Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner


Feb. 1-15, 2006


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The Origin of Species and Markets, by Victor Niederhoffer

I often turn to The Origin of Species by Darwin for insights into life, markets and science. I usually start with the last paragraph in the book, which most scientists consider, along with The Principia, one of the two most important and influential books on science ever written.

"It is interesting to contemplate an entangled bank, clothed with many plants of many kinds, with birds singing on the bushes, with various insects flitting about, and with worms crawling through the damp earth, and to reflect that these elaborately constructed forms, so different from each other, and dependent on each other in so complex a manner have all been produced by laws acting around us."

The laws that Darwin discovered are:

  1. The great variability of attributes of organisms in nature.
  2. A differential survival value for each of the attributes.
  3. A mechanism for transmission of the attribute.

Subsequent work showed the causes of the variabilities and how they were transmitted.

I have written a book, The Education of a Speculator, about the the tangled market bank, clothed with players of ephemeral and and information-based qualities, with the media and the analysts and the promoters singing, and the market makers crawling about breaking up and consuming much of the public's overplus through the execution process. And I have reflected that the elaborate differentiation between the public, dealers, hedge funds and market makers, all trying to profit, creates markets that move in interdependent ways leading to many highly complex and ever-changing relations and price patterns produced by the attempts to make a living by these feeders.

Dawkins, in the Selfish Gene, applied these concepts to the transmission of ideas and activities that transmit the culture of a society. A nice effort to relate these ideas to the transmission of ideas like how P/E affects prices and the uses of technical analysis by major players is contained in Joshua Frank's his article "Applied Memetics to Financial Markets: Do markets evolve towards Efficiency?" in The Journal of Memetics, a very fruitful and intriguing publication that discussions memes in such fields as linguistics, music, mental illness, animal behavior, taboos, suicides, religions, bird song, irrational behavior and chess moves.

I always end my rereading of the Origin by reading, preferably out loud, the conclusion of Chapter 3, "The Struggle For Existence," on the difficulties that we face in dealing with markets, facing competition from so many others of great merit and competence:

All that we can do is to keep steadily in mind that each organic being is striving to increase at a geometrical ratio, that each at some period of its life, during some seasons of the year, during each generation or at intervals has to struggle for life, and to suffer great destruction. When we reflect on this struggle, we may console ourselves with the full belief that the war of nature is not incessant, that no fear is felt, that death is generally prompt, and that the vigorous, the healthy and the happy survive and multiply."

I believe this consoling thought is a good place to throw the discussion open for classification, quantification, prediction and the formulation of good questions by readers.

P.S. To provide a Adam Smithian incentive for readers to augment the above discussion, an anonymous donor has agreed to disseminate $1,000 above and beyond any other prizes to the being that reduces our ignorance in this field the most.

Steve Ellison offers:

The "declining dollar" meme has surprising longevity and resonance. One of the leading websites for free futures quotes runs an advertisement saying, "Currency Crash! Is the dollar fall precipitating inflation?"

I looked up the prices of a few currencies and compared them to the year-ago prices:

           Price     Price
        2/14/2005 2/14/2006  Change
Yen        0.9526    0.8544  -10.3%
Euro       1.2966    1.1930   -8.0%
Pound      1.8856    1.7357   -7.9%

Some crash! The declining dollar meme is so deeply ingrained in the collective consciousness that a full year of facts to the contrary in the form of market price action has done little to change perceptions. Advertisers who carefully craft their appeals to trigger the desired responses still believe that touting the "declining dollar" will bring in business -- and it probably will.

A thought from Sushil Kedia:

The arrival of markets, the arrival of exchange markets perhaps 5,000 years later and the development of meticulous record-keeping in exchange markets 100 years after that, and reflexive markets 50 years subsequent, is not just a story of evolution of the markets, but a very important substream of the evolution of "evolution."

Speaking of struggles, the worst and the deadliest struggle is the one that is unleashed within a specific species. The most dangerous, the most prolific, the most portentous of all wars that the most evolved species, i.e., we the humans, could have seen was the Cold War turning Hot. However, with the mindnumbing dumping of gigatons of aluminum, petroleum, phosphorous (name a commodity) in the global marketplace at discount for years led finally to the overnight crumbling of the Red Flag. For a moment, please evaluate if such an ongoing sequence of market-originated and market-based blitzkrieg, even if at the centre of which was a very rich man who obtained a historically quizzical pardon, was productive in saving evolution from unbelievable collateral damage and near annihilation.

Could he not be seen as an unsung hero who saved the "world" from regressing a few hundred years if not thousands of years in development? Destruction, even if creative, is destruction; the point well made well in the Shakespearean creativity of "She stooped to conquer" a couple of centuries ago. But then, isn't that anything more than drama? Antibiotics being known widely as such an advance in health care make us forget most of the time that our intestines do need to have some bacteria which do us good as well!

Now at such a point in the story of evolution, if markets seen as significant vehicles of evolution is clearly a thought beyond the bounds of absurdity, drawing applicable inferences from the story of evolution to improve understanding of markets is agreeably a high point of reflexive thinking.

The Chair's announcement of an additional reward of $1,000 USD just geometrically raises my desire to pinch the balloon of a thought process that the wisest man speaks last hoping an immediate bout of bashing getting triggered will prevent the wiser from speaking last.

Maybe the intensity of this thread will make the Chair allow multiple postings, addendums, errata et. al. to ensure the survival of the fittest.

Joe Hughes says:

Do markets evolve toward efficiency?  When left to the customers alone, yes. Markets will move towards efficiency and liquidity.

The most jammed-up bid/ask spreads and general liquidity problems seem to occur where there is a market maker or specialist involved. Generally it seems that they hold the bid/ask spread so wide, it prohibits the speculator working in the middle. I have seen bids blocked, continually sized out. I have seen this in most screen-quoted markets, stocks, options; from high-priced stocks to securities quoted in thousandths. This practice aside, I would have to agree that markets do evolve to efficiency, and only when manipulated by man does their growth stunt.

Gary Rogan adds:

What is often missed is that while biological evolution is based upon propagating one's genes over a very long, from the evolutionary perspective, period of time (if numerous individuals who share the same genetic makeup do not propagate they will disappear as a group thus will lose in this game) the markets evolve on a much faster scale and without any genetic code. This distinction fundamentally changes the game in the following sense: while the best adaptation using randomly selected mutations is what happens in nature, optimizing the subconscious desires of all the participants is what happens in the market to the extent that the participants do not run out of capital.

The behavior of the market, of course, influences the subconscious desires of the participants in a reflexive way near and dear to Palindrome, thus overvaluation bubbles will continue to evolve towards bigger bubbles because:

(a) nobody is running out of capital; and

(b) the subconscious desires of most participants are positively influenced towards lack of fear and overabundance of greed.

Since increasing one's capital is NOT the only thing that increases the overall satisfaction, "animal spirits" of a large portion of the participants will play a bigger and bigger role. This is obviously highly non-profound and almost self-evident, yet many economists continue talking about optimizing economic performance. At any one point, asking oneself,  "What would optimize the overall satisfaction given the zeitgeist and the latest information widely available to all the participants?" is useful in order to "guess" the direction of the market. There is private information available to most of the participants that cannot be easily discovered by any one participant, and it will also make itself felt, but since it's essentially unknowable it's also not useful in guessing the direction of the market. Periodically, given unpredictable external events and well-known dynamics of bubble puncture, the zeitgeist will change. Re-asking the same question about increasing the overall satisfaction at that time will also prove useful.

Jim Sogi comments:

The market is an experimental world in a bottle, modeled on the real world, with fixed rules. Activities are carefully recorded and plotted. Inputs are transmitted from outside actors, and effect changes within. Unlike the elusive and enigmatic meaning of life, the purpose of the market is readily understood: to provide capital to the productive ends of mankind.

Just as the struggle of the individual for existence is the mechanism in evolution for the advancement of the species, the quest for profit is the mechanism for providing capital for productive enterprise. In the market and in evolution, both loss and gain at the individual level is the gain of the organization. The dichotomy is that the needs of the individual differ from the needs of the organization, but in the end the organization is supported even in the failure of individual need.

This dichotomy is illustrated in other systems. The adversarial structure of the legal system pitting parties against each other, which while creating strife and struggle for the individual, brings out the best result from the competition. The mouse about to be eaten by the lion does not say, "Ah, I sacrifice myself gladly for the good of the whole." The losing litigant does not say, "I sacrifice myself for the good of the system." The trader does not say, "I give up my profit and capital for the good of the system." In each case, the individual viewpoint and the system view differ, but the system serves a higher function. Viewing occurrences from the system level works better in marriage and in legal matters. This key dichotomy can be applied profitably to the markets.

Darwin theorized, "If under changed conditions of life, structure, before useful, becomes less useful, its diminution will be favored, for it will profit the individual not to have its nutriment wasted in building up useless structure. Thus I believe natural selection will tend in the long run to reduce a part of the organization, as soon as it becomes, through changed habit, superfluous, without by any means causing some other part to be largely developed in a corresponding degree. And conversely, that natural selection may perfectly well succeed in largely developing an organ without requiring as necessary compensation the reduction of some adjoining part."

Through these processes, the whole improves and survives, though a trail of individual tears follows. Look at the system's purpose to maximize transferal of capital, maximize liquidity for the maximum productive use rather than focusing on individual needs. The idea that "I am what I am, and do what I can" leads to extinction or diminution. As conditions of life; change, adapt, learn new things, change. The system is not there to reward the individual, it is there to maximize its transferal of capital. For the reason Darwin theorized, each system has a life cycle that fits some curve. Two weeks ago the markets closed down for the week, this week the closes were up. The systems that worked last week don't work this week. Are you going to be the dinosaur or the crocodile? See your place in the firmament. The trader inside the market system can transcend the evolutionary forces by seeing above the individual transaction.

A Word, or Two, from the President of The Old Speculator's Club:

For those who enjoy parallels between "descent with modification" and the market, let's start with this fact: over 99% of all species that have ever existed are now extinct. If you are married to the Darwin/ Dow analogy, this could prove troublesome. But let's assume you can remain solvent until the lottery of life calls your number. In that scenario, Darwin provides some insights that can enhance and, perhaps, lengthen your survival. Especially if we appreciate that there is a critical difference between our standing in nature and in the market. In the former, we are participants whether we like it or not and it's an irrevocable "until death do us part." In the latter, we are there willfully and may withdraw at any time.

It's an important difference since it affords us the opportunity to choose to play and, if so, to choose our "biosphere". The sea, like the entangled bank, offers abundant life forms; but the system is an extraordinarily complex (and extraordinarily dangerous) ecosystem. Of course, the greater abundance offers greater potential rewards. If the sea were our chosen milieu, most would prefer to be a shark and a demented handful would opt for the angelfish. However, neither birth nor the market is fair, and we must play with the chips we have accumulated. With that in mind, and cognizant that the market is no less cruel than the sea does the angelfish choose to sup with the sharks? Incredibly, yes.

The day trading coral atoll is notoriously lethal but as long as movies are made and books are written glamorizing the pursuit and making it appear simple, fresh fish will keep the sharks well fed. The option reflection pool is another popular starting point for many of those who have read, and believed, any one of several hundred newsletter writers claiming expertise in this field. Few people are put off by the prospect of modest profit or the promise of a good meal at a reasonable price. More desirable is Archimedes Lever and the potential for a huge profit and a free banquet. Major brokerages promise to keep the initiate safe and comfy in their highly capitalized, well-protected, deep-water grotto.

Unfortunately, our angelfish aren't aware that they're represented by the anglerfish. Found only at the deepest, darkest depths, the female anglerfish possesses a huge mouth and an expandable stomach; not surprisingly it can consume a fish as large as itself. The male anglerfish, only 1/10th the size of the female, lives its life attached to the female and totally dependent on it for food and safety. (However, because it requires oxygen just as much as many other organisms, but lives so far beneath the surface, the anglerfish has very thin skin - and must be handled with care.)

