer of wealth to stockholders from bondholders in spin-offs, that spin-offs in two separate industries create more wealth for stockholders, that the co-variation of returns between the two companies is an important variable in determining how much the separate stakeholders benefit. That the abnormal returns are concentrated around the announcement, that the amount of collateral involved in the deal determines how much bondholders lose, that the degree of of the financial risk influences the returns to bondholders with low grade companies showing bond losses greater than high grade companies.

All in all, the paper is a useful descriptive exercise in qualitative analysis, like a critique of a novel in a typical college English class. But the paper points out the problems of such studies. The data collection is so hard , that it's likely a fertile field for abnormal returns. However, the timeliness of the analysis and the wholesale retrospective elimination of companies that one would be unable to eliminate a priori makes any conclusion complete behind the form.

The Da Vinci Code by Dan Brown, Reviewed by Sushil Kedia

I've reached only page 171 and already I'm thrilled to recommend it strongly.

Linguistics, semantics, art, religion, dogma, intrigue, science, mathematics, history, God, Devil, cryptography.. All intertwined with real-to-life pictures in the special illustrated collector's edition in this work of fiction that unabashedly interlaces real names, places, people and facts leading everything together to a 'story' of the pursuit of sangreal - the Holy Grail! Well, it's a story still.

Symbolism and symbols, patterns and reactions of humanity to them across ages is one thing which I guess sets into thinking a mind ever engaged in deciphering thought patterns for better trading. Constructive digression of reading hours, that opens up the mind to think afresh, independently and a priori yet again how generations of 'followers of a method' distort the meanings, implications and applications of symbols and patterns.

Martin Lindkvist responds:

Yes, it is a riveting read for lying back in the couch and just relaxing. But from the perspective of the scientific quest, I instead find a resemblance to many of the technical analysis books out there, with their search for the Holy Grail, keeping the reader on his toes to learn "the secret".

Dick Sears Weekly Commentary: Welcome Turnaround

Shanghai: The Rise and Fall of a Decadent City 1842-1949 by Stella Dong, reviewed by Jim Lackey

A Speculator's Valentine, by Victor Niederhoffer and Laurel Kenner.

A story of how the Spec Duo came to be, with a bit of counting relating to canes.  

Hussman's Weekly Comment, reviewed by Allen Gillespie

The Fed Model certainly has shortcomings (what model doesn't?) but that does not necessarily mean it has no value.

I called Stan Levine, former Director of Quantitative Research at First Call, to ask about the dataset for earnings estimates. He says that using IBES data you can "maybe" get reliable forward estimates data starting in 1972. Good data after 1976. Prior to 1972, he says you may be able to string together some data from Value Line. Thus Hussman's comment regarding long term data seems to stretch further than the data.

Stan also volunteered that he believes there is certainly a relationship between forward earnings and interest rates, but there is no reason to believe it must be one-to-one.

Victor Niederhoffer comments:

Apparently sent as a parody by one of our most distinguished members, Hussman's essay contains considerable pseudo-science and pretension without showing any knowledge of statistics or economics. Those who use the Fed Model, like me and Dr. Schmetz, test it using predicted forward earnings as an independent variable and stock market return as a dependent variable. There is no implicit random correlation in returns versus bond yield levels, albeit there would be between levels of S&P and levels of bond yields. The basic economic argument for the Fed Model, which people like Hussman don't seem to realize, aside from their ignorance and pretensions of statistics (to be ignorant of what you are ignorant of is the malady of the ignorant), is that the value of an asset is the discounted value of the cash flows it brings in future. With interest rates down, the value goes up. With interest rates at half the level of the average of the previous 30 years, the values of other things should be twice as great.

As for his arguments about the twin deficits, they commit the Nebraskan folly by neglecting that the deficit comes from the joint determination of long term inflows and outflows. Other things being equal, better to have a short term deficit. Look at how bad the European situation is and think how they're going to pay back their debt and balance their budgets, relative to the U.S., without any growth. No wonder they pay so much for U.S. assets, and wish to place all their investments here.

As for the quality of earnings and buybacks, they keep rising. In short, Hussman's piece is biased, ignorant and pretentious and of no value over and above the kind of thing the chronic bears have been publishing ever since the days of Howard Ruff in 1975.

Bear Watch: The Latest From the Leading Financial Columnist

After the usual litany of reasons to be bearish this week (the twin deficits, the tensions in North Korea, the coming letdown in Hewlett-Packard, the deterioration in the trade deficit if you take out oil, the totally unjustified rise in semiconductors that doesn't gibe with the industry's truly dismal outlook, what looks to be a speculative whirl rather than a sustained advance, his unnamed friend's bearishness for Wal-Mart when and if it goes through the support level of 50 which would have spillover effects on the economy and the market as a whole, the labored action of Wal-Mart right now, the imminent confirmation that the trend is definitely down in Wal-Mart, his friend's current bearishness and his past record of being right as rain), the chronic bear from the financial weekly reaches what to me seems like a new height of duplicity when he states, "Much as we hope we're wrong [in being bearish] -- the world's a much better place when the market's on the rise -- we're pretty sure we're we're not. "

Please tell me how a columnist who as far as we know has not been once bullish in over 2,000 columns (one or two might have slipped by our content analysis reported in Prac Spec), can say that he hopes that the market will go up.

"The Trader," a column by James Santoli (who we hope puts everyone out of their misery soon by stepping up in the lineup), continues the mysticism by noting that "Since 2005 began, the S&P Index has crossed the range's center line at 1190 in 12 out of 29 trading sessions. Since the Nov. 10 upside breakout, the S&P has traversed that level 20 times." But how consistent is this with randomness to say that the center of a market over the previous 29 trading days has crossed that level 2/3 of the time. "The Trader" almost makes up for his mysticism by discussing the maxim that breakups of stocks provide the best payouts. He talks about Coach and Carter's from Sara Lee went through the roof. And that currently Citi and Amex and Dean Foods and Cablevisions are proposing divestitures. The performance of such spinoffs might be expected to be good on the theory that incentives would come more into play when the executives can be directly rewarded individually for performance of their specialized divisions rather than noted in the grand scheme of things as part of an aggregate. It's worth a study.

Review by Steve Wisdom of Leg the Spread: A Woman's Adventures Inside the Trillion-Dollar Boys Club of Commodities Trading, by Cari Lynn (Broadway Books, 2004)

A disappointing book. The author clerked at the CME for two years, and "Leg the Spread" is a quasi-memoir, although it's mostly a grab-bag of anecdotes and life stories of Merc traders and clerks she got to know. The book is too pedestrian to be "literature" but insufficiently trashy/raunchy to be a guilty pleasure.

A third of the characters are male, and they're uninteresting, both in real life and in the book. Frat boy hijinks, "$20,000 if you can eat 50 McNuggets", fast money, fast cars and fast women, fistfights in the pits, drug/alcohol burnouts, financial blowups, yada yada yada. The women characters are portrayed more sympathetically by the author, but even their stories are mostly cartoonish and uninvolving. A shapely clerk tells her boss, "Give me a trading badge, or I'll call your wife and tell her about us.." Another clerk is pushed to her death from a rooftop because she "knew too much" about prearranged trades on the floor.

Lamentably, there's plenty of wide-eyed "so much money changing hands so fast!!" sprinkled through the book, and the author has the irritating habit of capitalizing words such as Market, Floor, Open and Close, as if the were proper nouns.

The best 10-20 pages of the book are about Bev Gelman, purportedly the largest local in backmonth Euros, earning >$10m/year, and thereby the most successful woman floortrader in history. In her description of Ms Gelman's trading, though she doesn't understand the details of the spreads & strips being traded, the author comes close to grasping what trading is really about, i.e., having the brains and guts and conviction to come into a market where "everyone" in the pit is 1-bid/3-offer, and deciding to be either 2-bid or 2-offer, for better or worse.

Unaccountably "Leg the Spread" is >300 pages. But even if it were boiled down to 50-100 pages I couldn't recommend it.

Pam Responds:

I've not read the book so won't comment on its particular merits but I have seen a number of book proposals over the years by women about their trading or Wall Street experience and I have to say that they have mostly struck me as 1) uninteresting; 2) irrelevant. More importantly, there is no market for these kinds of books, and one simply can't make a market for a product no one cares about. The publisher of this book made it a major centerpiece of their Fall 04 season, featuring it prominently in their booth at the big publishing convention last spring and giving it a huge spread in their catalog. Despite the publisher's getting very good reviews for this work in the publishing/trade press (Publisher's Weekly, Booklist, etc.), and promoting the author as the next new exciting writer (she attended the Iowa Writer's Workshop), plus the obligatory media appearances, the sales have been (and there is no way to sugarcoat this) simply embarrassing -- fewer than 2500 copies (Chair can now officially stop declaring Prac Spec the worst selling investment book). One of my colleagues suggested that it might have sold better if they'd called it "Spread the Leg."

More Tips on Talking Like a Stock Market Operator, from James Sogi

From Humphrey B. Neill, "Tape Reading and Market Tactics"

It was not too long ago that the chart users were in the minority. In the old days, when even Chair and E were young, most speculators watched the ticker tape, now referred to as time and sales. I wonder how this changing cycle affected (if at all) market action. Here are a few of Neill's juicy tidbits.

"Long-pull investor." "If you are not willing to study, if you are not sufficiently interested to investigate and analyze the stock market your self, then I beg of you to become an outright long-pull investor, to buy good stocks, and hold on to them; for otherwise your chances of success as a trader will be nil."

"Clean out." At the end of the decline in August 1930, "I well remember that day, because I was short the market, and was trying to decide whether there was sufficient volume to mark the turning point or whether the selling was likely to carry much further. However, the action had many of the ear marks of a "clean out," of a temporarily oversold condition. Although there was a terrific churning of stocks, little headway was made for approximately three hours. There was no progression heavy volume. That was our signal."

"Reading the Tape." "We must be cynics when reading the tape. I do not mean we should be pessimists, because we must have open minds always, without preconceived opinions. An inveterate bull or bear cannot hope to trade successfully....Realize that you are playing the coldest, bitterest game in the world." (I'd have to disagree with that. The legal world is the coldest bitterest game in the world where you are face to face with your opponent and look him straight in the eye and see his fear and the sweat roll down his collar.)...""You cannot analyze tape-action and at the same time listen to forty two people discussing the effects of broker's loans, the wheat market, the price of silver in India and the fact that Mr. Raskob and Mr. Durant or bullish."

"Dull market." "Dull markets are puzzling to traders, doubtless because it is difficult to rivet the attention on the tape when it is inactive."

"Quick turn" "It is often a long road to a quick turn."

In Honor of Playwright Arthur Miller, by Kim Zussman

Miller's signature "Death of a Salesman": pastel tones transcending tribulations of a salesman's charm as gambit. Willie Loman's life is meted out in mediocre aliquots of debt service. In death he is rich with life insurance bequeathed to his suffering clan; he lived poor to die rich.

Here in the west coast capital of culture, the bumper sticker says, "I'm spending my children's inheritance" (BMW required).

Sybarism and conspicuous consumption versus the Suze Orman convent of retirement and tuition. Really? You don't care to be rich? We gonna scrimp and save and invest so those little ones can be even more demotivated and inured to the meaning of money and learn the word "outsourcing."

In honor of the young ones: at what targets this week shall we aim our arrows of risk? Do we explain to adult children that investing is continuous redeployment of assets into the center of maximum perceived risk, with payoff either by luck or faintly better than luck with stats the crowd doesn't see?

One of Miller's ironies is Willie's ne'er-do-well son Biff as guilty retribution for dad's marital indiscretions. This, when in fact Biff was, by definition, a Galtonian failure devoid of liberal blame diversifications. Besides, who can fault a lonely man of the road? Yet again, life bigger than art: with Jewish intellectual Miller's moribund psych rehab of the mother of all blonde bombshells (OK, well, at least she did convert), we see the seer is a hack.

Then again there was the sack. OK, OK -- take it back.

It was only ever about risk, human or otherwise.


Dick Sears Weekly Commentary: Welcome Turnaround

All Gamblers Die Broke, by Victor Niederhoffer

There is a nice revue of Jule Styne at the Algonquin with excellent piano playing by Mark Nadler and singing by KT Sullivan. (Mark's specialty is playing the “Rhapsody in Blue” while singing “It's Wonderful”, and tap dancing at the same time. And it's no wonder that the village voice calls him "the most prodigiously talented performer in America today). Styne is famous for writing  music for “Gentleman Prefer Blondes”, “Peter Pan”, “Bells Are Ringing”, “Gypsy”, “Funny Girl”, and “High Button Shoes”. His most popular numbers are “Diamonds Are a Girls Best Friends”, “Just in Time, and “The Party's Over”. He had a failing however, he liked to gamble, and no matter how successful his shows and songs were, he apparently lost it all at the track.

Many of his songs describe a man's state of misery as he lives in penury through suffering the curse of winning his first bet. It brings to mind what Artie always said "all gamblers die broke". Thank goodness I did not have the good fortune to make money on my first speculations so I had the sense to call it quits after I had lost 75% of my first fortune. Since then I have found that too fast a profit sets up forces that cause the mistress of markets to take it back. Artie always added "and most of them end up degenerates".