If any of these situations mimic real life, it might be time to reassess your investment approach. Nature and the market offer a large number of less abundant and less attractive niches. The dessert seemingly offers very few attractions; but, anyone who has ever seen Disney's "The Living Dessert" can attest, if you are patient and in the right place and the right time, the rewards can be breathtaking. Mountainsides and tundra are equally dreary - but the former occasionally lie atop tons of valuable minerals and the latter serves as a drab cover for oceans of gas and oil. Rarely, however, do these venues offer extraordinary rewards - more often, the rewards are in line with 7-10% expectations that have characterized the market for decades.

Can you beat the market? Why do you care? The key question is "How much do you need to survive and leave heirs?" Anything beyond that demonstrates an over-riding concern with what others think - that's easy:  They don't think about you, they're too concerned pondering what you think of them. Angelfish with greater appetites are forgetting one of nature's great truisms: for 99% of all existing creatures, every day is a battle to get just enough food and proper shelter to get through until the following day. In nature obesity is a chimera, vacations non-existent, and sympathy non-productive.

Like the lowly and vulnerable angelfish, investors should content themselves with modest expectations and a limited field of interests. One might argue that even a few fields is too many and one is more than sufficient. Maybe, maybe not. With a 99% fatality rate, is it not more than likely too many species became too specialized - and subsequently, when the sharks moved in, were unable to adapt to a different diet? The secret here is "preadaptation". Though relatively comfortable and protected in their current environment, our angelfish (according to Ridley) spend some of their spare time bouncing across the muddy bottom with their lower fins. One of these days they may have to hop along the mud flats as Jaws closes in.

But few of these niches (and water, by the way, is a very nice niche) offer huge short term returns. And this is contrary to Joshua Franks' observation that "there is much more desire to make large gains quickly than to invest for the long-term." Therefore, and you're given this freely, you must invest for the long-term and your expectations must be modest; with the miracle of compounding even modesty can achieve an immodest stature.

For those few who heed the word, expect to be lectured repeatedly on "opportunity costs". Individuals who embrace the opportunity-cost argument, dream of a mythical world where all of one's capital is always invested at a rate of maximum return. Some worry about "dead money". Better they should worry about no money. If they're insistent, demand to know precisely where you should place your money and for how long it should remain. Mark it down and compare 10-20 years later.

Never forget that the success of any given market area is a function of reproduction or, in Franks' terminology, "interpersonal reproduction (where the meme is transferred between individuals)". Call it news, call it gossip, call it a rumor, call it a lie - whatever it may be, it becomes so prevalent in every day discourse, that it becomes a "must own" or a "must short". But again harkening back to Franks, "a meme's interpersonal reproductive fitness may have nothing at all to do with its economic reproductive fitness." In short, the latest hot stock may be the biggest lemon on the market (can you say Lucent?).

Undoubtedly a few words should be expended on mutual funds. Nature provides similarities in both the predator (lions, wolves) and prey (zebra, buffalo) categories. Generally speaking, if you follow the rules (and they're not negotiable) you'll live a hard life hunting with the predators and, unless you're an alpha (and if you're thinking mutual funds, you're not), with only enough food to keep you healthy and no sex and no offspring. If you're prey, the rules are pretty much the same - the only solace to be found is in the large numbers. Unless you're very young, very old, or crippled, the odds overwhelmingly favor your survival should the herd come under attack. It may not seem like much of a life, but if it's a no-load fund you'll find contentment in starving the anglerfish.

Steve Ellison rejoins:

An excellent book on the application of evolution and other scientific principles to business is "The Power Laws of Business: The Science of Success" by Richard Koch. Below are a few key points from the book, with some thoughts on how we might classify or quantify them.

  1. The "struggle for existence" makes the few survivors stronger. The struggle is more intense at some times than others. Measures of competition might include the number of mutual funds, the number of hedge funds, and the prices of exchange seats.
  2. Variations in both organisms and environment result in fitter organisms and a richer ecosystem.
  3. Ed. Spec. likens the public to producers, dealers to herbivores, large speculators and hedge funds to carnivores, and locals and vulture investors to decomposers. Environments include bull markets, bear markets, trading ranges, recessions, recoveries, rising interest rates, and falling interest rates. Ed Spec classifies markets into open and closed markets. Competition is an important part of the environment. Questions to ask might be:
  4. As complexity increases, niches increase. Lawrence Harris identifies several types of information advantage: order flow, non-randomness of price movement, value analysis, and news. What niches within these categories are opening?
  5. Reproduction is as at least as important as survival. However, most offspring will not survive. New market players might be classified into new mutual funds, new day traders, new brokers, and new 401K investors. The nature and level of sales of market best-sellers would provide clues to what market memes are reproducing fastest.

Sushil Kedia adds:

With all the due respect to the President of the Old Speculators' Club, a few queries emanate from his observations:

Is our standing in nature and in the markets really very different? Not having a position at points of time is different from not being in the market. I mean ,is a market pro ever really out of the market? Likewise, until death do us part, people do withdraw from the zig of life, either to escape to temporary temporal leisure or withdraw inwards. What happens if a withdrawn anxious or depressed soul refuses to brush his teeth twice daily, ignores the required exercises or ignores keeping regular track of expenses? Please correct my belief that a career in markets or for that matter any career and the targeted quality of life existence are both like riding a tiger, which you would rather never dismount from. Taking a respite in not kicking the tiger to run faster is different maybe.

From the focus of the evolutionary perspectives even those who do not engage in a specific market could be highly impacted by unknown or untracked markets. A cricket player who may not be participating in legal or illegal betting syndicates could very well be part of a losing side even while setting up a world record shattering performance in a particular match. A Red Indian never interested in the global spice trade could very well have come in touch with Columbus who had set out to find a sea-route to India.

It is an interconnected world where economics and markets are facilitations for improvising interdependence.

Now if markets are about interdependence and have grown to a point of being highly reflexive, causing events to happen or not happen which have in the previous 5000 years of economic history have been seen as driving the markets, one arrives at an angle to think closely about whether markets evolve to efficiency?

In answering the central question of this thread, one starts and stops soon in asking which efficiency are we concerned with? The type of efficiency defined in the earlier models of Financial Theory or what it is actually supposed to be? If markets are adapting constantly, continuously and perpetually then they are not efficient yet but moving towards efficiency, right? Well no, since the purpose of markets is to enable us to collectively as a race move towards more efficient adaptation. Well then markets are already efficient since they are achieving their purpose. The mechanisms of the market-place evolving each moment further is then nothing but the evolution of markets. The question is similar to asking if we as a race are evolving towards better efficiency? It indeed is different from asking whether markets are evolving efficiently?

There is one serious difference though between the evolution of life and the evolution of markets or arriving at an understanding of the propagation of markets through the evolutionary framework of memes. In nature there is no periodically appointed regulator, who is often limited in its role by the compulsion to be politically correct, while in markets there is. In markets however much of a strong shade of freeness there may be, the purpose of the regulator is to ensure a fair game and a level playing field. In life, nature is assumed to be fair and winning is the only option to level with the field. In markets the process of 'natural selection' has to be modified with suitable quantification, if and when possible, of the (ir)rationality of regulatory action. Now, if it could be answered unambiguously whether the purpose of markets is to allocate capital and risk adjusted returns on such capital efficiently, but not ensure that the trusting will be protected from the cynical, then the markets are trying to move to efficiency. However, if the purpose of markets is focused on a fair way of allocation of matching returns for risks they are obviously efficient since they are mutating forward further, and propagating.

I think that with such a wide bandwidth chewed up already, I have still not been able to get anywhere close to the central question: Are market memes leading the markets to be more efficient? Markets, as one has tried establishing in my earlier paragraphs, are already efficient. The compression of returns, the reduction in size of the percentage moves we are able to capture in the major markets in the world today has not taken any of those markets closer to efficiency; it is just a variation in the game. When the crowds lurched into finding bigger fish the better hunters shifted game to newer shores, and while the crowd keeps hurting itself becoming small fish itself, the better hunters are happy catching these smaller fish.

To pause and organise my thoughts further, I submit for the moment two more question:

Is nature evolving to efficiency? The answer is no, since it is already efficiently facilitating evolution. So the question is, do markets sound similar to what nature is doing?

Because (al)most whatever we humans have been accomplishing in our contribution to the pathways of evolution is drawing upon our ability to observe, gain perspectives on and respond to the challenges of the natural environment we operate in, are markets not a human response mechanisms to the vagaries of nature? No, this question does not derive motivation from noticing the growing market in weather futures or carbon credit alone. The entire chronicle of every invention and every discovery is a creative replication of our observations of the prevalent phenomena in nature. So, the second question is, are markets not a reflection in our observing minds of the picture of evolution we see in nature?

Vinh Tu adds:

The market is distinct from the state of nature because the market embodies certain rules and ideals. We can forget this when we think of the market as a Darwinian struggle for survival. Mr. Sogi points out, however, that the purpose of the market is to produce wealth and transfer resources. I'd like to expand on that theme, and contribute my own ruminations.

The market depends on certain conventions such as respect of private property and respect for contracts. We sometimes speak of "levelers" who seek to bring down those who generate value and possess value and sometimes are tempted to think of them as strange unnatural beings driven by warped beliefs. Yet the "leveling" drive is also present in the realm of international relations, where it is sometimes called "balance of power", and involves ganging up to attack the strongest. I would not be surprised if similar behaviour could be found in monkey tribes. Therefore, it may be better to regard the leveling drive as not some aberration of nature, but simply as a primitive tendency that must be taken into account and managed if one wishes to build towards something higher than a jungle free-for-all. The more noble force which enables us to overcome the levellers is the convention of reciprocal respect for our fellow man's labours and accomplishments. Respect for private property enables trade, and trade creates markets, and this enables the mistress of the market to come to life. In one sense, then, it is possible for a person to withdraw from the market. Playing the market game means respecting people's private property, and attempting to acquire property for oneself by following the rules of trade. It is fierce competition, but competition in accordance with certain beliefs regarding fairness and regarding the betterment of oneself and one's position and the right of others to better themselves and their position. One could refuse to play the game, for example, by violating the rules of the markets, by expropriating companies, and by inciting and unleashing the levelling desires in the population.

What distinguishes the market from collectivism is that although market participants must share certain values such as the pursuit of good things, and the right to enjoy the fruits of one's accomplishments, participants agree to disagree as to the specifics of how to carry out this pursuit. This area of disagreement provides the battleground for ideas. This is the entangled bank. One might be tempted to look at individual people, traders, as the elements acted upon by natural selection. However, I prefer to think of the memes that occupy the traders minds. Some minds provide a permanent home for bearish memes. Others may only provide a temporary resting space, and pain in the back of this trader is enough to eject the present meme in favour of the next. One thinks next of the pathways, or vectors, along which these memes travel: news, tv, analysis, reports. Each provide varying amounts of bandwidth. Then there's price. Price can be considered either a meme in its own right, or a message that conveys a portion of a meme. A meme (such as Hubbert's peak) cannot be conveyed by price alone. On the other hand, the memes can be supported or undermined by price action. Rising oil prices give vigor to the Hubbert's peak meme. Falling prices damages the meme's ability to spread or survive. The general population can hang onto some memes despite price movements (and so we have the websites that continue to proclaim the falling dollar.) However, for entrepreneurs and speculators, price is one of the sharpest knives for cutting away a meme. When the selling price of a product drops below the cost of inputs, the businessman is forced to abandon the meme despite what protestations other sources of "information" may trumpet. While a speculator may not change his ideas in response to a particular price movement, he will notice it nonetheless. As a channel of information, it is ubiquitous.

The query, then, is not only whether memes lead the market to efficiency, but whether the reverse might be true, that the market leads to more efficient memes. As we are all allowed to have our own ideas, we have a rich ecosystem of memes. The memes proliferate through the media, personal communications, government publications, and so forth. Contradictory memes can fight it out in debates or can compete for mindshare and eyeballs. One particularly useful tool for culling memes, though, is the law of one price. When the law of one price holds, when one has liquid and efficient markets, then memes associated with high-price cannot easily coexist with memes associated with low-price (except in a minority of specially configured perma-minds). Various meme-complexes relating to various prices must sort themselves out. In a sense, the law of one price acts on memes in a similar way to the philosophical Principle of Non-Contradiction. Self-inconsistent belief systems become undermined. Insofar as several internally consistent outcomes are sometimes possible, reflexive effects arise and perceptions cause one outcome to dominate the others. The result of the culling process is that fewer memes survive, but these are now more compatible with one another than previously.

Direct culling affects the business-plan memes that are rendered unprofitable. "Now, you say, this is simply standard econ--we need not be talking about memes." However, I want to talk about memes, and I will. Now, surrounding each business plan we have the related meme complex: memes about strategy, trends, society, paradigm shifts, etc. A new price level can decimate whole meme complexes while speeding the growth of whole new meme complexes.

And so, I picture the mistress of the market constantly using her mesh of moving prices to cull some memes and promote others, while generating energy from order flow and commercial activity.

Regarding speculators, I suppose the meme model supports trend following, since a continued move strengthens the meme. However, memes don't exist in a vacuum, nor do prices. Actual producers and consumers force prices to fit the constraints of the real physical world. So we learn what we already knew: that trends continue until they don't. Furthermore, as a trend develops, a whole meme complex may develop--any one of which should sooner of later run up against reality.

Regarding a different aspect of this debate, the question of whether we (or our memes) serve the market or whether we are individuals in a pure Darwinian struggle could be examined as a debate between group selection and individual selection. From the vantage point of group selection, one remarks all the situations in which individuals sacrifice themselves for the sake of the group, where traits can spread which benefit the group at the expense of the individual who posseses that trait. We can think of those who buy at the top, or who build excess fiberoptic capacity and then fade away. Or, in terms of memes, we can think of well-formulated scientific theories with clear, falsifiable hypotheses. Group selection theory proposes to explain these in terms of the benefit to the group: i.e. the group that contains these elements will dominate the group that lacks them. On the other hand, individual selection theory seeks to show why the trait is in fact a selfish trait, and why it is in fact well-suited to making copies of itself. For instance, the trend-following meme's fitness could depend on it being easy to learn and promote, and the commissions generated by it, as well as atavistic copying and herding tendencies. To be a good meme, a scientific theory needs to be falsifiable otherwise it is rejected by scientists and cannot propagate itself through the many channels available to scientific theories.

For related books, I like Dawkin's Extended Phenotype, which explores the way in which genes, and complexes of many genes, interact and produce long-range effects. There are extremely interesting examples, including genes inside parasites which influence the behaviour of the victim... in such a way as to help spread those genes, of course. Really, I think individual selection's got it all. Not that I dismiss everything about Edward O. Wilson's sociobiology. There is a good case for group selection existing. Only, I think group selection can really be reduced to individual selection. And I mean that in the same way chemistry can be reduced to physics. A fun book is Howard Bloom's Global Brain, which contains some interesting ideas and many great examples of group dynamics and complex systems; unfortunately I find that the main thesis of the book is to attack a straw man version of the individual selection theory. In fact, the selfish gene theory encompasses extended phenotypes and complex systems.

But let's return to the levelers, and the mistress. A group selection theorist might say that market participants might sacrifice themselves to protect the mistress against external threats. An individual selection theorist might say that the participants behave in a way that maximizes their fitness, and in the process of ensuring their own survival, help the market to survive. Both theories are correct, or rather, the individual selection theory is the correct general theory and the group selection theory is the applicable special case.

If one looks at the market as an organism, it must have a defense mechanism against the levelers, which endanger the market through rule violations. Being a meme, the market gets its "energy" from the belief people have in it. When people are made happy by the market, the market gains energy. When people profit by the market, the market gains energy. And when people take a loss gracefully and attempt to better themselves, the market does not lose energy, but rather gains energy later when those same people come back as better traders. We look at the market and see first the sharks, the angelfish, etc. In addition, there are the photosynthesizers, the algae and the phytoplankton: these are the hamburgers and widgets. Every time a widget is made, or a hamburger is eaten, the market gains energy. A meme that undermines the root source of the market's energy is therefore one that is harmful to the market. One such harmful meme is the one that says one has a right to any hamburger or widget, regardless of who has made it, how it was made, and the conditions necessary to ensure the ongoing production of goods.

I wonder whether it is a reasonable hypothesis that the mistress of the markets is an organism equipped with self-preservation instincts. She's done well so far. Markets have emerged many times in many places throughout history, each time stronger. Perhaps she's evolving. If so, one has to believe in her having the means to defend against her enemies. Yet it seems strange to say the market is evolving, since evolution presupposes units that can be subjected to natural selection. Are there a many mistresses of the market constantly struggling and dying and multiplying? In the form of parallel memes, parallel market mistresses, parallel sets of market-oriented values and conventions, constantly being born and dying in the consciousness of each and every participant? But these thoughts now seem to lead me back to mythology, and to Utgard.

Reviews of the Day, from Ryan Carlson

I feel a bit guilty to come out of posting hibernation to offer a negative review of a book w/out offering some positive reviews. Perhaps of interest then:

I came across a couple of vanity books that the CBOT and NYMEX put out years ago to celebrate their 150th and 125th anniversaries respectively. Both are beautiful glossy books that delve into the founding of the exchanges, development of contracts and offer some war stories along the way. The CBOT book, Market Maker: A Sesquicentennial Look at the Chicago Board of Trade was written in 1998 by William Falloon who also did an excellent job writing Charlie D  The NYMEX book, "Trading Through Time" isn't as deep as the CBOT book but is worth picking up for anyone with an interest in the history of futures trading. Both should be able to be found on some used book websites for $20-50 but availability is limited.

"A State of Mind" is a DVD that was released in the US last week  that chronicles the preparation of two girls for the Mass Games in North Korea. The BBC camera crew was able to follow the girls around to school (where they're indoctrinated w/anti-American teachings), at home, during their training and then to the performance. Although the girls certainly come from model Communist families, it's probably the closest Westerners could come to understanding the North Korean psyche. Netflix stocks it for the easiest access.

On to activities. Anyone who watches Olympic skeleton this Friday and wants to do it should head for a half day intro at the '02 Olympic track in Park City, UT (or Lake Placid, NY).  I went for it last weekend and found it to be ultra safe, enjoyable and addictive! Skeleton season is closing in a week or two however.

Climbing Devils' Tower is a great way to relieve stress or shall I say, overwhelm previous stress with the kind that comes from scaling the Tower. Anyone in reasonable shape can do the climb but I wouldn't say it's easy. My climb last fall was the first climb of anything and the most dangerous part is the car drive to the Tower (which in itself it very safe, hence the irony).  showed me how to ice climb recently in a beginners 101 course which I'll also suggest as a good way to burn a weekend in Colorado.

January 2006 Letter and Contribution Awards

Readership of Daily Speculations, measured both by visits and page views, set records in January. Along with the surge in attention came many noteworthy contributions and letters to the editor. A few highlights:

  1. U. Maryland sophomore Henry Magram on Thoreau's market observations.
  2. Brief and elegant: Steve Leslie of Melbourne, Fla., on the circumspection of old gamblers; G.M. Nigel Davies responds to a fellow Spec's question on how many balls to juggle.
  3. Mike Good's correction to our piece on crocodiles was such a pleasure to read that it took away the sting, while the Las Vegas Whale's extension of the subject to long-short and equity-neutral funds made us shake for the folks on the other side of his trades. The Whale also weighed Byron Wien's list of predicted New Year's "surprises" in the scales and found it wanting, and shared his own forecast for 2006.
  4. "Top 10 Daytrading Lies" by Craig Maccagno and James Lackey, augmented by Nathan Stewart, set off so many bells that we thought it was noon.
  5. Rod Fitzsimmons Frey's first-hand account on riding the public bus in Madagascar; the last line applies to markets as well as jungles.
  6. The modest self-styled Assistant Webmaster Steve Wisdom set the standard, as usual, with a Friday the 13th counting piece, ending with an explanation of why he does not write almanacs. Dr. Kim Zussman also continues to generously post distinguished countings.
  7. Jim Sogi of Hilo, Hawaii, a regular and honored contributor, started a Galtonian exchange on private jets, "The Friendly Skies," among George Zachar, the Las Vegas Whale, and the Assistant Webmaster.
  8. The exchange among J.T. Holley, John Lamberg and Kim Zussman on parent participation in the Pinewood Derby and classroom science experiments is a Daily Spec classic.
  9. Russell Sears' post "Tying Your Shoelaces" was a standout and a meal for a lifetime.

The material on this Web site is provided free by us and our readers. Because incentives work, each month we reward the best contribution or letter to the editor with $1,000 to encourage good thinking about the market and augment the mutual benefits of participating in the Daily Speculations forum. Prizes are awarded at the end of each month by the Chair and the Collab. This month, we award the $1,000 prize to Russell Sears for "Tying Your Shoelaces" and $250 to each of the honorable others mentioned above. -- Victor Niederhoffer and Laurel Kenner

Winning January 2006 Posts in Full

Query: Can you learn programming after Forty? Dr. Castaldo and others respond

Rookie Pilots, by Andrew Moe

Love was in the air as overflowing baskets of couples took to the skies for hot air balloon rides over San Diego on Valentine's Day. It is not uncommon to see 3 or 4 of them dancing in the onshore currents, but today several dozen jostled for space. The sky was full of rookies.

Of course, you have to make hay when the sun shines. Lots of businesses deal with seasonal crushes. My local flower stand was kind enough to hire half the local high school to parcel out $59/dozen roses from the back of a semi. But the sky is different, especially when Mother Nature flashes her whimsical smile.

The Santa Ana winds that had kept us in the 70's all week receded quickly this morning and brought an early marine layer in, drawing the low flying air from the ocean over the hot, dry land. As the sun set, clouds quickly scraped just above the land, teasing a soft mist over the dust.

When flying a balloon over the coast, winds blowing inland are good so anyone with a license and a few passengers set sail. Naturally, many of the rookies tried to stay below the cloud level for safety and ended up getting sucked inland faster than freeway traffic. They were forced to land at the base of the mountains within minutes.

But every now and again you could peek through the clouds and see a balloon way up above, shining in the setting sun. The pros had shot straight up through muck to the warmer, calmer skies above and treated their passengers to a spectacular sunset in the fiery mists.

The rookies learned a lot today.

Learning To Weld, by Jason Schroeder

I am taking an introductory welding course. Parallels to trading are left silent.

  • Welding is solitary.
  • Welding is done in the protective dark. A steady hand must be trained while the eyes are shrouded.
  • One needs a routine oxygen break.
  • The wisdom of Metallurgy and Material Science are packaged into one novice instruction: control the puddle of molten metal.
  • With practice, an overhead weld, a vertical weld and a regular flat weld should look the same.
  • Not all metals glow when heated; simple observation will not predict failure. Aluminum just buckles when it gets too hot.
  • A weld may fuse but there is a desire for it to look pretty.
  • Some puddles are pushed, other puddles are dragged and yet other puddles can get away from you.
  • Henry Carstens suggests:

    Overhead welds are contra-trend trades, vertical welds are opening range breakouts and horizontal welds are scalping trades. Fortunately, as in trading, there are machines which will do all three, but the operator still has to configure the machines correctly.

    From one whose welding days are long gone, but whose scars still remain...