I am trying hard to be the exception that proves the rule. And I encourage all the kibitzers out there to insist that I won’t be, as it tends to keep me even further forward on the balls of the feet.

Tom Ryan responds:

I grew up 'out here' near to Vegas and the numerous Indian casinos and have a bit of my own philosophy on the nature of gamblers. One distinct aspect that I have found is that gamblers primarily enjoy the thrill involved in being right/wrong, in/out of the money, up/down, win/lose. The speculator although subject to these same base human desires also greatly enjoys the figuring out of things, developing the understanding of how markets work, and formulating hypotheses as much as in the winning and losing and to that end you sir are no gambler. In other words the thrill of the search for the edge to exploit is equal to the thrill of the exploitation itself. But it is a good point that as traders we must be constantly on guard against bad judgment and overconfidence. I think a firm knowledge of statistical methods, a humble attitude that one can always be improving, an inquisitive mind that looks for insight from other people and disciplines (even though 95% of such prove to be dead ends the 5% are, as the commercial says, 'priceless') and also a robust reading program all keeps the mind sharp and counteracts the tendency towards the 'overconfidence from winning' syndrome. My $0.02. What do you think?

Bridge and Trading, by Bruno

Rumors and the Markets, by James Tar

Rumors and the markets are one of the more interesting phenomena in this world.

News services pick up and propagate them often. Phones ring all over the trading rooms around the world as multitudes of traders, analysts, assistants, and salespeople are mesmerized by a sudden spike in the Spoos, "Rumor Osama captured in Pakistan", with no reference to today's action. Such things are manufactured just because market people feel that any single action in the market has to have some all important single reason for its occurrence when they can't find anything on the tape that is factual. How bizarre.

Some of my all-time favorite rumors that are so ridiculous they remain imbedded in my memory bank:

"Market sells off amid fears of Greenspan collapse" -- Actually, this would be a good thing for the markets.

"Market rallies on smooth outcome, no terrorist activity during the Athens Games" -- Some may say this is rational, but really, what fund manager is going to lighten up on his GM, Ford, and Microsoft before the Olympic Games? The same manager must have been buying back those babies when the Olympics completed. Baloney.

"Market selling off, rumor of large earthquake in California" -- If earthquakes are so bad, why is California the most populous state in the country?

Similar to rumors are the loads and loads of "experts" and their willingness to share their "expertise" on what the market likes and what the market does not like:

"The market didn't like that CPI number" -- Well, if the Dow in fact sold off 80 on the CPI, then why the heck was the Dow up 200 the next day?

"The market doesn't like it when it doesn't find a level." -- Enough said.

What is the best, however, are stockbrokers and their immense commitments to provide quality service to their clients. As a new fund manager, I have been blown away by the "information" I get from every broker I know trying to "add value" in exchange for some trades:

"Hearing from a good source MXT to be bought out by COF."

"Talk of a slowdown in employment, we should get involved in MSTR."

"Hearing Agere to be awarded large contract from MXO, great for Agere, but could be a hamper on MRVL's model."

"Hey you know AAPL has had a heck of a move, but sooner or later there will be slowdown in their growth, you should keep an eye on it."

Will someone please tell me what this means? It certainly demonstrates I have some pretty useless people trying to earn my business, but it also tells us just how much nobody really knows about anything.

Aggregately, it is amazing how much money is being controlled by so many people who do not have a clue as to what the heck is going on.

"The market does what the market wants"

I Like Spam, by Jason Goepfert

I like spam (the email version).

I sign up for all sorts of disparate junk lists all the time.

I find it useful to track the volume of certain types of scams in my email box over time. This "spam indicator" reached a fever pitch for gold investments in November of last year, and for oil schemes in October - good pretty good tip-offs of trend exhaustion.

By the time an investment theme reaches the interest of an audience so broad that bulk emailers find it worth their expense to send out spam, I believe counting the drivel can serve as a poor man's guide to potential reversal points.

I keep such a spam indicator for the term "refinance". Such emails telling me I must refinance now to lock in low rates are hitting high levels - today I got the second-highest number of emails with that word since the year began.

The correlation between the change in 10-year T-Note yields over the prior 3 days and the number of refinance emails over the next three days is -.17 since last November (suggesting that as rates drop, the number of emails increases).

To see if there is any predictive power, I also looked at the number of emails over the past five days and the change in 10-year yields over the next five days. The correlation there was +.10, suggesting that the more emails I get, the more likely yields will rise. With the current number of emails I've received, it suggests Note yields will rise by 23 bps over the next week. Please understand this is somewhat tongue-in-cheek.

Like everything else, this is subject to changing cycles. These spamsters are clever folks - they monitor bounce and open rates, watching what percentage of their millions of emails are caught by spam filters. Something I have noticed over the past few days is that the word "refinance" is being dropped altogether, I'm sure due to the fact that people are complaining to their ISPs about the number of refinance spams.

Don't KITCHEN Your Opponent's St. Pete, Apply Shuffleboard Strategy to your Trading, by Charles Pennington

Chi-Town Music, by Mark McNabb

Given that my long SP Index itch* is increasing as the full yellow orb ascends in the crescent city while the breezes of Jost van Dyke tempt Mr. Chesney's latest effort thought i'd give the chi-town chillies a live music tip-- James McMurtry, most literate rocking Texan wields an axe and opinions as dry as a New Mexico butte, is playing Martyrs (hopefully not a Hamas owned bar).

*Long side seems easier as the resilience of recent days shrugs at bad news....what me worry? My toes in sand and Blue Merle plays in the background.

The Right Brain, by Janice Dorn

All one has to do is look around at the present rush to yoga, alternative and complementary healing techniques, being so overburdened with email and feeling chained to the computer, needing and wanting real live human interaction, the proliferation of wellness spas and the search for serenity and beauty both within and without, to realize that we are attempting, as a species, to transform ourselves.

This has been said more eloquently than I can in the Feb 05 issue of Wired Magazine entitled Revenge Of The Right Brain by Daniel H. Pink.

The implications of this concept for behavioral neurology and psychiatry are immense, and beyond my ability to comprehend at the moment...but I am working on feeling my way through it, being in the moment with it, nurturing it and letting it flow. My right brain is simply thrilled about this whole process.

Step Lively, by Bo

Street people realize a limp attracts robbery or trouble. Street fighters may feign injury to draw the foe. Walking lost the Florida swamp a few years ago, gators everywhere, my mantra was 'step lively' hour after hour. I'd heard reptiles detect the fatigued by gait. Once in Iquitos, Peru, I sat at the base of the Bengal tiger cage for study. She was a gigantic pussy cat like the smallers I'd handled hundreds of times in vet school. In five minutes it reached through the bars and grabbed my tank top drawing me in with claws on a huge mitt. I tore the shirt to escape, lesson learned. Some vets of Sand Valley wouldn't think of picking on a weak prey.

Department of Reader Complaints

Why not comment on what truly works rather than what doesn't? Is it grander to find fault with the world thereby increasing one's presence than to address the truth that would benefit others? -- Donald Brown, Knight Templar AAONMS

Victor Niederhoffer: The Big Con

Part of the Big Con that has the market in its grip is that every book that makes you trade too often, and that  sounds sensible, will be accepted as a divine dispensation to the investment community. Such is the case with all the books that advise buying the market when the P/E is low and selling when it is high, like the work of the chronic pessimists. And such is the case with the book that many say is the best book they've ever read, the Zurich Axioms by Max Gunther. The book has 12 major axioms and 16 minor axioms. Not one is tested. Almost all contradict others. And all will give you a false sense of confidence when you're doing the wrong thing and channel you away from doing the right thing, while at the same time causing you to overtrade, and have a false sense of confidence. The basic premise of the book is that Mr. Gunther's father, a successful banker from the mountains, had some great techniques of making money that only his Alpine friends knew. And that the son started to ask sharp questions about them, and systematized them in a book that makes you rich.

Some examples of axioms:

  1. Always take your profits too soon.
  2. When the ship starts sinking, jump.
  3. Accept small losses cheerfully, but expect to experience several while awaiting a large gain.

Will someone please tell me how to take your profits too soon and at the same time hold for that large gain that offsets the small losses ? On the occult: if astrology worked, they would be rich. But a superstition can be enjoyed, provided it is kept in place. Will someone please tell me how to strike the proper balance between reason and superstition. Until further notice, I'll insist on things like evidence, refutability, verification, repeatability and principles of analysis.

Like all such books, there are no economic principles or data to back up rules that could be subjected to actual tests in different markets. Nor any understanding of the principle of ever changing cycles that makes all fixed systems losers on average when you have enough confidence to try them.

One of the worst rules which one tests here often is "if it doesn't work the first time, forget it.". On the contrary, even the fixed rule players know that the losers are to to loved as a prelude to better times.

Needless to say, the book is given unanimous 5 star ratings by all reviewers. Why is this guaranteed to happen and why does the public have to lose so much more than they should? Where is the archaeological libertarian trader when we need him?

Charles Pennington Responds:

I buy book after book on trading and markets from Amazon and discover when they arrive that they have no tests of anything inside. Nowhere inside these books can you find a sentence that says "This would have resulted in N trades with an average return of x%." You could scarcely find a baseball book out there that didn't include some batting averages and ERA's, but markets are not worthy of such consideration.

Jame Sogi Responds:

But Vic, aren't gedenkan an important part of the scientific method. Even Einstein's special theory of relativity arose out of thought experiment, Newton's Principia from an apple. How does one know the right questions without some sort of qualitative framework to frame scientific inquiry, a horizon from which to navigate?

Position, by Nigel Davies

I am thinking about this very seriously, and in my hands is Znosko-Borovsky's book on the middle game. Here is a quote from the chapter on the valuation of positions in which he examines a position in which Black 'appears' to have many cumulated advantages:

"Yet in spite of the gain in all elements Black was defeated after very few moves.

"From this it follows that, even with a full agreement of all elements, one cannot rely too much on such an external judgment of position.

"On what can we build an internal valuation of quality? Is it some curious unaccountable instinct, "Positionsgefuhl" as the Germans call it; or can we make certain deductions founded on objective facts? Undoubtedly such an instinct plays a great part, and its significance is shown both in the judgment of position and also in the working out and realization of plans.

"The more difficult the position is, the deeper are the characteristic features, the less noticeable are superiority and inferiority and the greater is its meaning. It is possible to say that this instinct shows itself in the guessing of the qualities of a position before they are visible. If a player is less gifted, he does not realize and does not account for them, but very often notices them later on when their results are imminent. Therefore this instinct helps to the discovery of the true path in the game and is more dangerous to the opponent, because he does not understand all the peculiarities of the position and does not see the menace. The real facts, however, also play a very great part, since chess, being an impersonal game, cannot be reduced merely to a matter of guesses...."

Napoleon at the Chessboard, by Nigel Davies

Here's Napoleon bravely attacking Madame de Remusat, but with only queen and two knights developed. Judit Polgar would have played 8.Bf4 and crushed him like a bug.

Madame de Remusat - Napoleon I [B02]
Paris Paris, 1802

1.e4 Nf6 2.d3 Nc6 3.f4 e5 4.fxe5 Nxe5 5.Nc3 Nfg4 6.d4 Qh4+ 7.g3 Qf6 8.Nh3 Nf3+ 9.Ke2 Nxd4+ 10.Kd3 Ne5+ 11.Kxd4 Bc5+ 12.Kxc5 Qb6+ 13.Kd5 Qd6# 0-1

The Fed Watch, by Allen Gillespie

On the 7th day God rested, and after 7 rate hikes the Greenspan Fed rested in 1995 and stocks broke out. In 2000, the Fed rested after the 6th hike, but tech topped the day after number 5, while value stocks bottomed. I think one must watch with full attention over the next few weeks.

The questions I am pondering are:

Will tech continue to dip then turn when the Fed says it is finished?

Will the home builders finally run out of gas as the Fed catches the inflation rate?

Will large stocks gain the upper hand on small stocks?

Will stocks be just below their peak going into the meeting like 1995 or will they be following weakness in tech?

Will people start looking past the meeting with Greenspan's talk next week? Many many questions. Any thoughts?

Ask The Senator, a continuing series

Q: Do you recommend MarketQA for trading system design and testing?

A: As one of the founders of the company, now with a minority interest, I can say it is very powerful, very expensive and very hard to fully learn and use, unlike the more popular software packages. It is similar to LIM from Tony Kolton; both allow for lots of data and have access to data, something TradeStation and Metastock are not designed for.