    From the Archives: Casanova and the Speculators, by Victor Niederhoffer and Laurel Kenner

    [Editors' note: This column originally appeared on MSN MoneyCentral on Feb. 14, 2001. We resurrect it today as our Valentine to readers. While it contains some fictional elements, the counting is all business.--VN and LK]

    Thought for the Day: 10 Things Happy Couples Do, by Mark Goulston

    The Story of Thor, Utgard, and Bernanke, by Victor Niederhoffer

    The Norse myths are particularly rich in timeless folk wisdom that served the Scandinavians in dealing with the unknown and maintaining the feeding relations necessary for the survival of that rough, seafaring society. Thor was particularly revered by the Norse because of his power, symbolized by his hammer and belt, but was easy prey for deception. Such a deception was practiced by the Giant Utgard, who met Thor and Loki in the forest. Angered by Utgard's husbanding and the poor provisions that resulted from pooling food with him, Thor took his hammer and banged it on Utgard's head. Utgard asked if a leaf had fallen. Next the snoring angered Thor, and this time when he banged it, Utgard asked if an acorn had fallen on him. Finally, Thor dealt a blow with all his might, and Utgard only asked if the birds above in the tree might have been disrespectful. After further adventures where Thor mistakenly is tricked into trying to drain the ocean and move the earth, Utgard reveals that he had tricked Thor over and over. Thor had been hammering the wrong thing, a mountain, well after Utgard had disappeared.

    The myth might provide a lesson for Ben Bernanke. Never has there been such a decline in inflationary expectations in recent year. Let's look at the commodities once considered bellwethers of inflation because they were used by industry and consumers so extensively. Natural gas is down 50% over the past three months to $8 per million BTU, heating oil is down 45% at 1.38 per gallon at a 9 month low, gasoline is down some 50% over the past 3 months to $1.38 a gal, an 8 month low and crude oil is down 13% in the last month, breaking below $60 a barrel before closing at $60.10, about its average price for the last year. The Goldman Sachs Commodity Index futures is at 414 down some 86 points from the October levels, near a nine month low. Except for a brief dip from October 2001 to Dec 2001,which registered some 20% in the GSCI, these representative declines may be the greatest declines in inflationary expectations in history. No wonder the Dow broke 11000 today for the second time this year, and this time up up and away. Needless to say, this decline in inflationary expectations has not been noticed by those who would try to make the economy seem much worse than it is, so as to level and weaken. That's understandable, given the nature of things. But what's difficult to grasp is how people at the Fed could proudly be talking about continuing to knock all the inflation out of the economy with further interest increases. A lesson in Norse mythology would be good for the powers that be there. There's been far too much looking at the retrospective production statistics that was "Doc Greenspan's" specialty used as a guide to their actions in the past. But it's an ill wind that blows no good.

    Eventually, someone at the Fed will realize what every economics student and every trader knows - that the market looks forward and captures the balance of expected supply and demand in its price signals. At that time, the economy will be able to fight off the drag of all this retromingent thinking from the central bank planners, and it will not be long before anticipations of such activities and reflections will be registered in the always forward looking stock markets.

    Steve Ellison adds:

    Of the top 10 physical commodities by open interest, 5 are up and 5 are down so far in 2006, with the average year-to-date change being -3.3%. The bull case for the biggest gainer is that it is an energy substitute.

                   Price     Price
                12/30/2005 2/14/2006 Change
    Crude oil      61.90     59.57   -3.8%
    Corn          215.75    218.75    1.4%
    Natural gas   11.359     7.114  -37.4%
    Sugar          14.68     17.72   20.7%
    Gold           523.4     545.3    4.2%
    Wheat         339.25    347.25    2.4%
    Soybeans      613.50    583.25   -4.9%
    Live Cattle    95.05     89.10   -6.3%
    Soybean Oil    219.0     220.4    0.6%
    Heating Oil   179.13    161.00  -10.1%

    "To Tell You the Truth", James Lackey contributes to the Personal Development Department

    Briefly Speaking, by Victor Niederhoffer

    1. Vigilantes. Someone has to write about the stock market vigilantes and how the stock market's function now to find out what is good and bad in any politico-economic activity and then go up or down to show what the imbalances and ultimate impacts would be so that the activity can be vetted, signaled and adjusted. Such an occurrence always happens before Fed meetings, as the vigilantes send messages to the Fed as to what had better or better not be done. This messaging must have been behind the mayhem in commodities last week, and the moves up in interest rates. Second-handers and the media play a similar role in shaking out the weak longs and shorts from the market at times that are good for the top feeders.
    2. The surest thing that you can count on is that a business will knock its competitors. Thus, every search engine and every buyer of the same can be expected to be knocked by the old media. Every manager can expect to receive a thumbs down from those who do not follow his methods. Such badmouthing is one of the beauties of competition and is one of the reasons that it is the main force that gives the pitiless consumer what she wants. One of best things that a former owner of R#fco told me the last time I spoke with him 11 years ago was that he learned a great way to get very favorable treatment by the media. That was to become a very big advertiser with them. He was using that technique very effectively as of the mid '90s. Sic Transit Gloria.
    3. The Theory of Corporate Finance by Jean Tirole is, along with Triumph of the Optimists and Harris, one of the three best and most useful books written about investments. I will be reviewing it shortly.

    7 Common Roads to Disaster in the Stock Market, by Victor Niederhoffer

    It is good to know common mistakes that investors make when they decide to sell a stock, because each brings opportunities for profit. I will try to illustrate each mistake with current examples.

    A good framework to keep in mind is that while many ephemeral factors affect the value of firms, their value is based on a discounted value of an infinite stream of future earnings. Also good to keep in mind is that there is immense competition in all aspects of business. Whenever opportunities for above-average returns on capital emerge, other firms will attempt to enter the field or innovate with better products or lower prices, based on superior methods of production or distribution. Whenever the price of a good rises, consumers will tend to substitute another good that can provide superior utility per dollar of cost, starting with the least valuable uses of the good whose price rises.

    The balance between all these factors -- the innovativeness of the entrepreneurial spirit, the availability of capital and the incentive to make a profit -- has led to a situation where all over the world the return from investment in seasoned equities has averaged some 10% a year for the last 150 years. Any factors that lead to excessive selling based on ephemeral factors extraneous to these principles provide opportunity for profit.

    Seven Common Mistakes

    1. "Company X's P/E is too high." Because of retrospective biases, data mining, failure to properly date the announcement of earnings and note that good surprises tend to lead to higher prices, thereby making the lower p/e at the cutoff date before the announcement show inordinately high returns, throwing out of the study the low p/e's that go belly up, the tendency for negative reviews to be taken more seriously than positive reviews, the ease of remembering fallen stars, the failure to take account of interest rates, the ecological fallacy and numerous other biases described in PracSpec there is a line of thought that whenever a company sells at a high P/E, it is overvalued. A current version of that is a company like Google has a p/e of 40, but if any little thing doesn't go right, the stock will immediately fall to a P/E of 20, for a slightly better-than-average company, and when applied to the then disappointing earnings numbers , say 10% below expectation, a 50% drop will ensue. The fallacy here is to assume that the current value does not already reflect investors taking into account the possibility of competition and missed earnings estimates. The competition for a company with 50% profit margins and 50% return on capital is always going to be high. The question is how long will it take before that competition reduces the prospective rate of growth to a level that is standard for the economy. Notably absent from all the talk about the competition for Google is that in addition to a nice algorithm for determining which items people are most interested in when they search, the company also has a few hundred thousand computers wired together that provide the fruits of that search in a half-second or so. Also absent are the costs of gaining information, the tendency of consumers and advertisers to purchase from companies they trust, the cost of switching or of searching for other vendors, the repeat business from existing customers, the growth of the basic business, the importance of the brand name, the stiff competition from rival firms Google has faced from its very inception. If ever a company had an insurmountable lead over the competition in a business growing as fast as this, I haven't seen it.
    2. "The customers are stupid." They don't realize they're being charged for fraudulent clicks. The idea that a advertiser doesn't measure the results of advertising and doesn't know the value of a sale that comes from each element of its direct marketing budget is an absurdity to those who have been in the direct marketing business. Everything is measured. Everything is quantified and compared to all substitutes. Apparently the online advertising industry is growing 50% a year or so, and the advertising on traditional media is flat to up a few percentage points. Is it really likely that companies like Wal-Mart and AOL don't know what the value of a sale is, or that they care if they're paying x or x + 10% a click when what they're interested in is what the marginal cost of an advert expenditure is? It's even more ridiculous to think that the small retailer who spend $1,000 bucks on an ad doesn't know what the value of sales is. He's paying for the ad and ringing up the sale in the cash register. You don't stay in business too long if you spend money on ads that don't bring in revenues. And owners of small businesses are very much concerned with their own welfare. With all the faults of the pay-per-click ads, the industry is growing 50% a year. Are all those advertisers really so naive that they don't understand that the cost per true, interested, clicking customer must be adjusted based on the spamsters?
    3. "The expenses are understated because they fail to account for the cost of options, so the P/E is really too high." It's a major tenet of investment that rational expectation rules. This is certainly true for anything so well advertised as option expenses. Numerous analysts point out what the expenses would be if stock weren't used as an inventive and what the balance between additional stock issued, additional salary expense, and the change in incentives of personnel might be. These are taken into consideration in the price, at this very moment in every company and that's why the companies that switch from one method to another show no differential in their performance.
    4. "The market's in a holding action because of fears, doubts and uncertainties." Yes, that's when the opportunities for profit are greatest because the required rate of return goes up. And that's why the IPOs have gained about 50% a year for the last three years -- because of this excessive triangle of worries that resulted from this inordinately salubrious-for-the-future period in which stocks have not risen over the last seven years.
    5. "The stock is down 35% from its high, but it won't be finished until it goes down 62% to its Fibonacci retracement." Like the vast majority of technical analysis mumbo, this kind of statement can't be tested. You wouldn't be able to tell the high or low until after the high or low occurred. Moreover, there are many different ways of describing the waves that constitute the basic difference equation of X(t)= X(t-1) +X(t-2) that is at the heart of all such magic. In a nice part of EdSpec, I document how two different Fib analysts, working at the same time with the same data, were able to predict a Dow of 10,000 and a Dow of 500. In many posts on this site, I have shown with simulation how scientific analysis of turning points in the Dow over time leads to results completely consistent with randomness, even though you can point out 10 times that it would have been good to buy and 10 times that it would have been good to sell over the last 50 years with profits 10 times as great as the buy and hold, if only you knew these points in advance. The same is true for filter rules that sell when a stock has gone down x% from a previous high. None of them can make money unless they have survivor bias, because they can't overturn the steady beat of the tom tom buy and hold.
    6. "A investor or analyst thinks the stock is too high and could fall by 50%." Yes, there's always going to be an analyst who thinks the stock is too high and another who thinks it's too low. In the Barron's article on Google, much prominence is given to the analyst who thinks it should be 150, and mentioned as a ridiculous aside is the analyst who thinks the right price is 1,000. But do such analysts actually make money on their predictions? If there are more analysts on one side than another, is it bullish or bearish? Of course, someone who works for the "Cautiouses" or who missed out on buying the stock at the IPO, or who's lost a fortune by shorting in the past relevant period and is trying a Hail Mary that might possibly make 1% back is going to be bearish, and of course the investor who owns the stock is going to be bullish. What value is it that Legg Mason thinks it good and the "Cautiouses" think it bad because others might come up with a better search engine? You know, Federer has many competitors with more muscles and more speed. I'm afraid his winning days are numbered and he should sell at a 20 P/E right now.
    7. "The executives are very liberal and principled, and can't run a profit-oriented business." Let me start by saying that the idea that the two founders are so pristine, so ethical that they are unfit to run a profit-oriented business for stockholders is an absurdity to anyone who has read anything about their personas and the path that this company has taken in its tortuous road to the top. Perhaps best typifying that the honest duo is at least as subject to the moral laxity as you and I is the fact that all the ads on their site, the ones that generate the bulk of their $6 billion revenue and are completely invisible to 99% of their customers, are called not ads but "sponsored links." Yes, of the 10 richest people in the world, there's not one who's not a card-carrying agrarian reformer -- starting with the Palindrome, the Sage and the Genius Harvard Dropout. Somehow they realized that in order to tap the mass mind, they had to subscribe to the same egalitarian redistributionist principles that are taught from the day they enter school by the state operatives. Yes, it's true that Google's two founders make a big deal about not caring about profits and just wanting to improve the Internet and solve the human genome, and that unlike other companies a very large share (3%?) of their profits go to socially conscious causes, and that all their employees are given one day a week off like the academics. Yes, they're utopian. That's true, until they have to negotiate a deal leaving anything for the other side. (Why does the proverbial words, "the nearer the church, the further from God" float in the mind?) A reading of the puff book that turned me around shows countless examples of the extremely street-smart negotiating ability of the founders. Consider how they were able to start a bidding war with two investment bankers to raise their capital; how they were able to value their company at $100 million or so when all they had was an idea, a program and a garage while the other Internet stocks were already smoldering; how they were able to put off hiring a CEO despite constant hectoring from their backers for two years; how they were able to work out compromise after compromise on such issues as China and pornography censorship. And yes, they're fighting the U.S. government over privacy, and each buck they spend on it comes right out of earnings. However, I would speculate that somehow they will be able to work out a face-saving and profit-enhancing settlement.