Send queries for the Senator to senator<at>dailyspeculations<dot>com

Seven Samurai, by James Sogi

Kurosawa's all time classic Seven Samurai is a 3.5 hour story of samurai hired to defend farmers from bandits in 15th century Japan during a period of 200 years of social unrest and economic collapse. (And you thought the recent recession in Japan was bad). Kurosawa explores complex themes of the samurai's disdain for the duplicitous peasants and the peasants' ultimate lifestyle victory over the landless samurai. Great cinematographic inventions of the cavalry riding over the hill on the horizon seen in hundreds of movies including Star Wars scene with the droid army work dramatically. This is the first cinematic use of the plot of gathering a "band"  together for a mission impossible inspiring dozens of copies. The samurai use brilliant military strategies against a numerically superior foe such as isolating and dividing the enemy, good advance preparation, allowing a weak point to lure the enemy in to trap them, impersonation to infiltrate enemy lines. A few market tidbits, of course...."When only defending, you lose the war." "When things seem safe, danger strikes."

Gibbons Burke adds:

An interesting modern re-make of this movie, which was also novel in many of its cinematic techniques, is PIXAR's "A Bug's Life". It's a cross between Aesop's fable "The Ant and the Grasshopper", "The Seven Samurai" and a bit of "On the Waterfront". I once met director John Lasseter at a PIXAR shareholder's meeting and asked him why, given the obvious similarities in plot and character, the debt to Kurosawa was not acknowledged in any way shape or form in any of the DVD extras about the movie and he nodded when I suggested they might be worried about possible legal liabilities. The Criterion Collection's DVD of "The Seven Samurai" is excellent, by the way. The critical commentary audio track sheds much illuminating light on the genius of Kurosawa's camera angles and blocking. IMDB provided the full quote for one of the lessons you cited:

Kammbei: Go to the north. The decisive battle will be fought there.
Gorobei: Why didn't you build a fence there?
Kambei: A good fort needs a gap. The enemy must be lured in. So we can
attack them. If we only defend, we lose the war.

and a few other good ones, such as the usefulness of losses in education:

[on taking Katsushiro as a student]
Kambei: You embarrass me. You're overestimating me. Listen, I'm not a
man with any special skill, but I've had plenty of experience in
battles; losing battles, all of them. In short, that's all I am. Drop
such an idea for your own good.
Katsushiro: No Sir, my decision has been made. I'll follow you sir.
Kambei Shimada: I forbid it. I can't afford to take a kid with me.

and taking quick windfall profits:

Gorobei: You're Good.
Heihachi: Yeah, yeah. But I'm better at killing enemies.
Gorobei: Killed many?
Heihachi: Well - It's impossible to kill 'em all, so I usually run
Gorobei: A splendid principle!
Heihachi: Thank you.


Gisaku: What's the use of worrying about your beard when your head's
about to be taken?

*Gibbons Burke is Editor of MarketHistory.com

When to Attack, by Nigel Davies

Lasker was very clear in his book that you had to attack when you held the advantage and that the strength of the attack should be in proportion to the advantage held. What is not so clear to most of us is whether we do indeed have an advantage and how big this is.

This is one of the biggest issues in chess and one of the greatest strengths of good players. Many games are lost simply because players look for moves which are 'inappropriate' for the situation, often attacking hard when they should in fact be building or building when they should be exchanging. When they then have the computer analyze the game they decide that a particular move was to blame, overlooking the fact that the real source of error was that the entire spectrum of moves they were examining at the time were out of context.

George Zachar adds:

The speculative parallel to this is what I think of as the idee fixe error -- having a preset array of mental tools -- and applying them to situations without awareness/understanding/sensitivity of current realities.

The obvious recent poster boy for this is the Derivatives Expert.

Gibbons Burke on Attacking:

General Nathan Bedford Forrest, a native military genius who rose in the ranks of the Confederate army from private soldier to Brigadier General many times illustrated the value of the attack - even when you were numerically at a disadvantage - especially if you could convince your enemy, by means of deception that you were a larger force than you actually were. The value of audacity, often asserted by General Patton with the phrase "Le audace, le audace, toujours le audace!" was a principle Forrest never articulated so grandly, but did so in action. Here's a description of the Parker's Crossroads engagement:

Forrest faced 2,000 Union infantry in Henderson County, Tennessee on Dec. 31, 1862. The Union detachment was attempting to block Forrest's like-size cavalry from escaping Union-controlled territory. Forrest unleashed his cannons and attacked with a three-sided effort, causing the Federals to retreat to a wooded area and then raise the white flag. Forrest ordered a cease fire and began to negotiate terms. Suddenly, a volley of musket fire came from the rear of the Confederates. It was from a fresh detachment of Federals, forced marched from Jackson, Tennessee.

The Federals had Forrest in a squeeze. An excited Confederate officer asked Forrest his intentions. "Charge them both ways!" bellowed Forrest. The unexpected and furious attack caught both Union detachments off-guard and Forrest and his entire command were able to escape over the Duck river and back into Confederate held territory.

*Gibbons Burke is Editor of MarketHistory.com

Deflating Ballyhoo, by J.T.

Karl Zinsmeister said in Who's Afraid of Investing?

There are many admirable, exemplary personalities working in American finance today--people like Kovner, Peter Lynch, and John Bogle. There are also some awful narcissists, scammers, and fast-talkers. While researching this issue I read half a dozen autobiographies penned by Wall Street titans like George Soros, Victor Niederhoffer, James Cramer, and Michael Steinhardt. I can fairly say that this was some of the most painful literature I've crawled through in the last few years. Finance guys generally do not give piquant interviews either. Being an economic prodigy doesn't necessarily make you a fascinating person."

J.T. Asks: Surely you didn't read the book Mr. Zinsmeister, or further more what about the follow-up that attempted to help the masses and clearly lays a plan of action to not be afraid to invest?

For this gross mistake and out of context use of our beloved Chair's eloquent prose, I have this as an explanation of Mr. Zinsmeisters obvious misunderstanding.
"Another reason why good literature was more easily accessible then than now is that the proportion of literacy in our population was much lower, and publishers were not under such heavy economic pressure to block up the access to good literature with trash. In Massachusetts, where literacy would be presumably highest, there were nearly a hundred thousand persons unable to read or write. Things were no better in Connecticut, where one-tenth of the child-population got no schooling at all; and it would be fair to suppose that in the more newly-settled regions of the country the level of literacy would be very considerably lower. One might assume that as the level of literacy rose, the level of general intelligence would rise with it, and consequently that the economic demand for good literature would also rise. This, roughly, was Mr. Jefferson's idea, and indeed it has always been at the root of our system of free public instruction for everyone. It has, however, somehow failed to work out according to expectation. The level of literacy has been pushed up very nearly to the practicable limit, but the level of general intelligence seems not to have risen appreciably, and the economic demand for good literature is apparently no greater in relation to a population of a hundred and thirty million than it was to one that was going on for sixty million; in fact, one would say it is much less. The reason for this is plain enough; there is nothing recondite about it. In his view of literacy, Mr. Jefferson was only half right. He was obviously right in premising that no illiterate person can read; but he was guilty of a thundering non distributio medii in his tacit conclusion that any literate person can read. On the contrary, as I discovered as long ago as my undergraduate days, very few literate persons are able to read, very few indeed. This can be proven by observation and experiment of the simplest kind. I do not mean that the great majority are unable to read intelligently; I mean that they are unable to read at all - unable, that is, to carry away from a piece of printed matter anything like a correct idea of its content. They are more or less adept at passing printed matter as is addressed to mere sensation, (a knowledge of this fact is nine-tenths of a propagandist's equipment), but this is not reading. Reading implies a use of the reflective faculty, and very few have that faculty developed much beyond the anthropoid stage, let alone possessing it at a stage of development which makes reading practicable."
Memoirs of a Superfluous Man, Albert Jay Nock

Geez, the nerve of some people. Did he read the same book I did? What category would he place Mr. Niederhoffer in (1) narcissists (2) scammer (3) fast-talker? The also other wrongful misjustice is to use the words American and Enterprise in the title of a magazine and have its contents be that of such mistakes.

Irony in Markets, by Mark McNabb

Usually irony provides a clue to inflections and today's market irony concern's Queen Carly. When pressed, journalists (?) on NPR will only say Carly had a 'culture' conflict rather than offend the PC-centric (but computer illiterate staffers) in our 'public' radio. She was a bad date for HP that wouldn't end. The market has spoken, the king...err queen is dead. Long live the king!

Round Number in Debt, by George Zachar

The big round number in US debt markets these days is 4.00% on the ten year treasury: a strike in OTC options, a potential inflection point for rebalancing mortgage portfolios, a psychological barrier inducing sticker shock, etc. etc. Well, not only did we close through 4% today (humble gif attached), but the street will be bidding on $14 billion of these things tomorrow.

George adds:

Street debt research departments are busily cranking out explanations for (yet another) unexpected decline in 10 year note yields. Mr.E, as usual, was ahead of the curve in steering folks to structural issues related to price insensitive demand.

Disclosure: I actually bought bond futures a few weeks ago, but spread them against the wrong thing, and managed to lose money on the trade. Following is a set of questions related to my post, which the chair forwarded.

(1) What happens when mortgage portfolios are rebalanced?

In the current situation, that means folks have to buy long dated fixed coupon (style) paper to keep their durations fixed as mortgages prepay.

(2) What happens when $17B hits the ten year note?

I assume this refers to the $14 10 year auction at 1pm today. There's a lot of cut-and-thrust hand-to-hand gamesmanship in the auction process that is invisible outside the tiny world of big dealer desks, super-size accounts, and related ramora. What's interesting is the auction result detail, and the market reaction thereto, which become visible for all to see, between 1:01 and 1:10 pm. My long-standing contention is that auction dynamics and their immediate wake only illuminate short-term market technicals, not "the big picture".

(3) Auction announcements occur at 1PM EST, does the trade have 'inside'information?

4) Is a move after the yield awarded is announced simply an adjustment toward the fact, or is there an additional expectation added?

Auctions are like unhappy families. Each one is different.

Allen Gillespie follows with:

The round number is the 10 year yield is interesting, as I think the action in the bonds has certainly made stock traders concerned. To me everyone seems nervous and negative, as they remember the flight to safety trade. I have even heard talk of inversion. The thinking seems to be that the Fed is too tight. I have pointed out on this list that there have been periods in which rates fell during an expansion (i.e 1935-1937).

Moreover, using the full data set from the Fed since its creation in 1913, one will see that the spread between long rates (unfortunately the data pre WWII, and pre-1976, are for a mix of various maturities as there was not standard issuance like we have today) and short rates has been on average about 80 bps plus are minus a percent and a half. Throwing out a few outliers from 1 quarter in early 80s when there was a an inversion at high absolute levels the average only rises to 84 bps plus or minus 1.25%. Thus in a really long time series the interest rate levels look low but the spreads relatively wide except in credits which look low and tight.

Responses to Cisco's Earnings, by Charles Pennington

Previously I have commented on the hubristic utterances of Cisco's chair and his resemblance to Don Quixote, and the other great Italian folk hero with long... . Every quarter a dose of reality hits when earnings are released, as follows:

Report Date %Return Next Day
 2/ 6/02       -8.3
 5/ 7/02       24.4
 8/ 6/02        7.6
11/ 6/02       -4.7
 2/ 4/03        0.0
 5/ 6/03       -2.6
 8/ 5/03       -6.4
11/ 5/03        5.0
 2/ 3/04       -8.8
 5/11/04       -1.3
 8/10/04      -10.6
11/ 9/04       -6.6

Avg   -1.0%
StDev  9.7%
T     -0.4

Data provided by Market History

Correlation is Not Causality, by Tom Ryan

As someone who has a science background, and who on occasion is called upon to provide expert witness testimony, and one who participates periodically on a MSHA board investigating fatal accidents in mining, the first rule that one follows in the case of causal inference, which dates back to John Stuart Mill, is that correlation is not causality. This is particularly relevant when one is trying to go from a part to the whole, that is, when ones sample used for developing a prediction is small compared to the total predictive effect, say a pie baked with macintosh apples (my personal fav)to a pie baked with one macintosh and eleven other different apples. In particular you have many problems with using the results of one time period, and applying it to the cumulative result of the next 11 time periods:

- Temporality can easily be confused with causality
- You may be ignoring multiple causes/effects
- In a time series there may be an underlying cause affecting both your sample and your prediction (post hoc fallacy)
- One is ignoring the probability of random intervening factors (11 times more probable for the prediction period because of its length compared to the length of the sample in this case)
- what about counter examples?

In engineering for example we deal with this a lot in terms of scale effects and extrapolations, that is what works at one scale does not necessarily work at another scale. This is discussed at length in Petroski "Case Histories of Error and Judgment in Engineering", with the classic case of the dangers of extrapolation being the design and collapse of the Dee Bridge in England.

Running Money, A Book Review by Michael Pomada

Running Money by Andy Kessler. It is what I would call a "popcorn & soda" book - reads just like watching a movie where everything is presented in bite sized, easy to digest chunks. It has the quick-version of the industrial revolution & how that pertains or doesn't pertain to the 'intellectual property' revolution currently occurring in the US. It also has some stories about his tech focused hedge fund in silicon valley, particularly about the trials & tribulations of finding the underlying, inimitable IP/product that will be the next important component in this or that new technology. all of this makes for an enjoyable, quick read, but it is fluffy.

"What a zoo," I said repeating myself. "H & Zoo. More like the H & Screw Conference," Nick quickly replied. "Who are all of these people?" I asked. "Well, it takes all types. See that guy drooling orange juice who looks like he just got out of high school? He runs the Fidelity Select Software fund....."

In chapter 7 he changes tone & topic to address the trade deficit. It is still 'dumbed down' in its presentation, but the concepts are salient & nicely illustrated: when you are exporting IP & importing physical goods you will run a trade deficit. Because of this trade deficit with the US, foreign countries will invest in the US (both financing the deficit & increasing stk market value).

"Let's open up that Toshiba laptop. With a $300 Intel chip (which has at least $250 in profit for Intel) and a $50 Windows license ($49.95 margin to Microsoft), the laptop is then sold by Toshiba back into the US for $1000. Toshiba and every other supplier are lucky if they make $50 in profit, combined, on the deal."

"So, while in this overly simplistic example, a $300 Intel microprocessor and a $50 Microsoft operating system are exported from the US, a $1000 product is imported, for a net trade deficit of $650. Yet on a profit basis, the US clears 300 bucks, and the rest of the world maybe 50."

His deficit theories run contrary to conventional wisdom & therefore were not well received. I am interested in what others more knowledgeable specs think about this line of thought, as I am a novice in understanding trade deficit economics.

Not a Good Begining-of-the-Month Spike, offered by George Zachar

From an article by Inga Kiderra in a UCSD Press Release:

Beware not the ides but the start of March and April and May and every month. In the first few days of each month, fatalities due to medication errors rise by as much as 25 percent above normal, according to new research by University of California, San Diego sociologist David Phillips.

Published in the January issue of Pharmacotherapy, the journal of the American College of Clinical Pharmacy, the study is the first to document a beginning-of-the-month spike in deaths attributed to mistakes in prescription drugs. The primary suspect, Phillips says, is a beginning-of-the-month increase in pharmacy workloads and a consequent increase in their error rates.

Government assistance payments to the old, the sick and the poor are typically received at the beginning of each month. Because of this, there is a beginning-of-the-month spike in purchases of prescription medicines, Phillips says. Pharmacy workloads go up and in line with both evidence and experience error rates go up as well. Our data suggest that the mortality spike occurs at least partly because of this phenomenon.

Phillips and his coauthors examined all United States death certificates from 1979 through 2000 to analyze the 131,952 deaths classified as fatal poisoning accidents from drugs. A small number, 3.2 percent, of the deaths were from adverse effects of the right drug in the right dose. The vast majority, 96.8 percent, resulted from medication errors the wrong drug given or taken, or accidental overdose of drug, or drug taken inadvertently. The study excluded deaths from overdose of street drugs or from intentional poisoning (suicide or homicide).

The beginning-of-the-month mortality spike was particularly pronounced in people for whom the mistakes proved rapidly fatal those who were dead on arrival at a hospital, died in the emergency department or as outpatients. In this category, deaths jumped by 25 percent above normal. But could it be that the mortality spike is due not to pharmacy error but simply to the increased number of people buying, then consuming drugs?
To test this, Phillips and coauthors ran analyses on populations of the elderly and the poor. If increased consumption alone was to blame, the researchers reasoned, mortality would be highest in the groups relying on government assistance and therefore purchasing their medicines at the start of the month.

The beginning-of-the-month spike was similar across groups, however. The spike was as evident in the young and well-off as in the elderly and poor, suggesting the problem was at least partly due to an increase in pharmacy error at the beginning of the month. Phillips notes that the National Center for Health Statistics database used in the study did not contain highly specific clinical information no information on prescription type, dosage, days supply, etc. and he urges further research with data richer in this kind of detail. To reduce the medication-error death rate, Phillips suggests that pharmacies (that don t already do so) consider increasing staffing levels at the beginning of the month and that government officials consider spreading assistance payments out over the entire month.

Even in the absence of policy changes or further research, Phillips says, it is appropriate for both patients and clinical staff to be especially careful to check the accuracy of their prescriptions at the beginning of each month. If this is done, it seems plausible that some lives will be saved.

Phillips coauthors are Jason R. Jarvinen, sociology student, UCSD, and Rosalie Phillips, executive director of the Tufts Health Care Center, Tufts University.

Slow Growth Can Mask High Returns, by Jeffrey Beckwith

Article on the back page of today's FT regarding a study by the London Business School concerning stock investment returns link to GDP growth. "Our findings are unambiguous: Investors who allocate assets to countries with high expected GDP growth do not, on average, achieve higher returns." Authors of the study are Elroy Dimson, Paul Marsh and Mike Staunton. The study is to be found in the Global Investment Returns Yearbook 2005 published by the London School of business.

Carly Bye-ku, a Haiku by George Zachar

Fiorina gone.
HPQ up 10 percent.
What took them so long?

Victor Niederhoffer: The Chart below shows a nice doubling in IPOs...

from March 2002 to present (index weighted by market value), in accord with required return when conditions are very risky. And guaranteed to happen when all professors are saying that required returns in next century will be much less than the previous.

See our Buyback Study Update

Black Swan Philosophy at the FDA, by Victor Niederhoffer

The FDA has scheduled a Feb. 16-18 hearing on whether Celebrex and related drugs approved as painkillers should continue to be marketed. But that’s only part of the story. Consider the 1 million google references to Celebrex as a cancer-fighting drug that has shown efficacy in colon cancer, breast cancer, bladder cancer and lung cancer with increasing doses showing greater reductions in recurrence.

The FDA likes to be seen as the benevolent captain of a happy, healthy American ship. This witch hunt against Celebrex and its relatives makes it seem like a particularly malevolent version of Captain Ahab.

A sample of the entries showing Celebrex’s anti-cancer role:

“CEA vaccine combined with Celebrex prevents colon tumor in mice (100% reduction)”

“Celebrex-like gene suppresses growth of colon cancer”

“Celebrex turns on cancer cell ‘death receptor’”

“Normal doses of Celebrex may be too low to trigger significant anticancer effects, but the new finding points the way to .. death receptor induction as a target for screening novel Celebrex-based anti-cancer drugs…”

And a googol of studies showing that Celebrex reduces polyps in people with FAP.

We can all see that the FDA has been captured by the idea that the purpose of treatment is safety rather than usefulness, and that no balance between the two should be considered. And we all know that by taking into account the costs to the FDA of emphasizing safety, the agency doesn’t weigh the benefits to the users of having efficacious drugs.

And we all can see what I have said for many years -- that when you multiply witch hunts like this 1,000 times, and consider the molecules that never are developed or never reach the market because of the FDA, that the life expectancy of all of us is reduced by, say, 5 to 10 years.

It’s the same reasoning as that employed by the Black Swan philosopher, who says that buying puts before October 1987 that much temporary disaster and profits to the risk takers could have been achieved. But he doesn’t take into account the costs and benefits of buying such a product over time; nor does he consider the benefits of buy and hold.

In both cases, the conclusions can only be understood by acceptance of the idea that the purpose of life is safety, that life is not worth living, and that people are small.

I realize that everyone hates to read about efficacious drugs until they have the disease. But excuse this rumination from someone who owns Pfizer, notes that the FDA on its Web site says its purpose "is to serve the needs of the pharma industry," and realizes that despite all the bad science, the outcome of the meeting will be in the interests of the painkiller companies themselves.

Feng Shui Finance, by Nigel Davies

Not that I know anything about Feng Shui (and may in fact be using the term incorrectly), but I recently discovered the joys of simplifying life by reducing the number of bank accounts, trading accounts and credit cards that I have. I've also been setting about repaying our mortgage like a thing possessed, for no other reason than to clear my head.

Lasker advised against overburdening the memory with too much information as the mind should be free to think. I suspect that having too much paper in your office can have the same effect, not to mention too many computer programs, too many indicators, too much data. I have chess databases with literally millions of games, which is all very well until you try to use them. In the information age could one of our major challenges be selectivity? It strikes me that this could also be one of the main ways to get an edge.

The Nebraska Chronicles

Allen Gillespie says:

"I think the Euro tumble has more to do with short rates, elimination of the hate Bush premium, and Europe's domestic economy troubles like the German unemployment rate than Bush's budget. I would hardly call the budget radical."

Another Paul Rotter Interview, forwarded from Trader Monthly by Steve Wisdom

Best graf :

"The problem for the locals," says a former Eurex official, "is that the herdlike mentality they learned in the pits is very hard to break. And the Flipper was taking advantage of that trading style. A lot of the locals probably made a good deal of money in the pits just following the crowd, and now they can no longer do that." Rotter, characteristically, is more blunt. "I probably stepped on the tail of some monkey who was making great money on the Schatz and couldn't compete anymore," he says.

Today's Range, by Victor Niederhoffer

Today's range of 5.2 in S&P from 1204.8 to 1199.6 appears to be the second lowest in last 70 days. And this leaves the market mistress unrequited and angry that she hasn't gotten everyone on the wrong foot yet. (This kind of descriptive statement makes me sound much more sapient than I am).

More on Michael Porter: A Personal Recollection by Professor Ross Miller

It is safe to say that Bruce Henderson's infamous Cash Cow/Star method at BCG (1976) predated Porter's Competitive Strategy (1980). I attended one of Henderson's lecture at HBS in 1977 and his system was fully in place back then while Porter was sweating (literally, with big armpit stains) over in the econ department teaching industrial organization. GE's operative strategy under Welch was a variant of the BCG's matrix (Be first, be second, or be gone) and Porter/Monitor (his consulting firm) were quickly deemed persona non grata (kindly refrain from contacting us) at GE.

I view Porter's work as a clever repackaging/dumbing down of the industrial organization theory developed by his mentors in the Harvard econ department (Richard Caves and Michael Spence) for the business world. The concepts that Porter supposed pioneered, especially barriers to entry, were well established in the industrial organization literature long before Porter came along.

Having sat in on several of Porter's industrial organization classes (fortunately, I got to take the course for credit from Richard Caves while he was still teaching it), I can vouch for the fact that Porter does indeed have a reasonable grasp of microeconomics and understands basic statistics. If this does not come through in his written work, it is either by choice or the result of faulty memory.

New in the Daily Spec Barbecue Files: Rich Bubb's Deep-Fried BBQ Shrimp ("works well with chicken, too!")

Victor Niederhoffer: Nobody Asked Me, But...

  1. When a hedge firm stops reporting monthly results to the performance rating services, chances are the returns were much below their norm. And this was the first tip that all was not well with predictions made in the Gladwell article.
  2. The lessons that one gains from shuffleboard -- particularly about using the block, i.e., the St. Pete and the Tampa, and going for the numbers only at the end of a frame when the predictions concerning the hammer's moves are much better -- reminds me of proper strategy for the game of seeking market returns. After hitting a number, a block is always the best strategy.
  3. The market has not shown a decline for an extended period, and this should have put the trend followers back on the wrong leg again.
  4. The trend following firms have lost from 4% to 20% in January 2005, and this seems like a cruel blow after they were crowing about their great comeback in 2004. Such letdowns are often the case in games, and life.
  5. A History of the Businessman by Miriam Beard is one of the best reads I have had in recent months. Section headings include: “The Heritage of Antiquity,” “The Patrician City Rulers,” “The Monopolists,” “The Individualist,” “The Big Businessman.” I loved the chapters on the merchants of Venice, the Dutch business empire, swordsmen and salesmen of the Homeric Age, Bourgeois and Puritans in France and how the American Revolution blazed a way for the manufacturer.
  6. The hearings on painkillers coming up in next two weeks should lead to a communitarian solution that will appear to slap the wrists of Big Pharma while precluding entry and showing the regulators have  big teeth.

Magic, Hocus Pocus, Illusion, Conjuration, by James Sogi

Before we start, glance up at your light. Now even though you may forget everything I've written, you can say, "I've seen the light." Not being the brightest light, some critical elements of statistical theory did not quite sink in while reading Snedecor, but looking at all the nice pictures in Tufte's Visual Explanations, made some interesting ideas clear.... one of those "light bulb" experiences. Here are a couple of ideas.

Time series data are sensitive to choice of intervals and ending points which allows data mining, multiplicity, or specification searching. A computer can search though varieties of graphical and statistical aggregation and present a finding favorable to one's case. An example is trading time frame. Bullish? ...search through the time frames that show an up trend. The problem is that a 5 minute up trend, might hide an hourly or daily downtrend. Yearly trend may hide the quarterly dip. The choice of time frames is an issue that appears to be a statistical anomaly of time series graphs which lead traders to no end of mischief and loss. Avoid misleading conclusion by examination of all the underlying data. There are right ways and wrong ways to show data; there are displays that reveal truth and displays that do not, and it can have enormous consequences.

Another area relevant to trading is Magic, the art of conjuration and illusion, hocus pocus. Illusionists can make elephants disappear. Illusionists like Ebbers, Fastow can make billions vanish. Nice trick. How is it done? Selective presentation of evidence, distraction, disguise, attention control. Lefevre, Ney speak of painting the tape. What tricks do illusionists paint with the chart...the false breakout, the rapid decline in January, the expanding range, the disappearing gap, the trend. All old chart tricks to fool the unwary.