    I mean this enumeration of common mistakes as a template for meals for a lifetime. Numerous other common errors -- mainly related to confusing the short run with the long run, neglecting to compare alternatives and failing to test whether a given event was bullish or bearish -- are outlined in PracSpec, and formed the basis for the 50% rise in the market since that time.

    The more articles there are that talk about some consistently bearish analysts who have sold this stock or are currently short the stock, and have not yet gone belly up the way almost all of them eventually do (the last short selling fund closed down at the end of 1999 in the last cycle), the more opportunities there will be for those who follow the Triumphal Dimsonesque, Lorie and Fisher message.

    P.S. This exegesis on common roads to disaster is inspired by the financial weekly news story titled "In the Drink" by Jacqueline Doherty. On the first page of the article she summarizes her projections:

    To get a sense of what might happen to the stock, we gave one über-bull's 2006 revenue estimate for Google a 20% haircut, trimmed his projected expenses by 5% (but no further, because bulls greatly underestimate Google's costs), deducted stock-based compensation and, generously, gave the company credit for the considerable interest income on its cash. The result: Earnings would be 30% lower than the bull's projection, at $6.28 a share. If the stock were to maintain its current multiple of 41 on those lowered earnings, it would be worth $257. It's more likely the multiple would shrink to as low as 30, in line with the slower growth. That would make the stock worth $188, versus its recent $360.

    The author apparently doesn't consider what would happen if an über-bear's revenue estimate were to be given a 20% kick in the pants and the expenses increased by 5% but no further because bears generally underestimate the latitude for decreasing expenses by reducing such things as research expense which have been increasing ferociously. If the stock were to maintain its multiple it would be worth approximately $600. The story, and related bearish pieces surrounding it, travels on almost all of the seven roads mentioned above. Particularly well traveled is the road that competition from Microsoft and complaints from customers could make the über-bull's projections too great. I would recommend reading the puff book, The Google Story for a blow by blow description of the many past encounters between the two companies on this front reminding one of the likely outcome of a series of virtual match-ups of Federer versus Connors today or Laver versus Mulloy from the past. .

    You know, Federer has beaten many competitors with more muscles and more speed than himself, and many of the shots he used to win the last 3 Majors were lucky and based on fancy footwork and only good for hard surfaces.

    The last time he beat Agassi he made some crucial points in the first set by hitting the edge of his racket. . Furthermore, one fourth of his points won on serve were won by aces. And the French Open in the next quarter is on clay where no aces will be possible. Next time they meet there is no way he could ever win. Federer makes an average of 5 backhand errors down the line each game. That kind of ferocious going for the jugular is bound to cost him. Furthermore, he's Swiss and aloof and really doesn't seem to care as much about winning as those competitive and hungry up-and-comers from Eastern Europe.

    The fight he had with the Federation is bound to take away his energy over the next several years also, and they have never been known to lose a fight with one of their players. If you fight with the devil you need a long spoon. When he played in the China open, he paid a visit to the party leaders there and agreed to wear red socks just so he could compete for the 2 million dollar first prize. It would have been much better if he didn't play in that tournament. Even worse, waiting in the wings to play him in the second quarter at Wimbledon is Ivanisevic and Mojo, who are practicing their serve right now, and have both been clocked at 150. The odds on Federer winning the French and Wimbledon in succession in Ireland are 1 to 2 in his favor. I'd say that's much too low, but I am more of a football and cricket connoisseur.

    (One of the difficulties with written communication is that it's hard for an amateur like me to show that he's speaking tongue in cheek. Let it be noted that I admire Federer and don't think his opponents or these fake critiques, idempotent with the ones that have been leveled at Google, have any merit at all.)

    The article is so bearish about Google it could have written by Alan Abelson himself. It certainly uses all his techniques:  the testimonial quote from the revered old friend, the glittering generality, the card-stacking with selected numbers to make a point, name calling, the "plain folks" tone, the bandwagon, the appeal to authority, et al. To back up her point about the risk posed by a lofty stock multiple, the author appeals to authority in her first card:

    "Google reminds me very much of what went on in 1999 and 2000," says Fred Hickey, editor of the well regarded High Tech Strategist newsletter and a member of the Barron's Roundtable. " The valuation is insane, relative to what they do. "

    Apparently not worth noting is that the well regarded one is a well known permabear and friend of Abelson who has been bearish for at least the last five years on tech, who uses a fax machine as his distribution mechanism. While not still editor of Barron's, apparently the bearish financial columnist's influence lingers on at the paper. Other stories in the weekly include "The Trader" column's "Bulls Are Fighting the Old Ennui": "A midweek rebound steadied the market, but any pep mustered was quickly sapped by mounting concerns about economic growth," as well as "Housing Bomb Set to Explode," "Bon Voyage?

     This IPO May Never Happen," "Day of Reckoning," and the curmudgeon's column itself, which points out the disaster that would occur "if the foreigners holding our dollars one day decided to call in their loans."

    P.P.S. It is impossible to keep up with all the negative things about Google that are coming down the pike. The latest I have heard is that much of their gains in earnings comes from a gain in interest revenues, and that this cannot continue. Again, are people that stupid, that they care that the net gain in non-interest earnings was 55% rather than the 75% with interest. Is it not possible that without all that interest income that Google might not have spent so many hundreds of millions on projects like connectivity over the normal phone lines, the digitalization of books and the mapping of the genome? Are these and the dozens of other projects they are involved in, in the way of out of the box research, really totally worthless or might one hit big? How long does it take a company to quadruple its earnings growing at 50%?

    P.P.P.S. I have never performed a written analysis of an individual stock before, and I am in completely uncharted waters -- or, as Tom Wiswell liked to say, "I'm in over my head." I should point out that there is no reason for anyone to find what I say worthy of any more merit than the numerous contrary opinions about this company. Indeed, because I am long the stock, what I say must be taken with even more salt than would be appropriate for a novice, because it would be hard for me to say anything that would be against my self-interest even if I thought I was being objective. I would also note that while I have been investing in individual stocks off and on for over 50 years, my track record in such investments appears to me to be somewhat worse than random selection and considerably worse than a buy-and-hold strategy.

    Mark Goulston contributes to the Futurology Department

    One of my co-columnists, Richard Watson, is an internationally known futurist. You can find his and all our other columns at Fast Company, I think they are a really good read.

    Here is a sample of stories from his most recent newsletter:

    Aggregated customization. A new business called DayJet based in the US is about to launch a new airline that allows business travellers to fly direct to regional airports, avoiding time-consuming connections at big airports and also avoiding unwanted overnight stays in small towns and cities. Not that exciting? What is interesting is how DayJet plans to do this. The airline has ordered 200 six-seater micro-jets at a cost of US $1.3 million each. This means airliner style performance at a fraction of the cost. But that is still not the interesting bit. The airline has no set routes and no fixed prices. Instead the airline will aggregate demand on the fly linking small groups of people that want to go to the same place at roughly the same time. Routes and pricing will fluctuate in real time as demand comes and goes and customers will be offered a series of different prices depending on how flexible they are willing to be (give a little, gain a lot). What is really fascinating about this idea is how the business model combines some of the hottest trends that are around all of which will affect everyone in some shape or form in coming years. What are the trends? First there is mass customisation. This allows customers to order a customised version of a standardised product. Second, there is dynamic pricing. This is where the cost of a product or service changes depending on demand or supply. Finally, there are social networks how the Internet pulls people together that have similar interests or needs.

    The wisdom of crowds. In terms of hot business trends, we've written extensively about open-source innovation, the long-tail effect and simplicity but here is a new one collective wisdom. The idea is simple: the wisdom of a large group of people is nearly always greater than the intelligence of any single member. The theory is especially hot in Internet circles where obviously its very easy to access the collective intelligence of users but its also emerging as a hot forecasting tool in financial markets. The idea is as old as the hills, but its re-emerged due to technological developments (eg, convergence and social networks), and a book called The Wisdom of Crowds by James Surowiecki. Goldman Sachs, Deutsche Bank and Hewlett-Packard are all using group wisdom to predict everything from next quarter sales figures to future economic indicators. Group prediction can even be played for fun on various websites like www.ideosphere.com, www.hsx.com and www. longbets.org. Is this a future trend or just a short-term management fad? What do you all think?

    Reverse logistics. Once upon a time we bought stuff and then stored it away in the garage or we threw it out. Consequently manufacturers and retailers didn't worry too much what you did with their products once you'd bought them. Not any more. We are slowly moving from a permanent acquisition culture to a temporary acquisition or auction culture where people sell stuff the minute they get bored with it or when something better comes along. Blame eBay if you like. The site now has 150 million registered users globally and sells US $40 billion worth of unwanted stuff every year. There is even a secondary market developing where companies such as Auction Drop sell things on eBay for you. More important, perhaps, is what this means for traditional distribution channels and logistics. The auction (second-hand) paradigm is not new of course car companies have been selling used products to new owners for years but its new for almost everyone else. But why get involved selling a product for a second time? One reason is control of the flow of products on to the second-hand market and specifically the pricing of old versus new products (eg, Callaway Golf's recently launched a pre-owned program). Another reason is that access to data about what people want and what they don't can be used to influence new product development programs. And don't forget about the packaging. As sustainability becomes more important, responsibility for disposing of packaging properly will shift away from the customer back to the retailer and the manufacturer.

    A Baseball Tale from Rodger Bastien

    The following tongue in cheek comparison is by Rodger A Bastien, a former All American Baseball college player who replaces the dearly lamented Larry Ritter as our official baseball go to man.

    I am sure Ms. Doherty must also be a baseball fan and is cognizant of the sad story of Vladimir Guerrero, the superstar right fielder of the Los Angeles Angels. Despite having career statistics through age 29 second to none, comparable only to the greats such as Willie Mays and Joe Dimaggio, his undisciplined approach to hitting seems to be be finally catching up with him. Mr. Guerrero, who habitually swings at the first pitch (Ted Williams is turning in his container!) and has been known to even slap a base hit by hitting a pitched ball on one bounce, saw his batting statistics slump substantially in 2005 versus his MVP season of 2004. As examples, his batting average declined by 6%, his RBI total was down by 14% and his total bases declined by a whopping 19%. It appears as though his steadfast refusal to employ the use of batting gloves has finally done him in as he missed 21 games last year due to injury, undoubtedly as a result of the wear and tear done to his hands. Supporters insist that his decreased numbers last season were still good enough to place him among the league leaders, but it is obvious that this once bright star is approaching a flame-out. Should his statistics continue to decline at this rate and his obstinacy and lack of discipline persist, he will be fighting to remain above the Mendoza line before too long, it is assured. No modern day hitter has been able to continue to sustain hitting statistics of this sort. A preponderance of night games, specialized relief pitching and the emergence of the split fingered fastball are all facts of life in today's baseball which make it impossible to continue hitting at the same level as the all time greats....