One of the greatest illusions of the chart is that of continuity: it hides the spread which is the heart of the market. The market is not continuous, but jumps, always a gap between bid/ask. The chart purports to show history, but hides the probabilities of the future. This is where the table, and even the quote board with bid and ask, and statistics using the actual numbers will beat the chart gazer. the chart is missing some of the most important information in the market.

Big Salaries--Small Returns, from Steve Wisdom

Compensation as a predictor of share performance: a tidbit from Marty Edelston's excellent Bottom Line newsletter, 2/15/05 issue. I haven't read the referenced study, and the effect seems paltry at first blush, i.e., doubling executive comp equals 2% underperformance, but Doc may have more color and insight.

"Did you know that the more a company's executives are paid, the worse its stock performs? A 1% salary increase for the top five executives of a corporation is related to an average drop of 0.02% in shareholder return over the next year (.. ) Compensation information may be found in a firm's annual proxy statement, filed with the SEC (.. ) Form DEP 14A (.. ) Joseph Blasi and Douglas Druse, professors, School of Management, Rutgers University (.. ) are coauthors of an analysis of executive compensation at more than 1,500 US companies from 1992 to 2002."

George Zachar adds: Imagine what impact this "study" would have in a world of de facto compulsory stock market investment dictated by the Feds as pseudo-Social Security.

Stock Volatility in the 19th Century, by Dr. Alex Castaldo

Tom H. Kalinke has constructed a daily "12 Active Stock Average (1855-1885)" which covers the period prior to the start of the Down Jones Average in 1886. I have been working with this data.

The volatility during this whole period, 20.16% per year, is remarkably close to the values observed in more recent periods. On closer examination, the volatility during 1853-1862 seems to have been somewhat higher than usual, and during 1866-1882 somewhat lower.

Here are the year by year values:


As in modern data, the volatility is quite unstable from month to month, with sudden spikes occurring from time to time. (Visually I have the impression this spikiness may have been somewhat greater in the 19th than in the 20th Century, but it needs to be checked). Particularly high values were observed during these months:

Sept-Oct 1853
Jul 1856
Nov 1856
April 1857
April 1860
April 1861
Nov 1868
Oct 1869

I'll leave it to the history scholars on the List to tell us what unusual events (if any) occurred at these times.

According to NNT and the Mandelbrotians "volatility is undefined" or as Prof. Ross Miller would prefer that I put it, estimates of the second moment of returns do not converge. If that is the case, estimating volatility at two different times should give two crazy numbers, unrelated to each other or to any underlying economic reality. On the contrary, our finding is that volatility is remarkably stable; stock volatility in the middle of the 19th century was 20%, nearly identical to what it was during the 1926-2004 period. (The volatility can fluctuate sharply from month to month, but these changes are mean reverting within a few months). In fact the shoe is on the other foot and it is hard to explain how volatility could have changed so little in view of the huge changes in trading technology, financial market regulation and the economic environment over the last 150 years.

Dick Sears Weekly Commentary "Finally Something to Cheer About"

Intelligence Failures, by Big Al

Discovery Times channel has been showing an interesting series on intelligence failures. The thread that works its way through most of the stories is how a preconceived idea causes key decision makers to block out all contrary information.

A dramatic example is the buildup to the Yom Kippur War, during which the head of Israeli military intelligence, Eli Zeira, was certain that Egypt and Syria would not attack and rejected reports from soldiers on the Suez Canal about how the Egyptians were obviously making preparations for a crossing. He also ignored a warning that the Soviets had evacuated their diplomatic staffs from Cairo and Damascus, remarking that the Soviets did not understand the Arabs and that there would be no attack.

As another dramatic example, they explain that Churchill and other British leaders dismissed the dangers of a Japanese attack on Malaya and Singapore in 1941. There were many disparaging remarks made by the Brits about how the Japanese didn't make good soldiers, couldn't see well enough to be pilots, etc. Churchill sent a task force composed of two battleships, Prince of Wales and Repulse, to make the Japanese think twice. Which seems like an almost hilarious underestimation given that the Japanese had developed one of the most powerful navies in the world at that time.

However, Discovery Times might need to do a little more due diligence themselves.

And in researching the general topic, I found "Psychology of Intelligence Analysis" (R. Heuer, CIA). A few points from the last chapter, "Improving Intelligence Analysis":

"Start out by making certain you are asking--or being asked--the right questions."

"Relying only on information that is automatically delivered to you will probably not solve all your analytical problems."

"Do not be misled by the fact that so much evidence supports your preconceived idea of which is the most likely hypothesis. That same evidence may be consistent with several different hypotheses."

"Proceed by trying to reject hypotheses rather than confirm them. The most likely hypothesis is usually the one with the least evidence against it, not the one with the most evidence for it."

Lasker's Bunker Lesson, by Grandmaster Nigel Davies

One memorable chess lesson I received from Lasker (via his book, not in person) was the principle of economy in defence. Lasker explained that one should defend a position with minimal means and have the rest of the forces engaged in counterattack so as to tie up enemy units.

Passive defenders often like to laugh at others from the safety of their bunkers, but fail to understand that whilst they are delaying their destruction past that of more enterprising souls, they can never win.

Calling the Cards, by Big Al

Opening Scarne on Card Tricks (John Scarne, 1950), I found that the very first trick, Calling the Cards, reminded me of mutual fund window dressing and maybe a few other tricks, too.

The Presentation

The performer asks a spectator to shuffle the deck thoroughly. The performer then spreads the deck out face down on a table, and the spectator is asked to point to a card. The performer then predicts what that card is, and a second spectator writes down the performer's prediction. The performer picks up the card and looks at it, without showing it to anyone else, and then sets it aside in a new stack. This is repeated five or six times. The performer then says he will pick one last card himself, points to a card, predicts what it is, and then adds this last card to the stack. The second spectator then reads off the cards named as the stack is revealed one card at a time, and, behold, the performer has guessed all cards correctly.

The Trick

The performer, by sleight and with some distracting patter, notes the bottom card in the deck handed to him by the spectator after shuffling, e.g., the Queen of Diamonds. When he spreads out the deck, he keeps track of this bottom card's location. When the spectator points at the first card, the performer predicts that it is the Queen of Diamonds, then picks up the card and looks at it -- let's say it's the 8 of Clubs -- and sets it aside. The spectator then points at a second card; the performer predicts it is the 8 of Clubs, picks it up, looks at it, and adds it to the stack. And so on, until the performer points at the last card himself, which he makes sure is the card that was on the bottom of the deck after the shuffle, the Queen of Hearts, and predicts it to be the previous card he picked up from the table. While making some distracting comments, he places the Queen of Hearts not on the top of, but on the bottom of the stack of predicted cards. And so, when the second spectator reads out the list, and the cards are revealed, the performer has "called" all the cards correctly.

Larry Williams adds:

It's called "one ahead" and is the basis for many, many magic trick, seance scams.. and not mutual funds.. Harry Houdini, where are you when we need you?

Salt of the Earth, Offered by Gibbbons Burke

A Fourmilog Review of Salt: A World History by Mark Kurlansky

You may think this a dry topic, but the history of salt is a microcosm of the history of human civilization. Carnivorous animals and human tribes of hunters get all the salt they need from the meat they eat. But as soon as humans adopted a sedentary agricultural lifestyle and domesticated animals, they and their livestock had an urgent need for salt--a cow requires ten times as much salt as a human.

The collection and production of salt was a prerequisite for human settlements and, as an essential commodity required by every individual, the first to be taxed and regulated by that chronic affliction of civilization, government. Salt taxes supported the Chinese empire for almost two millennia, the Viennese and Genoan trading empires and the Hanseatic League, precipitated the French Revolution and India's struggle for independence from the British empire. Salt was a strategic commodity in the Roman Empire: most Roman cities were built near saltworks, and the words "salary" and "soldier" are both derived from the Latin word for salt.

This and much more is covered in this fascinating look at human civilisation through the crystals of a tasty and essential inorganic compound composed of two poisonous elements. Recipes for salty specialties of cultures around the world and across the centuries are included, along with recommendations for surviving that "surprisingly pleasant" Swedish specialty surströmming (p. 139): "The only remaining problem is how to get the smell out of the house. . .".

Professor Ross Miller Considers Taleb/Niederhoffer

This week I will be covering the Gladwell article on NNT/Chair in my derivatives for graduate accounting students class.

In a recent communiqué NNT reiterates that he believes volatility to be "undefined."

To quote him precisely and in context: "By saying 'weakly correlated' I know I may be saying something lacking in rigor. 'Volatility' is necessarily a Gaussian concept; we do not even know how to measure it the weights are Norm L2 (meaning that observations are weighed by themselves, so large observations weigh more than smaller ones). In a power law environment, with exponent a<2 (or a Multifractal process with about any a), volatility is undefined but the fatness of tails can be known, measured by a and some degree of asymmetry. Hopefully in the victory of Mandelbrot paradigm we will not talk about such thing as volatility but tail exponent."

NNT is, however, himself lacking in rigor. He uses "undefined" when referring to volatility when the right word is "unbounded" or what a layman would call "infinite."

It is noted by Gladwell that NNT worships Karl Popper.

Here's the conundrum: Any amount of finite data will lead to the empirical conclusion of a finite volatility. To fit NNT's "theory" into a Popperian framework requires that it be refutable. That, however, would require unbounded data to test this hypothesis EMPIRICALLY. (Note: The infeasible alternative is to know the distribution-generating process a priori, but only Plato can do that and he's dead and no one can find the keys to his cave.)

It is left as an exercise for the reader to show that if NNT is correct (empirical proof or not), not only does any calculation involving volatility become "incorrect," so does any calculation involving returns--completely invalidating all forms of "counting."

Michael Porter, reviewed by Victor Niederhoffer

If there's a Bible in business strategy, it's the concept of "Competitive Strategy" as pioneered by Harvard Business School dynamo Michael Porter in his book as well as his follow-ups on "Competitive Advantage" and "Competition Between Nations" and follow-up articles like "What do we know About Variance in Accounting Profitability" with Anita McGahan in Management Science (2002).

“Competitive Strategy” has been read by millions of business students; it has been reprinted 50 times and translated into 20 languages; Bill Gates is a fan. It contains the basic language that businesses and consultants use to make their strategic decisions and consider their strategic advantages and disadvantages. It pioneers such concepts as the five forces of business: Supplier Power, Barriers to Entry, Threat of Substitutes, Buying Power and Degree of Rivalry. It contains the three generic competitive strategies: cost leadership, focus and product differentiation.

The follow up book introduces the concept of value chain, which again is at the hub of all business decision making these days. Numerous 2-by-2 and 3-by-3 classifications used by consultants such as Bain and McKinsey, and companies such as GE like the growth share matrix (the star and the cash cow) and the Company Position Industry Attractiveness screen (build, hold or harvest), which are noted as specific but defective short cuts to a very limited application of Porter's framework.

Thus, after reading this legendary classic and the follow-up books and articles, and some of the 15,000 references to Michael Porter’s consulting firm, including his specific analysis of the defects of the health-care industry (competition is zero sum rather than win-win) one gets a good understanding of the framework for business strategy at large firms

Since I haven’t kept up with the practice of competitive business dynamics, I found the book most provocative, the same way one does with such legendary tomes in our field such as the work of Ben Graham, the Founder.

And yet, I have never read such worthless palaver in my life. Not one economic principle is used to understand the myriad anecdotes presented, nor any understanding or appreciation of the knowledge and rich theoretical framework emanating from such fields as biology, evolution or geology. The book contains no predictions, nor any method of classifying companies into the various categories with any degree of stability.

In those fields that I am expert on, like mergers and acquisitions, the author is completely naive and his recommendations are particularly detrimental. For example, he suggests that it is good to find company owners that are willing to sell for non-price factors such as prestige or feeling that the acquiring company can do the job much better than the owner so you can get a better price. But anyone in the business like I have been for 40 years can tell you that no such companies exist, and that such expressions by sellers are sales talk designed to amuse the business development functionaries, the intermediaries and the company's own management.

The technical articles that Porter has written are riddled with descriptive details and don’t take account of any alternative random no-information models. For example, they conclude that the business that a company is in explains much more of the variation of profits among firms than the parent. But how much extra information does this provide than considering each company as unique, and how does this vary over time?

Porter should be considered a vapid marketing expert without any technical knowledge of economics, statistics or any other discipline that would have left the reader with some foundation for making useful decisions about business strategy. And nothing he writes about will give you any insight about which stocks to buy, or industries to enter, or plants, or markets to expand or contract in, except that like 6 sigma, when you hear someone's a devoted follower of his principles, you'll know that he tends to lead a company with all hat and no beef.

The Chairman Repents

I was out of bounds in my analysis of Prof. Porter’s “Competitive Strategy,” saying that it was insipid and completely devoid of any principles or foundation for decision making or scholarly analysis that could have been drawn from such fields as economics, ecology, evolution, or modeling.

I said that his academic papers were a mishmash of bad statistics, descriptive anecdotes that could fit in with a myriad of competing theories, and case studies that seemed like they were cribbed from his graduate students’ papers (for example, his use of the saw blade industry to prove his points about concentration).

Also, that the author commits the fatal conceit of encouraging communitarian strategies by companies and industries guided by the helping hand of altruistic regulators, presumably selected from HBS faculty rather than the dispersed knowledge and know-how of pitiless consumers intent on better price and quality, and purveyors focusing on providing same.

Yes, all that on retrospect was true and much too kind.

I went to the other extreme, however, in harshly saying there was nothing of value that one could get vis-a-vis stock selection from the promotions and extensions of his consulting firm and the affiliated Institute for Strategy and Competitiveness at Harvard. You see, I ran a search of " competitive policy, NYSE” on google and that brought up a nice 1,000 entries of companies that apparently believed in the buzz work and were trying to be stylish and conformist, thereby signaling a laxity and sponginess that would lead one to eschew. One notes for example that Professor Porter has served as a counselor on competitive strategy to companies including AT&T, Credit Suisse First Boston, DuPont, Proctor & Gamble and Royal Dutch Shell, and currently serves on the boards of Parametric Technology Corp, R & D Falcon Corp and Inforte Corp. I note also that companies like Southwest Airlines were big proponents of competitive strategy.

What is really required is a study of the performance of companies that mention competitive strategy (or, for that matter. Six Sigma) as one of their mantras, from the time of first mention relative to the market in subsequent years. I hypothesize (but not retrospectively like the highly flawed work of good and bad companies where he looked the stock prices to determine the good and bad and then concluded that the good had better stock performance than the bad) that a prospective study would show major inferior performance of such competitive strategy-captured companies.

But unlike Professor Porter’s sensible-sounding homilies (try to lower your costs, or pick an industry where barriers to entry are high), this hypothesis must be tested. If I am wrong I will be the first person to apologize to the professor for leaping to this natural conclusion from a detached reading of his book.

Lloyd Johannesen responds:

My suggestion is that competitive strategy is brought in when corporate change is obvious, but you need to bring in the consultant to serve as the bad cop, rather than top management. "I would love to keep the division, but the good doctor says we have to do this to stay competitive." In essence, employee morale is retained to the maximum extent possible while enhancing, maintaining, or limiting the decline, in firm value due to a change in market conditions. Six Sigma could be useful because it creates an alternative recognition system for the employee to improve work processes and quality, when they are not picked up by quarterly financial reports, but can radically affect firm value over time. Thus, my view, is that the value is not the words that are used to describe the process, but how it recognizes human motivation and psychology as having meaning to the financial well-being of the organization.

Art Cooper adds:

Vic said "Where I erred was in saying there was nothing of value that one could get vis a vis stock selection from the promotions and extensions of his consulting firm... I ran a search of " competitive policy, nyse " on google and that brought up a nice 1000 entries of companies that apparently believed in the buzz work andwere trying to be stylish,and conformist, thereby signaling a laxity and sponginess that would lead one to eschew... I hypothesize...that a prospective study would show major inferior performance of such competitive strategy captured companies."

Art offers: "It may be that you are not yourself luminous, but you are a conductor of light. Some people without possessing genius have a remarkable power of stimulating it." Sherlock Holmes to Dr. Watson in "The Hound of the Baskervilles"

Roger Arnold Responds:

When I was at IBM in the mid to late 80's one of the subjects I taught to incoming managers was Demings 14 points and later the Baldrige award requirements - I would be interested to hear what the chair and members have to say about them, if anything, and how they may relate to competitive strategy - I will preface that though with the fact that even though I taught the concepts, personally I believed them to be ludicrous - shortly thereafter came Welch and his six sigma - which I also found to be ludicrous - I hired one of Welches stars to run one of my companies not that long ago - and was stunned, and I mean mind boggling stunned at the mans uselessness and ability to destroy an ongoing, growing, in the black business - I also found that when I was at IBM the Deming and Baldrige ideas were not used as practical application but somehow as ideals to be appreciated for what they represented - respect your employees and empower them with decision making - blah blah blah - I have always preferred the I am the boss - if you work you will do well - if not you will be fired approach - but that may simply a reflection of my inability to rally the troops.


Q: Larry Connors had interesting post on Tradingmarkets.com. He claims that his testing showed that if one had bought an index (SPX, NASDAQ, or SOX) on the open the day before last day of month and sold on open on 5th day of next month, only when prices above simple 200 day MA, the following gains would have been realized: (test period was from Jan 1995 to end of 2004) SPX 753 pts. vs. 743 pts. for buy and hold; NASDAQ 1768 pts. vs. 1217 pts. for B+H; and SOX 952 pts. vs. 293 pts. for B+H. He didn't mention any drawdown amounts you would have taken and figures might have been different trading SP500 and NAZ 100 futures. (I don't understand why futures contract data wasn't used). His claim is that one could have gotten outsized gains (for NAZ and SOX anyway) over B+H being in market less than 20% of time. I would have liked to see a much longer test period, even on indexes, as this period had huge up bias in the late '90s and early 2000s. I would also have liked to see drawdown amounts. You would not have made any trades for long period of time indexes were under 200 day MA. Pretty boring. Still, premise is interesting and possibly worthy of further review. Any comments? T.M.

Chair's response: I agree. The tendency of money to come in at the end of the month is probably a regularity that rational expectations hasn't hit yet. Of course, most of the effect comes on the first day of the month, and all else is insignificant. The use of adventitious starting and stopping points is a typical bias of palookas. The upward drift makes it such that you could find almost as much for any 5 days randomly. Yale de la Mancha been talking about this spurious effect for 15 years, and we hope one didn't try it this January. Like most such published shibboleths, advice like this is always behind the form. For more Chair Q&A

Press Note, from George Zachar

Not one mainstream news portal page tonight showcased the drop in the US headline unemployment rate to 5.2% -- a post 9/11 low.

The ones that bothered reporting the labor data release headlined that payrolls came in below street forecasts.

Given the public withdrawal from mainstream media, I'm not sure this matters very much, but it is a reminder that the rhetorical war on free markets continues.

Editor's note: The latest missive from Newport Beach contained this related comment, targeting the headline of the day: Social Security. "Production can only come from employed workers and so the basic solution is to produce more workers, either through immigration or postponed retirement for the existing workforce. It's the diminishing "size" then of our working population, or if you will, the increasing "size" of our future retirees that makes the critical difference and raises the spectre of crisis."

One of Daily Spec's token liberals connected the dots: "The Clinton/Ruben trade policies, promotion of trade agreements that sent jobs overseas, created this situation. Production, according to Gross, is necessary. And America cannot produce if workers are unemployed. We don't make much in America, the logo 'Made in America' is near extinction."

To which  Professor Ross Miller replies:

Actually, a fair bit is still made in America, including Japanese autos. The logo "Made in America" is "extinct" because there is no legal requirement that merchandise made in the U.S. bear any such marking. The absence of any "made in" designation usually means the item was made in America. Only C***** unions insist on the Made in U.S.A. union label.

If nothing else, the high cost of transportation makes it impractical for many goods to be manufactured offshore. Rising energy costs accentuate this effect. Other goods could be made in America, but the toxicity of their production makes everyone better off that they aren't, as Larry Summers has pointed out.

Don't worry, be happy.

Roger Arnold adds:

And if the employment figures had come in 50,000 above expectations we would have been told that inflation was on the way, Greenspan was behind the curve, short and long rates will rise, killing housing and dragging the US economy into a recession, and perhaps worse! The mainstream media have become cartoon characters.

Grist for Chair, by Steve Wisdom

A good day's work.. After today's batch of 8:30 "random numbers", the $/Euro did some quick housecleaning, filling 2 figures of stop orders, per the Zachar chart below. I think of these as "Zussman days"; the market poking around like a dentist with a pick, seeking "soft spots" in need of "filling".

More "Market Operator" Talk, courtesy of Martin L

I browsed through the Talk Like an Operator section of Daily Speculations and came to think of an old book ("a dictionary of buckish slang, university wit, and pickpocket eloquence") with some funny definitions on some words pertaining to speculation. I know you like old books, so here it goes:

1811 Dictionary of the Vulgar Tongue, by Captain Grose et al

SMART MONEY. Money allowed to soldiers or sailors for the loss of a limb, or other hurt received in the service.

REVERSED. A man set by bullies on his head, that his money may fall out of his breeches, which they afterwards by accident pick up.

STOCK JOBBERS. Persons who gamble in Exchange Alley, by pretending to buy and sell the public funds, but in reality only betting that they will be at a certain price, at a particular time; possessing neither the stock pretended to be sold, nor money sufficient to make good the payments for which they contract: these gentlemen are known under the different appellations of bulls, bears, and lame ducks.

WHEREAS. To follow a whereas; to become a bankrupt, to figure among princes and potentates: the notice given in the Gazette that a commission of bankruptcy is issued out against any trader, always beginning with the word whereas. He will soon march in the rear of a whereas.

Facts and Fantasies about Commodity Futures by Gorton and Rouwenhorst, reviewed by Charles Pennington

The claim of this paper is that a fully collateralized, equal-weighted portfolio of long, nearest-month futures positions in all the commodities in the Commodity Research Bureau (CRB) database has performed as well as stocks during the 7/1959-3/2004 period. Both stocks (the S&P) and commodity futures returned 11.02% compounded annually over the period (It is apparently a coincidence that these numbers are exactly the same). The standard deviation for stocks was 14.9%; the standard deviation for commodity futures was 12.1%.

The authors emphasize that their findings apply only to commodity futures, and not to spot prices. They find that futures outperform spot prices, returning 6.3% adjusted for CPI inflation vs returns of 3.8% for spot prices, also adjusted for CPI inflation. (Note: I actually extracted these numbers from a graph that the authors presented. I can t find these numbers given explicitly in the paper.)

It is not obvious that one should expect high returns from commodity futures, or even that one shouldn't expect high returns from short positions in commodity futures. The authors mention a prediction of Keynes, that companies that produce commodities would have a strong need to sell commodity futures short, in order to hedge. This results in a risk premium for speculators taking long futures positions. One could counter Keynes by arguing that many companies use commodities as raw materials. Such companies would hedge by taking long positions in futures markets, and that would result in a risk premium for speculators taking the short side. The question of whether there is a premium on the long or short side, or neither, is therefore an experimental one.

The authors find several more attractive features of commodity futures:

--The returns of commodity futures and stocks are negatively correlated, with correlation -6% for quarterly returns.

--While quarterly returns in stocks have a -20% correlation with the quarterly change in the CPI, the correlation between commodity futures and the CPI is +14%.

-- During the 5% of the months of worst performance of equity markets, when stocks fell by an average of 9.18%, commodity futures experienced a positive return of 1.43%.

--Both stocks and bonds do poorly in the early stages of recession (as defined by NBER), averaging -15.5% and -2.9% respectively, but commodity futures do well, returning +3.5%.

The authors find similar conclusions when they compare the returns of Japanese stocks and commodity futures denominated in yen.

1) The authors have a survivorship bias problem of unknown magnitude. They use only the CRB database. They state that some commodities that were traded during at some point from 1959-present are no longer traded now, and are no longer in the CRB database.

2) During the period of the study, the authors report that CPI inflation adjusted spot prices returned 3.8%, while CPI adjusted futures returns were 6.3%. I do not see any reason why spot prices, over the long term, should appreciate faster than the CPI. Perhaps the high increases in spot prices during this 44 year interval are not indicative of what will happen going forward. If we subtract this 3.8%, then the CPI un-adjusted returns for commodity futures would be about 7.2%, less than the return of bonds, which was 7.7%.

A Query on Logs

Doctor Castaldo was asked: "Why logarithms (logs) are used to measure price changes?"

His Reply:

If p(t-1) and p(t) are the prices on successive days, then there are 3 ways of looking at how prices have changed that are in common use:

The "point change" is p(t)-p(t-1)

The "percentage change" is -1 + p(t)/p(t-1)

The "logarithmic change" is Ln[p(t)] - Ln[p(t-1)]

The logarithmic change has several good things going for it:
For small changes the logarithmic change is very close to the percentage change (because Ln[1+epsilon] is approximately equal to epsilon). So it is intuitive.

The logarithmic changes are additive. So for example if ln[p] went down -0.05 one week and up 0.05 next week, we can deduce that prices are back to where they started. (If the percentage changes are -5% and +5% then that would not be true, at least not exactly). The theoretical result proved on the web site assumed additivity, so logarithmic change was a natural choice for the empirical verification).

The simplest model of randomly changing prices is that during any time interval, the log of price receives a random shock from a Normal distribution with standard deviation proportional to the square root of the length of the time interval. Black and Scholes for example assumed this kind of model. So it is a widely accepted way of doing things.

Philip McDonnell adds:

In my opinion using logs is a good idea for stock market data. Arguments in favor of logs are:

1. The natural log (ln) is the natural choice for financial work because it relates to continuously compounded returns.

2. The distribution of stock price changes most closely resembles a log normal distribution thus making logs a good choice.