    Musicals and Testimonials, by Victor Niederhoffer

    One of the most enjoyable books I have read recently is Making Musicals by Tom Jones, the book and lyricist for the Fantasticks, the longest running musical in history. The first part of the book describes the path that the musical has taken since its origin from the minstrel shows of the 19th century, and the second part describes how to write a musical, with particular emphasis on Jerry Robbins's troubleshooter extraordinaire magical formula for fixing a sick one. Robbins would go in and ask one question: "What is it about?"

    That is a great question for market people to ask, but that is another story.

    The modern American musical, as American as apple pie, was a hit starting from its invention by Jerome Kern with Showboat, proceeding with its adoption by Rodgers & Hammerstein with Oklahoma in 1943 and right up through the '60s. There was a formula:

    1. book
    2. integration
    3. movement and change
    4. lots of singing and dancing
    5. strong melody and simple to grasp plot with enough reprises to have you leaving the theatre whistling one
    6. positive message
    7. simple one dimensional characters
    8. entertainment, humor, variety

    Everything was fine, the boat of the musical was sailing with the wind at the back, the Rodgers & Hammerstein style. But then something changed. The old formula stopped working and Hair and Disney and Sondheim and Mackintosh concept musicals took over.

    In analyzing why it all changed, Jones sounds even more Baconian than Bacon. Time was an important factor. Things change, the wheel is always turning. Predictability was another. The form was too well known. Too many small towns in Indiana, too many predictable Latin production numbers, too few young people. And the economics changed. You could not afford all the people. Choreography replaced character, a la Jerome Robbins, Gower Champion, and Bob Fosse. By the '60s the old systems did not work. The cycles changed.

    I am always reminded of how the formulas stop working in every complex form when someone quotes a great such as John Templeton or Ben Graham, and tells us his formula was to buy companies at four times earnings or half of book value. Or figuring out what the wife liked at the mall a la Peter Lynch or what the Sage, who has been bearish on stocks since 1995, said in his last 10 annual reports. Yes, that worked during the Depression era, in the time between Kern and Rodgers & Hammerstein and before Compustat and Lorie and Dimson and 4% interest rates. But it ain't relevant now. We need to test the changing cycles. We need to take account of time and predictability, and faster information flow and liquidity.

    Please do not quote someone who made money in the '90s or who called the Internet boom as a model we should accept, unless there is some reason to believe that their expertise is appropriate for the future, that their message has not been discounted, and that the foundation they based their formula for success on is not as irrelevant as that of the great Kern/Rodgers & Hammerstein formula is for the modern musical stage.

    Dr. Brett Steenbarger comments:

    Changing cycles are actually the psychologist's stock in trade, although they're not usually discussed that way.

    People shift their emotional, physical, and cognitive states all the time in response to their environments. In different states, they process information differently, experience themselves and the world differently, and act differently. When those differences are large enough to make a difference -- and when people lack control over their own changing cycles -- a whole host of negative consequences can ensue. That's when the psychologist gets involved.

    Most problems that people have feel like something alien to them: "I don't know why I (fill in the blank: drink to excess, put myself down, worry excessively, explode with anger, hurt other people, etc." is the usual refrain. People constantly change, but only realize it in retrospect.

    What good psychologists do is catch people as they are changing and help them see it for themselves. This allows them to gain some measure of self-observation and control. An example is a woman who has been abused and neglected by parents. She shrinks in her chair as she describes her family life, talking in a little girl voice. Later in therapy, I tell her that I will have to miss our next session due to vacation plans. She shortly thereafter shrinks in her chair and adopts the same voice that she had used when discussing her past.

    That's how I know that she is experiencing me as neglecting her. It is a reliving of her past -- but the changing cycle, her shift of state, is what gives it away. Psychologists refer to the shrinking in the chair and the change of voice as markers. A marker is a characteristic behavior that occurs when an individual shifts from one state to another, usually in the face of a difficult situation. Markers occur outside of therapy, as well. Poker players call them "tells."

    The countist who identifies markers of changing cycles in markets would have quite an edge, like the poker player reading the faces of opponents. I watch large orders that are entered at the market by aggressive traders and then track if those orders are quickly profitable or unprofitable. How the mistress accepts or rejects aggressive courtship is one of her tells ... a marker of changes to come ....

    Stefan Jovanovich adds:

    I think Templeton's choice of a 5five-year horizon is sensible because it looks to the average duration of a complete business cycle. I agree with you that his 4-times multiple is not applicable to the present day. For one thing, GOOG and every other company with a market capitalization over $2B each have more liquidity by themselves than the entire Japanese stock market did when Sir John was using his 4x5thYr metric.

    That is why I posed the question -- what is an appropriate multiple now for a company like GOOG? My own answer has been a scale of multiples from 4 to 12 depending on the market capitalization of the company. As far as I can determine, Templeton never bought anything selling for more than 12 times future earnings, and market capitalization seems like a decent proxy for determining relative liquidity.

    Comparing Templeton to Ben Graham seems a bit unfair. Sir John bought companies selling for as much as 10 times book, and the only other yardstick that he seems to have used was to avoid companies whose enterprise value was significantly different from its equity market cap. That seems to be the main reason that he consistently preferred insurance companies to banks. I think Templeton's valuation ideas about price to book and equity to enterprise value are robust for the same reason you refer to the memoirs of traders from the 1870s. Templeton's yardsticks have a pedigree that can be traced back to Morgan and Peabody. Whatever the changes that have occurred since the 1950s, they are no greater in scale or scope than the ones that occurred in the 100 years before Sir John made his forays to the Tokyo exchange.

    One thing we can agree on is that the wisdoms of Graham & Dodd are mostly sophistry. In my case, the skepticism is based on the 30 years experience of owning small, private companies. In all that time I have never seen one available for "half book" that did not have either bad accounting or crushing debt. Their notion about buying companies for less than liquidating value is equally improbable.

    I think Templeton's notions are of an entirely different class. So, along with using his multiple of fifth-year earnings valuation, I follow the two other "Templeton rules" that I have found from my researches:

    1. Stay away from companies selling for more than 10 times book. That keeps one from buying sound companies like GOOG, but it also avoids the kind of soap bubble companies that were so common during the last period of general euphoria.
    2. Only buy companies with a equity market cap/enterprise value of less than 1.25 or 0.75. That avoids interesting speculations like GM and F, but it also keeps one from owning them on the way down.

    Islam and The Cartoon Scandal, by Yossi Ben-Dak

    I am wholeheartedly in agreement with many commentators for valuable elucidation of 'Islamic rage' being manufactured to fulfill another agenda.

    Read full article.

    Fibonacci's immortal contribution to Finance, by Alex Castaldo

    Leonardo of Pisa, known as Fibonacci (1170-1204) wrote Liber Abaci in 1202. It was intended as a practical mathematics book, with business examples such as the division of profits among venture partners or conversions from one currency to another (with no central govt, there existed 28 different currencies in Italy alone). According to friend-of-chair William Goetzmann, Fibonacci developed the concept of Present Value of a stream of payments 700 years before Irving Fisher.

    Italian traveling merchants of the Middle Ages would invest their capital in locally produced goods, then travel to another city where they would sell the goods at a profit, spend some of the proceeds on personal expenses and reinvest the remaining capital in other goods. Then on to another city.

    Goetzmann quotes Fibonacci:

    "A man proceeded to Lucca on business and doubled his money, and he spent there 12 denari. He then left and went to Florence; he there doubled his money and spent 12 denarii. Then he returned to Pisa, again doubled his money, spent 12, and it is assumed that he had nothing left. It is sought: how much he had at the beginning"

    In modern terms Fibonacci is asking what is the present value of (12,12,12) at a discount rate of 50%. Fibonacci multiplies the periodic cash flow of 12 by the sum of individual discount factors (1/2 + 1/4 + 1/8) to come up with the answer 10.5 denari.

    In this first example the numbers are artificially chosen to make the calculation easy; in more than 20 other examples that follow, Fibonacci generalizes to allow for different cash flows at different stages, different rates of return at each stop, or an extra cash flow at the end. Routine stuff for today's MBA, but pretty impressive for 800 years ago.

    This, Goetzmann tells us, was Fibonacci's most important contribution: the development of Present Value, at least in a simple form. Later, in 1558, J. Trenchant would take the next step and analyze annuities, perpetuities, etc. Fibonacci made other contributions, such as convincing business people to use Arabic numerals and abandon Roman numerals, but 'retracement levels' was not one of them.

    Jay Pasch on Web Investments

    It is all nearing the realm of the absurd Captain; one would gladly exchange a healthy portion of retirement assets for 318-20 and even 330 and even a bit more here under 350. One was away from the game for the capture of MSFT's birth, and missed the early days of NOVL, and CTXS, and now this wonderful creative environment delivers yet another gift, and this one is perhaps the biggest no-brainer of all ...

    Horace & Satire, by Gregory Van Kipnis

    "Semel emissum volat irrevocabile verbium." -- Once a word has been allowed to escape, it cannot be recalled. -- Book I, epistle xviii, line 71 by Horace.

    "Life grants us nothing to us mortals without hard work." -- Book I, satire ix, line 59 by Horace

    From Wikipedia,


    Satire is a literary technique of writing or art which exposes the follies of its subject (for example, individuals, organizations, or states) to ridicule, often as an intended means of provoking or preventing change. In Celtic societies, it was thought a bard's satire could have physical effects, similar to a curse. The humor of such a satire tends to be subtle, using irony and deadpan humor liberally. Most satire has specific, readily identifiable targets; however there is also a less focused, formless genre known as Menippean satire.

    There are two fundamental types of satire: Horatian satire, which is gentle and urbane; and Juvenalian satire, which is biting, bitter invective. The burlesque form of satire can also be segregated into two distinct categories: High burlesque, or taking subject matter which is crude in nature and treating it in a lofty style, or low burlesque, taking subject matter traditionally dealt with in an epic or poetic fashion and degrading it.

    The following commentary on satire is illuminating:

    Satire is a mode of challenging accepted notions by making them seem ridiculous. It usually occurs only in an age of crisis, when there exists no absolute uniformity but rather two sets of beliefs. Of the two sets of beliefs, one holds sufficient power to suppress open attacks on the established order, but not enough to suppress a veiled attack.

    Further, satire is intimately connected with urbanity and cosmopolitanism, and assumes a civilized opponent who is sufficiently sensitive to feel the barbs of wit leveled at him. To hold something up to ridicule presupposes a certain respect for reason, on both sides, to which one can appeal. An Age of Reason, in which everyone accepts the notion that conduct must be reasonable, is, therefore, a general prerequisite for satire.

    Macro Monetary Musings, from Jim Sogi

    After looking into the microscope all week, it is nice on the weekend to take a look up and around to see which way the wind is blowing on the horizon and how the stars are aligned.

    Exchange rates provide additional return to foreign holders of US bonds. Thus global currency exchange rates affect US rates. The theory is that increasing short rates here make the USD stronger, which attracts foreign money which lowers longer term rates. Rising short rates strengthens the currency which would attract funds and lower long rates further. As the global economy warms up (see EEM), global rates will rise, putting pressure on the currency exchange rates. The Palindrome considered the constitutional mandate for the German Central bank to conclude that it would raise rates in his famous BP trade. If Japan starts raising their rates (and currency) by withholding intervention and not flooding overnight rates down (kr post), their currency may strengthen vs the dollar. This in turn may affect Japan's holding 1/3 of US debt. This is the global component of interest rates.