3. Over the long run of multiple decades stocks appear to offer fairly stable compounded returns. Logs are the appropriate way to measure these because adding logs is logically equivalent to multiplying the underlying numbers.

4. Statistics are better when we normalize all returns to a log scale. If the s&p makes a 1% move when it is at a level of 300 that is 3 points. When it makes a 1% move at a level of 1200 that is 12 points. If we try to take an average of these point changes over a long history we are significantly weighting the more recent data. It's a nasty stat problem called heteroskedasticity and it's not even covered under the Defense of Marriage Act. Basically you can't trust your standard deviation if you don't use logs when dealing with long sets of historical data.

5. Logs relate to what should be your utility function for your portfolio. A log function weights things so that a 20% drop is equal to a 25% gain. Your stock drops 20% from 100 to 80, now it needs to go up 25% to get back to 100 for breakeven.


1. It takes more thought to understand logs.
2. It takes more work.

Do Charts Lie?, by James Sogi

Thanks Mr. Gardiner for recommending Edward Tuft, The Visual Display of Quantitative Information and the two other books in the series about statistical graphing. "Escaping Flatland" recalled one of my first articles here. Does your chart communicate necessary information or contain extraneous misleading elements? What information do charts convey? Do they mislead?

Tufte says "modern data graphics can do more than substitute for small statistical tables. At their best, graphics are instruments for reasoning about quantitative information....Excellence in statistical graphics consists of complex ideas communicated with clarity, precision and efficiency." At their worst, graphs can mislead, present false conclusions and hide valuable information. Show the necessary data, maximize the data ink ratio, erase non data ink and redundant ink. Remove the "chartjunk". First, remove all the distracting grids. They convey no necessary information and obscure the relevant data and cause the whole chart to 'vibrate' by optical illusion.

Take the simple bar. Studies have shown that people often misperceive the size of an object, due to context, or the comments of fellow observers, or due to illusions such as the Necker Illusion. A bar may look long or short depending on the scale or context. For example, a 1 minute bar and 1 day bar bar look the same, but they do not convey the same amount of information. A series of 1 minute bars appears to show a trend, but may in fact mislead one into taking an apparent 1 minute trend, when the day trend is the opposite direction, resulting in consistent losses. Been there? The 1 minute chart leaves out the context, what happened last week, or yesterday. Including a week or two or more of price action on the screen provides much more information than 1 minute charts, even if your trades are only 5 minutes long. Context in a chart conveys more information than just the prior prices, but reveals the relationship between prior price action and current action. When combined with the data export function to export the tables to statistical programs such as R, you have potent tools.

In Practical Speculation, Kenner and Niederhoffer deflate the effectiveness of a number of technical chart indicators. Clogging up a chart with indicators conveys no useful information, obscures the necessary information and misleads. The eye has a tendency to detect patterns even in random data and the illusion causes losses. I've removed indicators from my chart.

The Candle has redundant information and unnecessary ink. Each side of the candle can be replaced by a single line. The top and bottom by a single bar. The filling adds no information beyond the open and close, and takes up visual space and adds clutter. Lines miss the highs and lows and for that reason I find are impossible to trade with misleading one into turning, when it is only a false turn.

What information do charts convey? The change in price. When price heads down, the bears and media conclude, economy set for destruction, slide starts. That is the conclusion. But the context is Dimson's century, Sogi's millennia. Looking at four months, instead of one week, one might conclude that January's 4% drop was a merely reversion to the mean. Other's with a foot in the grave look at the drop as the opportunity to pull out their canes, and hobble to the brokers office. Show the necessary data, maximize the data ink ratio, erase non data ink and redundant ink. Remove the "chartjunk". It will improve your bottom line.

Jason Schroeder Replies:

Tufte's critiques are cathartic. Clarity and the reminder that presenting data is different than presenting a picture or a narrative is very encouraging. For example, so many pieces of software are written attempting to visualize the non-existent and create metaphors for situations not warranting concern. (PowerPoint diatribes extend this observation.)

The passion that accuracy in data presentation will increase the potency of hypotheses, decisions, conclusions and actions is pragmatically well intentioned.

BUT. At root my intention for digesting data is to conclude. Believing in the first place that charts might not lie to me removes me from the culpability of concluding.

Visualization is not a reasoning process and it preys upon the handy(!) assumption that "I will know something when I see it". The observation and the hypothesis become one in the same -- somewhat hard to test especially after I have supplied a name or a narrative for what I thought I saw.

Consider the computation of the mean. Its utility rests on a single hypothesis, that is, "The errors in observation of the actual observed are uniform". (The error introduced by utilizing the mean in further hypotheses is thus minimized.) Challenging/confirming this hypothesis is a handy way to appreciate what is the actual observed after all. And there are plenty more hypotheses to choose from the compendium of statistical experience.

The association about what is actually observed by me must be what is seen by me is the one suspicion requiring the maximum amount of doubt. Removing "chartjunk" removes sources of spurious correlations but it does not inherently amplify the deductive process.

Wading into the world of Deduction under partial Information is not to be done lightly and opens the discussion of what is information and what is hypothesis in any given context: a passionate form/content debate encompassing many heroes of science.

I was surprised by the contents of the first chapter of "Probability Theory: The Logic of Science" (itself informed by theorems in "The Algebra of Probable Inference") because the author presents his case for a deductively reasoning automaton in order to sidestep the form/content and truth/tradition debates with which we humans identify so strongly.

I believe that charts never lie. But I am the most fallible person I know.

James Sogi Adds:

Tufte's second book Envisioning Information addresses the issue of conveying complex multivariate information from a multidimension world in two dimensions. 3D rendering is a possibility, but there are other good solutions. We digest large amounts of information to make a trade, both macro and micro, but screen space, resolution, time and our focus are limited. Last time, I discussed increasing the efficiency of our charts by maximizing the data to junk ratio. Paradoxically, to clarify, Tufte advises, add detail. Mies van der Rohe said, God is in the details . Show complexity but avoid confusing information overload or simplified information. Clutter and confusion are failures of design, not attributes of information. Chair's recent wedge table is an excellent example of multivariate information design. Though small in size, it contains both micro and macro information. SP, Bonds, and Euro, and each combination of daily returns are each a dimension and the mean change reflects a synthesis of multiple dimensions along a lengthy time axis. Chair condensed multiple dimensions of a complex system with deep implications on a flat screen in less than 5 of space. Of the stem and leaf plot, a favorite of our Wiz, inventor John Tukey wrote, If we are going to make a mark, it may be a meaningful one. The simplest-and most useful-meaningful mark is a digit. Multiple layers of information of variance, medians, skew and many years data are in the format of the digits. the stem/leaf conveys multiple levels of information, here the price day after 1% daily drop SP big since 94 as an example.

t-test data: t = 1.9205
df = 1207
p-value = 0.05503
Min. :-90.9000
1st Qu.: -6.2000
Median : 1.0000
Mean : 0.8016
3rd Qu.: 7.8000
Max. : 64.5000
(The decimal point is 1 digit(s) to the right of the |)

-9 | 1
-8 |
-7 | 8
-6 | 9
-5 | 7
-4 | 4443
-3 | 9654433222222110000
-2 | 99999888888777766665555554444444333333333222222222211111110000
-1 | 99999999999988888888887777666666665555555555555544444444444444333333+59
-0 |99999999999999999999999999888888888888888887777777777777777777777766+230
0 | 00000000000000000000000000000000111111111111111111111111111111111111+341
1 | 00000000000000000000001111111111111111112222222222222222222222233333+76
2 | 0000000001111111111111122222223333444455556667777788899
3 | 001144455566888899
4 | 0001344457778
5 | 001249
6 | 5

Layering and color can be used to convey multiple dimensions in two, as in this chart with last two day bars superimposed on top of 30 minute bars. This avoids clutter, redundant charts, looking back and forth, loss of focus. The Senator says he only looks at day bars for his style, but I use the intraday info for my work. So we get 3 dimensions of time in a 2D chart.

Clutter and confusion are failures of design, not attributes of information.

"What Should I Tell Them?" by Bo

I don't watch TV, haven t read a newspaper in three decades, nor listened to a radio in 20 years. I appreciate but don't read most your emails but disseminate them as from reputable sources. Think of me as your Email Buddha. My source of news is closer to America's heartbeat, in the Blythe, California, Carl's Junior and Subway. This redneck throwaway town from a century ago is skirted by Interstate-10. It's a gasoline and food oasis. Every evening I tune to a hundred mouths a couple seconds with a book in front of my nose. The two fast-food managers are ex-students who let me read well past mop time after the lobbies shut. He's in here cuz he's my daddy an' you ain't! screamed the black female manager through the Carl's window at a wanta-eater after lockdown a week ago.

Students wander in and out of the joints before closing and are resources too. Last night, I shifted focus among a veggie sandwich, Willeford's "Something about a Soldier," and a knot of youth chattering babies and money. That's life locally, and worldwide, isn't it? My jaw dropped as the news swept from reproduction to taxes.

Kids have babies to rake money; in some cases it's a priority over sexual pleasure. A new baby , the pregnant Subway hand beamed, opens a state dole and rent decreases. Mothers nearly all feed the county provided formula mixed with nasty city water that their breasts remain attractive through old age. The newborns through legal age are swapped around the neighborhoods during tax time. Double heads-of-house-hold within one home are claimed on IRS forms for a lower tax bracket. Kids are also loaned out as dependents among parents at tax time. Last night two deals were struck to sell the names of children for $1000 each to childless families that will save them $2500 each. Only kids sans SSN's are worth anything. The IRS tracks numbers but not names.

How's your credit? Monthly statements are sponged from mail boxes in the right neighborhoods to obtain card numbers. It happened to me a while back when a phantom ran up $900 on feminine products. Illegal documents are the most pervasive. Blythe is a Mecca but apparently there's a nationwide diffusion of illegal aliens. My better students will tell you where to get a driver's license fabricated. With that, the passport comes easy. It's gettin' to be a problem, someone drawled, cuz you gotta start with a SSN. Dipsh#ts by the thousands are getting jobs with new IDs, an about the same number of dumb asses are prosecuted by the IRS for nonpayment of taxes. Someone worried the IRS may fold that the country may survive.

What should I tell them? Anyone who's owned a white mice ranch and formicary knows the effect of overpopulation and crowding. That's my take on the state of the world from Carl's Junior and Subway.

In Honor of Bo, from Steve Wisdom

I couldn't help but think of our great friend and mentor Doc Bo when I heard
this wonderful hobo song on the radio this morning :

Big Rock Candy Mountains (3 meg)
Harry McClintock, from O Brother, Where Art Thou? © 2000 Lost Highway

One evening as the sun went down
And the jungle fires were burning,
Down the track came a hobo hiking,
And he said, "Boys, I'm not turning
I'm headed for a land that's far away
Besides the crystal fountains
So come with me, we'll go and see
The Big Rock Candy Mountains

In the Big Rock Candy Mountains,
There's a land that's fair and bright,
Where the handouts grow on bushes
And you sleep out every night.
Where the boxcars all are empty
And the sun shines every day
And the birds and the bees
And the cigarette trees
The lemonade springs
Where the bluebird sings
In the Big Rock Candy Mountains.

In the Big Rock Candy Mountains
All the cops have wooden legs
And the bulldogs all have rubber teeth
And the hens lay soft-boiled eggs
The farmers' trees are full of fruit
And the barns are full of hay
Oh I'm bound to go
Where there ain't no snow
Where the rain don't fall
The winds don't blow
In the Big Rock Candy Mountains.

In the Big Rock Candy Mountains
You never change your socks
And the little streams of alcohol
Come trickling down the rocks
The brakemen have to tip their hats
And the railway bulls are blind
There's a lake of stew
And of whiskey too
You can paddle all around it
In a big canoe
In the Big Rock Candy Mountains

In the Big Rock Candy Mountains,
The jails are made of tin.
And you can walk right out again,
As soon as you are in.
There ain't no short-handled shovels,
No axes, saws nor picks,
I'm bound to stay
Where you sleep all day,
Where they hung the jerk
That invented work
In the Big Rock Candy Mountains.

I'll see you all this coming fall
In the Big Rock Candy Mountains

Doc Bo adds:

To be thought of as a part-time mentor is earthshaking. Big Rock Candy Mt. is legendary along the rails. Historically this poem among good bo's has enjoyed dual translation: the Big Rock Candy Mt. as hobo Shangri-La and as a phallus.

Meme of the Past: Meme of the Future, by Kim Zussman

After the 2003 bull stampede which followed quick victory in Iraq, 2004 started strong in January. The consensus was "good through the election", ostensibly an extension of the human tendency to postpone risk and pain. However if one sold at the election they would have missed out on most of 2004 gains in the form of post-election rally to the new year.

Then there was the small-stock version of the January effect meme, which we won't discuss. Next came end-of-January Iraq election worries. These fears are now revealed to be unfounded since unlike prior millennia, Shia, Sunnis and Kurds will live happily together now under democracy. It's easy to lose count of all the assumptions which prove wrong as future becomes past.