    In the domestic component, rates rise because the economy heats up and demand for credit becomes stronger and also due to artificial intervention by the Fed to prevent acceleration through prior over accommodation. It is a circular reflexive process since a stronger economy will have a stronger currency and drive rates up. The increase in short rates in turn attracts global interest, and lowers long term rates, which in turn drives growth. This theory would explain the conundrum. An issue is that the increase in short US rates is more significant in its artificial increase relative to global rates, rather than a reflection of a heating economy. The artificial increase is the relative change from accommodative levels rather than by market forces. The question is whether there is a tradeable divergence between the market and the artificial forces that is forming an anomaly that will be undone when market forces eventually prevail.

    A model is required in order to know what to count. The correlations to look at might be exchange rates, foreign Bond purchases, yield curve and absolute rates or comparative foreign central bank rates. This would be counting global money flow for which there does not seem to be a good metric. This type of counting seems ideally suited to binomial models as the complications of the minutia would be Gordian, so a simple direction would give a great aid in the trade. Are rates headed up or down?

    To test the theory, Foreign Central Bank rates long weekly roc of the EU/Japan/US either up or down -- UP=1, Down=0, Fx from the quote board. Curve= 3/10. Information on the G7 10 year government bonds and the G7 yield curves was gathered from the linked sources.

    Contingency Table

                    US     EU   Japan
    Long  Yield     1      1       1
    Curve           1      1       1
    Fx              1      0       0

    To test the hypothesis that short rates strengthen currency and drive down long rates the table should show some significance in the fact that our currency is up, our rates have inverted and our currency is up, and the others are not. Use Cochran's Q test on this model to assess effects in block design in which the data or 0's and 1's. An exact p value is available by bootstrapping.

    The conclusion is that the data used does not give support to rejection of the data being random though simple examination of the table might support the idea retrospectively or descriptively.

    The defect in the study is that the relative levels between countries should have been used rather than the internal rate of change, as that is what a global investor looks at and that is what matches the qualitative model. This shows the benefits of the scientific method. It is just as important to know what does not work and why as it is to know what does work. The contingency table helps to define the appropriateness of the mathematical model and identifies areas for further experimentation. The model was created first, the data collected second, then tested.

    Unrelated PS -- SP Range Count

    SP Big March CME
    Mean closing price 52 days SP mini 1274.5
    Sd = 12 2sd=22

    A. Spie Comments:

    In my opinion, US investors have a very US centric view of the currency world. The dollar bear story is quit old. In fact, I would go so far as to say everyone expects the Yen to strengthen. In fact, I cannot recall a single article in which the author expected the Yen to collapse since 1998 when it was going over 200, so here goes. The China effect. The yen may loose its Asian reserve status. Japan may lose its competitive position. It is more determined to inflate its currency than the US, or anyone else in the world for that matter. That alone argues for long run weakness. The interesting thing is that the Japanese have moved much of their production overseas to countries that include the US. That along with the China effect means that Yen weakness may not have the impact that common wisdom assumes. Its population may decide to own things other than no and low interest bearing securities which creates a debt issue 3x the size of that in the US.

    Conversion on the Road to Mountain View: Rethinking Google, by Victor Niederhoffer

    Tears in the Eyes

    The estimable Dr. David Brooks of Brigham brought to my attention Jurgen Thorwald's 1956 book "The Century of the Surgeon," containing within it a tale of heroism and tragedy rivaled only by the best in O'Brian's "Reverse of the Medal" or Rand's "Atlas Shrugged."

    The story starts with Horace Wells, a humble dentist from Hartford, arriving at Harvard Medical School in January 1845 to demonstrate his new discovery: the use of laughing gas as anesthesia. John Warren, Harvard's austere and authoritarian head of surgery, told the assembled students in his solemn, haughty, aloof manner: "There is a gentleman here who purports to have something which will destroy pain in a surgical operation. If any of you would like to hear him you are at liberty to do so." Wells then proceeded to pull the tooth of a brave volunteer. The patient screamed. The Harvard students broke out into riotous laughter and chants of "Humbug! Humbug! Humbug!"

    Finally, Warren, stepped forward and quieted the crowd with a gesture. "With a touch of self righteousness of age, and of that acceptance of pain which had become an article of faith," he made it clear to Wells with polite formality that any further comment would be superfluous, and stalked out of the amphitheater. Laughter and catcalls rang out once more. Wells threw his instruments into his satchel and hurried out, eyes fixed on the floor.

    Nineteen months later, in October 1846, Well's assistant, Dr. Morton, was given the chance to make another demonstration. A young patient had a tumor on his tongue; Warren was to perform the surgery. "Warren bent over [the patient], his face expressionless as ever. He rolled up his sleeves and took his scalpel in hand. Then, with a lightning motion, he made the first incision. There was utter silence in the hall...the patient did not stir. Carefully, Warren scraped out the tumor. Not a sound! The surgeon severed the last threads of tissue, applied a ligature. Still nothing."

    Warren straightened up. His face was pale, his smirk was gone. "Gentlemen," he exclaimed at last, " this is no humbug." "And suddenly there was wetness on his lined, parched-looking cheeks. Warren, the terse, aloof, unemotional Warren, had tears in his eyes."


    I felt a similar shock at the falsity of my beliefs after finishing "The Google Story" by David A. Vise and studying some of the financial and descriptive reports on the company. Gentlemen, this is no humbug. Google's combination of proprietary software, repeat business, strong brand, wide customer base, technological innovations in hardware and software, growth of its basic product line through diffusion and word-of-mouth via the Web, and the steady flow of new products with great potential in all stages of the pipeline completely overturns my previous skepticism of the lofty multiples and intensive insider selling that are part and parcel of this company.

    I will describe my reasoning in subsequent memos. For now, I have changed my position, in the old-fashioned tradition of Russell Sage, from speculator looking for overnight profits based on statistical anomalies related to the vividness of fear, uncertainty and doubt emanating from last week's horrible performance after the earnings announcement, to long-term buy-and-hold investor based on a complete reversal in my belief system similar in magnitude to Warren's.

    A Man from the Moon

    If anyone told me that someday I would own a stock that had a multiple of 40 based on estimated 2006 earnings, run by two computer geeks that professed a disdain for profits, whose mantra was "Don't Be Evil," who spend two weeks each year at Burning Man, who had a holy terror of allowing their CEO to become chairman of the board and managed to give him 5% of their company partly in exchange for a investment of $1 million in preferred stock, who vetted all their employees based on aptitude test scores, whose culture was based on hiring an executive chef who boasted that he once was a part-time chef for The Grateful Dead and cooked only with organic foods, who bonded because of their common Montessori school background, liberal sensibilities and participation in a peace march relating to the Iraq War, who had no compunction about teaching Wall Street a lesson in how to market their IPO, and wished to market it based on a philosophic letter expressing their liberal sensibilities, with my buy decision based in part on a breathless celebrity-journalism puff piece emphasizing the principals' Darman/Sununu-like aptitude test scores, in a book whose "accuracy" was approved in advance, with massive insider selling in the billions each day according to a fixed schedule that allowed the principals to sell even before earnings releases that they refused to give guidance on, who boasted that they would never smooth earnings, and, most of all, who held the Sage as a venerable guide for how to run a company and how to look at the all-too-materialistic interest of all investors and of self-serving businessmen in particular -- why, then, I would have told them, as Artie liked to say: "Get out of here!"

    And yet, with tears in my eyes, I have to admit that I own the stock. Let's start with sales the last four calendar years of $0.4 billion, $1.5 billion, $3.2 billion and $6.1 billion, and operating earnings of $0.2 billion, $0.3 billion, $0.8 billion and $2.1 billion. If ever there was an example of riding an early part on a S-shaped growth curve, this is it. Under the circumstances, the trend in quarterly earnings, that they only went from $0.69 per share in the fourth quarter of 2004 to $1.54 per share in the fourth quarter of 2005 and that the IBES estimates for the first few quarters of 2006 are now only $2.00 a share, seems rather to miss the forest for the trees. My goodness, if a company is growing by a 75% a year or so, doesn't it deserve a multiple more than twice what See's Candy might sell at?

    It might be best for me to step back and analyze this company as a man from the moon might, since I don't know anything about search technology except that I wrote my thesis on content analysis, and I certainly don't know anything about the competitive situation among the constantly changing Internet technologies.

    Nobody Asked Peter Gardiner, but he comments:

    If one take the example of GOOG and compares it to other companies with huge first-mover advantages in hugely growing, highly profitable industries, and does the counting, the tears may be wasted at this price. Take, say, MSFT when it had 9 billion oi revs (similar to GOOG). The op margins, free cash flow and net margins are roughly the same. Should GOOG grow at the same rate on top and bottom lines (high and low 20s% per annum respectively) as MSFT did from 1996 to 2005, and we do a simple DCF with current rates (remembering that the greatest part of the value for such a high-multiple company, or indeed any company with a P/E over 15, is at the back end in the perpetuity) we get a prspective NPV for GOOG around 180 or so -- pick a different rate if one wants a different number. So to justify the current price, GOOG would have to grom 50% faster over the next 10 years that the largest monopoly on the face of the earth AND still preserve its huge margins. But wait: What effect will the future GOOGs of the world have on such a scenario? One thinks of the profits foregone by MSFT in GOOG's wake for a lesson.

    I think you were right in the first place.

    Stefan Jovanovich replies:

    GOOG's problems are with its rate card. Paid search rates are declining faster than the company projected so their increases in volume have led to a slower (though still spectacular) rate of profit growth.

    Mr. Brin's arrogance has a great deal to do with his Stanford diploma. Palo Alto has never been a wellspring of modesty or humility. That should not, however, prevent us from respecting the brilliance and energy so often do come from the Farm. The problem is that lack of a musical ear ("Don't Be Evil" has a terrible meter) and an inability to laugh at oneself (The Farm was never, in fact, a farm; most of the Stanford campus is a former WW I cavalry training ground.) In those ways, GOOG as a company is very much on same path that led to the "H-P Way".

    Allen Gillespie adds:

    One of the thoughts that keeps me attracted to the GOOGs and EBAYs of the world is this thought: what is the value of the MLS service for real estate? How many real estate agency owners do I know that are well off? What is the value of a list of links to all internet information?

    Ross Miller offers:

    As any devoted reader of my commentaries would know, Google's motto is "Don't Be Evil" not "Do No Evil." The real version has better meter and a very different meaning. The full explanation from Google's prospectus (which I doubt any member of the mainstream financial media has ever read) is:


    Don't be evil. We believe strongly that in the long term, we will be better served-as shareholders and in all other ways-by a company that does good things for the world even if we forgo some short term gains. This is an important aspect of our culture and is broadly shared within the company.

    Google users trust our systems to help them with important decisions: medical, financial and many others. Our search results are the best we know how to produce. They are unbiased and objective, and we do not accept payment for them or for inclusion or more frequent updating. We also display advertising, which we work hard to make relevant, and we label it clearly. This is similar to a well-run newspaper, where the advertisements are clear and the articles are not influenced by the advertisers' payments. We believe it is important for everyone to have access to the best information and research, not only to the information people pay for you to see.

    Steve Ellison reports:

    As it happens, I recently co-wrote a paper on Google (Google Strategic Plan, by Brent Hummer, Greg Jones, Audre Wilde, Steve Ellison) for one of my classes. I found many other interesting facts that did not make it into the paper, including the Googleplex's past life as the home of Silicon Graphics.

    Russell Sears writes:

    It may just be because I came of age while attending a Fundamentalist Baptist Church three times a week in my father's home, but I suspect that fundamentalism would not be a force if it weren't for all the good-looking, virginal young ladies to be found in the congregation.

    And I have seen many a wild young lad, tamed and civilized by such a delicate beauty willing to stick by her convictions. The poor prisoner of love often at first rants and raves about the injustices found in such a tightknit group, but soon is found leading the choir.

    But I have also seen many a straitlaced reputation soiled by such a lad. There is fleeting loyalty from the conquerer whom she reached down to help. Within the Church, there usually is an understanding of her vulnerabilty to be duped by the brash, worldly-wise, handsome gent. Will Capitalism tame Google, or is Google taking naive individual capitalists for a ride?