Beyond the objective statistical studies of price pattern behavior, is there alpha from positioning for what is not assumed to be risk? Qualitative and quantitative estimation of the current consensus to determine positions which are assumed to be true and bet against truth. This is a painful hike, however, since one is shorting rallies and buying sell-offs. Perhaps the analog of Soros's back-ache, the feeling that it is being done right, is chronic anxiety and upset with a Costco bottle of Tums. No wonder few do this well.

External Controls and Incentives, by Victor Niederhoffer

An interesting book, Wall Street and the Country, states: "Many organs of public opinion, even among those which have been credited with sound economic views, have been swept along upon a current of popular agitation favor of the extension of the power of the state in a manner radical in itself and far beyond any previous exercise of it sanctioned by American political ideals. The denunciation of the stock exchange, one of the most necessary functions of modern industry, and the abuse of large corporate insiders have become undiscriminating and extreme. These expressions have tendency to stimulate a degree of popular prejudice which militates against a dispassionate solution. There seems under present conditions to be too wide a chasm between men of action and men of thought."

The book is not reviewed on Amazon, perhaps because it was written in 1904, but the same situation is as true today as then.

Three things give stockholders protection. The main thing is competition. Everything has substitutes. An invaluable discussion of this is in Chapter 3 of "The Economic Way of Thinking," by Heyne, Boettke and Prychitko where they have a vivid discussion of the alternate uses of water showing its increasing inelasticity at very low levels of quantity demanded, but extraordinary elasticity as we change the way we mow our lawns, sweep the driveways, flush toilets, take showers and use washing machines as the price of water changes.

Companies, when they get fat and don't reduce costs to a minimum, tend to be eaten up by their rivals. Incentives come into play when they get deregulated or bought out by sharp operatives who have an eye to reducing costs. One-fifth of the Fortune 500 companies get taken over every 10 years. These external controls -- and the unrelenting competition from substitutes making demand curves for all our unregulated products highly elastic -- are our main protection. Knowledge of opportunities for increased competition provide the opportunity for profit. A beautiful case study of this is Cummins Engine, given in Chapter 11 of Pashigian, Price Theory and Applications. He shows the relentless fight that management put up to attempt to take the company over in the '80s using every legal and political trick in the book to ward off the Icahns of the world who wanted to use the resources more efficiently and make more profits for the stockholders. But in the 2000s it was to no avail; they had to perform, and their stock took off. The situation is repeated throughout the ensemble of public companies, past, present or potential, as they move from private to public or regulated or government owned to deregulated and the incentive system works its magic.

You might ask what the Hades does this have to do with practical investing, as many of our critics often do? Systematizing these forces, by ascertaining companies where incentives to perform or perish are coming into play a la Cummins Engine and CME, and many recently deregulated companies a la UPS, and ascertaining of commodities where substitutes are going to come into play, does lead to the main chance.

PowerPoint, by Professor Ross Miller

I am writing this as I take a break from completely redoing the PowerPoint slides that come with my derivatives textbook. They are truly sad in so many ways and typical of what academics think pass for acceptable slides. Tufte's examples of how PowerPoint stinks are drawn entirely from the academic and quasi-academic (government agency) worlds. Having once lived in a corporate culture where spending a week on a single PowerPoint slide was common practice (and mandatory if it was a slide that the CEO was going to see), I can tell you that there are people out there who can create PowerPoint presentation that put Tufte's examples to shame and rival (if not surpass) his own best graphics work.

The problem that I always have with PowerPoint was that concepts that could not be expressed graphically, simply did not exist. If anything, Tufte's work helps encourage the growing mass of illiterates in high places who can think only in pictures, not words. A picture may be worth a thousand words, but a thoughtful writer can compose a single sentence that even a thousand pictures cannot capture.

Ode to GOOG, by Yuri Skrilivetsky, Brooklyn, NY

Many bash in protest,
More they do, more progress,
More they do, more transgress,
Who buy, overplus possess,
Bears not impressed, earnings make them stressed.

The January Effect, by Victor Niederhoffer, Alex Castaldo and Steve Wisdom

Around January each year, a bunch of amiable idiots start transmitting data on the January barometer. If it looks like January is down, then all the chronic bears of the world and more pessimist followers of the "Abelprechtensteins" can be counted on rubbing their hands with glee to predict an imminent Dow of 5000. But of course when January is up, the whole year is likely to be up. And when January is down, the chances are reduced. And of course you can play with various starting points, indexes, changes in regime with lame ducks et al to make the numbers of rises and declines, look alluring, especially when you're dealing with a 8% a year drift and 0.6 chance of any month being up.

In any case, Doc Castaldo and Boss Wiz here respectively computed the theoretical correlations assuming randomness and compared it to actuality with the guaranteed to happen result of a bullseye at 29%. All other exercises will result in similar bullseyes consistent with multiple comparisons. When will these orgies of superstition go out of style? Never of course, because otherwise the public couldn't always be counted on to be on the wrong foot.

January Effect Cont. Part Whole Correlation, by Alex Castaldo

PWC is a dangerous fallacy which often affects people at this time of the year.

Suppose x is the amount by which the S&P rises in January and y is the amount by which it rises in the remaining 11 months of the year.  Then there will be a correlation between x and x+y, that is between January and the whole year.  And this will be "discovered" empirically and reported in newsletters and research reports.

Let us estimate this spurious correlation:

Corr(x, x+y) = Covar(x,x+y) / SQRT[ Var(x) Var(x+y) ]   /* by definition */

Assuming that x and y are not related, i.e. Covar(x,y) = 0 this reduces to

Var(x) / SQRT[ Var(x) (Var(x)+Var(y)) ]

If all months are equally volatile and serially independent, then the monthly variances add and so  Var(y) = 11 Var (x).  So we get

1 / SQRT[ 1 + 11 ] = 0.288675

So we expect a nearly 30% correlation even if January has no predictive value for the rest of the year.

January Effect--The Actual Numbers, by Steve Wisdom

An empirical check, SPX from 1970 till Feb-2004, with each month's log-change aligned with the log-change of the full year starting with that month. "As predicted" the correlation is 30%'ish.

Losing, by GM Nigel

This is an area in which I'm quite expert, much more so than the likes of amateurs such as Kasparov. Here are a few things I've found useful over the years:

a) Watch that you don't get punch drunk! A lot of players try and get 'revenge' for their defeat and play without much objectivity in the next game. Then one loss soon becomes three.

b) Try not to blame people or circumstances for the loss, or indeed be too hard on yourself. Sometimes we play OK and lose to a better player than ourselves. Find out what went wrong and make any needed adjustments.

c) Congratulate your opponent on playing a good game, whether it was a good game or not. Losing can be hard on the ego, so telling the guy that he played well helps to rebuild our own confidence. There's nothing worse than losing to an idiot, so make believe he was a genius on the day.

d) Don't hang around the tournament hall. Get the heck out of there and do something else.

e) Keep to your pre-game rituals and preparation, whether you've won or lost the previous day.

Strategy, by Victor Niederhoffer

I found an interesting discussion of strategy and the analysis of the value of indirection in war games based on writings from Chapter 20 of Liddell Hart's book "Strategy".

I came across it indirectly through my study of shuffleboard strategy but the principles seem so applicable that I remain flexible enough to transmit how they apply.

1. Adjust your ends to your means. Choose the markets, companies, risk and the position size that are appropriate for your own wealth and risk structure. Key question: "Are you trying to grind when the house has the edge?"

2. Keep your object always in mind. Do you really need to trade every day, trying to take advantage of every opportunity. What happens when you get contradictory signals. How about realizing that "just because an enemy held town lines between you and the finish doesn't mean that town is worth the time and cost of capturing". Perhaps save your men and money for another day?

3.Choose the line of least expectation. My goodness, we've all heard of the line of least resistance. But this is good. If your enemy is expecting you to be loaded up at 3 pm for example, as in the recent past, how about becoming active after he unloads. After all, some time he'll have to buy them back. "Where would you put your limited resources to meet the most likely advance. That's the point to focus on."

4. Exploit the line of least resistance. Aim at your your enemy's weak spot. That often occurs after they've utilized all their resources to force you into oblivion. Don't do more work than you need to.

5. Take a line of operations which offers alternative objectives. If you're going to get out at the close, like the mill run of day traders, you're a sitting duck with no alternatives. "if you have multiple objectives to choose from, you keep the enemy guessing.... but focus all your efforts along a single line but point that line so that it threatens several targets". Always plan your activities so that you're not dependent on a single strong hour, strong earnings report or single government announcement that you've been tipped about.

6. Ensure that plans and dispositions are flexible and adaptable. What will you do if your trade is not a success, if it goes against you and your mental stop is not in place. Oh my gosh, how would you react to a margin call, or a bear raid? "Be mindful that even if things go well for you against the enemy's weakness, they mite go badly on the flanks".

7. Do not throw your weight around when your enemy is on guard. Wait until the market mistress is demoralized. Or overconfident. Like on Friday, when the bears were relaxing in Davos, bashing America, not prepared for the inevitable triumphal profusion of the unquenchable spirit of freedom in Iraq. The 5 minutes around the Friday S&P close gave a nice 2% advantage against the chronics. "Confusion is cause d by cutting off the enemy's communications with headquarters" .

8.Don't renew an attack along the same line (or in the same form after it has once failed). The idea here is "hitting the same trade with the same punch that just failed is bound to fail because the enemy will likely send reinforcements up". But often the beaten favorite wins next time out. So I would modify this, to probe for where you think the enemy is weak. Like after they've given a ridiculous self serving reason to recall a drug and the stock has a nice drop and they're rubbing their hands in multiple comparison glee like yesterday in the big pharma fish.

Steve Winter, the author of these modifications of the application of Hart's strategy for war games et al is to be complimented for a nice analysis. He emphasizes at the conclusion the importance of sowing confusion, dislocation, and surprise in the enemy's field by planning what you're going to do in advance and after the battle. Perhaps market participants mite keep such a check list at hand before the market battle each day, updating it frequently for leads as to how to keep the market mistress on the wrong foot.

GM Nigel Davies adds:

One thing I've learned from playing and teaching chess is that the strategy only becomes significant once you're no longer bogged down by a lack of more elementary knowledge. It's not the game that counts but the mastery.

Dean Davis comments:

There is much to learn from the Colonel that counsels Generals, Basil Liddell Hart. You might benefit from an extended study of his life if that has not already occurred (Danchev wrote an interesting biography). While in Liddell Hart's case he had little that he originated, aggressive mechanized warfare had earlier British origins, he distilled it most perfectly and was its most visible proponent. He was an iconoclast whenever it was true to his vision and he felt he could press an advantage. He has many publications including his interview of captured German Generals after WWII's conclusion and a interesting historical review of Scipio Africanus (who was the Roman General that finally beat Hannibal).

LH offered many theories on warfare but his most famous was "the man in the dark". The darkness was the fog of war and I believe the idea was to find your opponent, fix him, and then attack from an unexpected angle. This tactic was seen in Scipio's attacking Spain and later Carthage and was utilized successfully by Napoleon in Italy so it was not totally fresh material.

I wonder what an appropriate analog would be for trading? Perhaps the unexpected angle might be alternating taking positions using cash, futures, or synthetic positions so that you leave different tracks in the snow each time you strike. Perhaps through such employ the odds that an adversary will be lying in wait will be reduced or delayed.

"Go" by George Zachar

After literally decades of procrastination, I finally sat down last night and started reading about the oriental board game of "Go". And what is the very first "go proverb"? "He Who Counts, Wins" (page 19)

Bonnie Lo adds:

About Go:

More representative of life and the market than any other game (in my humble opinion, of course) because there is one thing different - once a decision is made, it cannot be unmade. You can recover from a mistake, you can fall from strength, but the past is that - the past. The pieces you play and the decisions you make cannot be moved. Everything is black and white - win or loss.

And it is probability, as in the movie Pi - each space you fill means you drop the possible future number of moves. Future paths are lost while time goes by as you and your opposite act upon your decisions. A player can try to capture many small secure gains (many small eyes) or risk to capture larger, more difficult to defend territory - trying to keep the position alive - although that is the way to eventually win. There is also the handicap for less advanced players, like the rules for smaller investors. There are 'dead' stones as one finally realizes a position is lost. There are times in the game when a territory or point is played back and forth, and back and forth again generating movement but little net change.

And finally, it's all about capturing 'points'!

"Quote of the Day", offered by James Sogi

"Kulia i ka nu'u me ka ha'aha'a." Strive for the highest with humility. Wrote the teacher of the teacher of the hula halau (school). Humility implies reverence and gratitude. It is recognition of our place in creation, and the knowledge that everything, even the breath of life, is a gift that we did nothing to deserve...A dancer learns technique and responsibility. Beyond that, making mistakes is not as bad as not knowing or feeling. A teacher can always correct mistakes, but you cannot jump into someone's spirit. The hula spirit grows and blossoms at its own pace. It's the spirit that's important. The body and mind won't be well if the spirit is sick... Dance is only for a moment, but we can be in that moment of beauty and peace, and we can begin to express it every day in everything. From  "Hula is Life," by Ruth Ariyoshi.