    Beyond the philosophy of Google, the one thing that kept me out of AOL, EBAY, AMZN was the simplistic analysis of "growth." There ultimately is a point in which they staturate their market. As every competitive runner knows, you put 90% of the effort to get out of yourself that last 5% of your potential.

    Yes, search ads budgets are growing. Perhaps the current buyer of such ads do know their worth. But are people actually using Google more, are they going to double their use of Google before they make a purchase in the next three or four years? I think not. It's already got to the point of futility for me in using Google for such. There may very well be two to three times more companies buying ads from Google, but they will be worth half to a third what they currently are.

    I find myself having to do searches with specific brand names, companies and magazine sources to escape the ad bombardment I get from GOOGLE. It has got to the point that I don't trust them.

    Pamela Van Giesen adds:

    I concur with Victor's view on this count. Google has to say that they are going to put up the good fight but it is difficult to believe they have not observed and learned from Billy's fight. Further, if they don't say they will put up the fight then users will demand they stop keeping search data and/or flock elsewhere in which case they lose a lot of data that could well be quite valuable at some point -- and they lose their revenue base -- advertising dollars.

    My issue with Google is that I see them right now as too dependent on ad revenues which have been known to cause untold problems for those who have too many eggs in that basket (can anyone say Industry Standard?). But this may be a temporary state of affairs.

    I certainly would not have the fortitude (irrespective of any analysis and quantification) to buy Google but I have to admire someone who makes the bold decision in the face of nearly complete opposition. Very Chad Hedrick. And, look, he's got one gold already.

    Thomas Miller comments:

    Google's "fighting" the government to defend the privacy of its users may be one of the smartest public relations moves from a business I have seen in a long time. Privacy is a very huge issue with many internet users. If Google is perceived as the one fighting for the rights of its users to keep their privacy online, while their competitors sold out their users behind their backs, they will have marginalized their competition a great deal and their future stock price will reflect it.

    If volatility jumps because of Barr@@ns article, Monday morning may provide an opportunity to venture out with the cane if you like the long story on G.

    Mathew Alexander mentions:

    The fight Google chose to pursue opposite the U.S. Government on the subject of Child Porn doesn't strike me as a smart P.R. move. Just as I do not think Google's decision to cooperate with the Chinese Government is a smart move for shareholders.

    As Andy Kessler, the author of Running Money, observed when the news on Google's compromise with the Chinese Government broke.

    Google could have kept their cool and trusted image if they'd just worked with someone else in China, someone they could smash. Perhaps Eggroll.com - powered by Google. Someone else to blame for those unsearchable keywords. Users in the West may not desert them, but a billion soon-to-be-online Chinese will forever associate Google with lame and censored search results - tools of the state. That just dumb. And totally uncool.

    Thomas Miller retorts:

    Time will tell. I don't think many U.S. internet users will forget anytime soon that Google's competitors gave their private surfing habit info to the feds without telling them and Google did not and is fighting the demand to give it up. The feds claiming they need this information to fight porn is rubbish. They are on a fishing expedition looking for personal info on people. The bubble boy who would be king has lost his mind on his snooping positions. Even the BDRs, seeing impending disaster in the next election, are pulling away from him.

    As for China, everyone works with the government or you do not do business there. If Google offers the best and "coolest" products, I do not think Chinese surfers will care about them working with their government.

    Kim Zussman adds:

    Now that there is nothing of substance left to add there is room for the following:

    I wonder if GOOG is like MSFT in that it is a tech advancement comprehensible and widely used by large segment of the public? One of the reasons I (unfortunately) avoided the stock was the worry that it could be a hyper-visible desktop darling or demon that everyone used. (Other reasons included last year's university endowments disclosure of much googleship, and Dr Miller assigning GOOG valuation exercise to his class).

    Since we are now back to TA, I looked at a MSFT chart dating from 1986 IPO, and wondered how it behaved once some 20-day returns dropped more than 20% (like GOOG recently). The question is what happens to a market darling once taking a fall after a long grand performance.

    It turns out MSFT experienced 20%/20d drops starting in 1987, and again in 1988,1989,1990, then a gap to 2000, 2001, 2002. Looking at these drops as long opportunities, in the 1980s a year later these drops were at, or much higher than, the decline price. However starting in 2000 such declines often were not fully recouped in a year, which fits with the "young growth to mature company" thesis, and the leveling of stock price over the recent 6-years.

    Of course this analysis is subject to problems such as which companies are comparable, adjusting returns for market, how long the investing public can remain enthralled, etc. However using the term "TA" wins a free pass.

    Professor Pennington contributes:

    Following up on Dr. Zussman's work:

    For days when MSFT closed at least 10% below its close 20 trading days ago, here are the stats for its next-day return:

    Between 1/1995 and 1/2000:
    avg 0.76%; stdev 2.3%; count 52; t-score 2.4
    Between 1/2000 and now:
    avg 0.28%; stdev 3.8%; count 193; t-score 1.0

    For days when MSFT closed at least 10% above its close 20 trading days ago, here are the stats for its next-day return:

    Between 1/1995 and 1/2000:
    avg 0.19%; stdev 2.3%; count 348; t-score 1.6
    Between 1/2000 and now:
    avg -0.02%; stdev 2.6%; count 179; t-score -0.1

    For days when MSFT closed between 10% above and 10% below its close 20 trading days ago, here are the stats for its next-day return:

    Between 1/1995 and 1/2000:
    avg 0.23%; stdev 2.2%; count 863; t-score 3.1
    Between 1/2000 and now:
    avg -0.06%; stdev 1.3%; count 1163; t-score -1.1

    Mr A. Spie suggests:

    Since I have been so bold as to state my preference for Google over the last 16 months with actually price estimates on GOOG, I thought I would give an update using current data. Using 2006 and 2007 numbers, we now have:

    MSFT ($26.69) 2006 - $1.32 up 14%, 2007 $1.53 up 16%
    ($275 Bil Mkt Cap)
    INTC ($21.29) 2006 - $1.25 down 13%, 2007 up 18%
    ($128 Bil)
    Dell ($31.79) 2006 - $1.55, up 20%, 2007 up 14%

    GOOG ($362) 2006 - $8.85, up 53%, 2007 12.06 up 36%
    ($107 Bil)
    EBAY ($39.53) 2006 - $1.02 up 19%, 2007 $1.31 up 28%
    ($55 Bil)
    YHOO ($32.51) 2006 - $.54, down 6%, 2007 $.73 up 35%
    ($46 Bil)

    So at the start it would appear there are periodic table effects with PC stocks 1/100 of the price of a new PC, internet stocks at the price of a months cable modem charge, and GOOG at 100x that because they do not split the stock.

    Let us start the exercise with the common assumption among value types that MSFT because it is the largest is the most easily valued company. One might argue against this as the history of technology companies suggest the largest companies like T, IBM, etc. generally give up leadership to the next generation. Thus we will estimate that the market might be willing to pay between 14 x $1.32 and 16 x $1.53 plus cash and near cash to arrive at a range of $23 to $30 dollars, and maybe a little premium for new product rollouts.

    Using this as a base:

    INTC looks too cheap given that $1.25 is 94% of $1.32 (MSFT's est EPS) with similar growth rate expectations.

    DELL is in line to slightly lower.

    With the internets there is much more variability in all the things that must be estimated but here goes.

    GOOG - Let us start with current market estimates of $8.85 and 53% growth. Which incidentally 53 x $8.85 equals $469 versus a peak in GOOG of $475. Thus one might think 2006 was priced into the stock in January. That said here is the other math. $8.85/$1.32 (MSFT Est EPS) gives us 6.70. 53% Est. Growth v. 14% growth is x 3.78. So $26.69 (MSFT's price) x 6.7 x 3.78 equals $675. Let's assume growth is slowing closer and quicker to next year's 36% estimate, so we drop it to a 3 x MSFT growth rate off of last year's numbers of $5.79. We now have an estimate of $8.22 and put a 3 x MSFT multiple on it to get $8.22 x 42 or $345. The real bears might argue for 2 x multiples which gives estimates around $210.

    EBAY - using 2006 $1.02/$1.32 with growth 19 x / 14 x $26.69 or $28. Using 2007 $1.31/$1.53 with growth 28%/16% x 26.69 = $40.

    YHOO - using 2007 .73/1.53 with growth 35%/16% x $26.69 = $28.65.

    Blackhawk Down, by George Zachar

    The new bond is now trading at a spiffy profit of over a point vs. the auction, and has appreciated to yield 14 bp less than its nearest yield curve neighbor. With the benefit of perfect hindsight, we now can see that by halting long bond issuance in 2001, the Treasury created Greenspan's famous conundrum of low and sticky long term interest rates, by magnifying a scarcity in assets clearly in demand. During the bond issuance hiatus, the world's pension funds moved materially closer to the boomer retirement era as asset yields shrank and equity markets moved sideways (from the date of bond suspension to now).

    There were warnings about all this back when 30s were suspended, alongside fears that Treasury was missing out on never-to-be-seen-again low borrowing costs. No one foresaw that a future return of the capital market's favorite girl would come at an even lower yield!

    This episode represents a rare case study of how all the capital market pieces fit together. Blackhawk Ben's academic teeth were cut during an era of liquid treasury yield curves out to 30 years, and an embryonic swaps market. He's taking the fiat reserve currency helm at a time when long dated public debt trades at a sticky premium and a global opaque swaps market renders his data and tool kits suspect. I somehow doubt this will come up at his Wednesday maiden monetary policy testimony, but one can always hope.

    Binary Modeling, by James Sogi

    Given that we are at the same price as 52 days ago, the question arises what will the outcome of this range be? Following up on Dr. Zussman's recent excellent studies on up days and down days, some counting is in order. Within the range 21 days were down open to close and 29 up. Within that same range, 21 days closed above the mean and 31 below. Does this mean anything?

    Modeling Binary Data by David Collett is perhaps the most clearly written explanation of statistics terms that I have read. Collett gives excellent explanations of the the formulas he uses with good examples of models and how to insert the numbers from the data into the formula. Very few other authors writing about statistics have succeeded in such understandable writing. There is the best discussion of models and hypotheses ever. The trick is to convert the models of disease, growing rose cuttings and the like into stock price data use. The truly amazing thing to me is that 2x2 contingency tables of win/loss, success/failure, or up/down data can reveal valuable information and that formulas and models exist to quantify such things as up and down days in a range. This was made popular by Bernoulli in 1713 and is known as the Bernoulli Distribution. It is based on the rules of probability.

    The key is to organize the data into meaningful criteria, and formulate a mathematical model or hypothesis that will, when tested on the data, render meaningful results and add to understanding. Knowing the limitations is a necessary part of the process. No model will provide all the answers, and no model will explain the phenomena. No hypothesis or model proves anything, as that is not the purpose of statistical analysis. The goal is to determine if there is a systematic element amid the random noise, and to identify the systematic component and the extent to which it is different, if at all, from the random component. The purposes are for prediction, explanation, description or criteria for further study and refinement. The computations, as the following will show, are simple. More difficult is characterizing the data in ways a million others have not, and getting an edge on them. One must ask the right question.

    We return now to Dr. Zussman's idea of up days and down days and combine that with my idea of sales in the top of the range and on the bottom. Conventional advice is that increasing down days and down volume is bearish, and that momentum will continue. This theme is what creates those big down days like the 7th, the idea that selling will continue. My hypothesis is the opposite. What if we hypothesize the more selling at the lower end, as evidenced by down days and by days closing at lower prices in the range, exhausts the supply of available sellers, the so called 'weak hands'. Also assume that there is a pool of cash and investors who are not as exhaustible as the weak hands. This model gives us the criteria to count up/down days, and closes in up part of range or lower range as evidence of exhaustion of sellers on the idea that sellers use up their energy by down closes and driving price in low part of range. Market data is particularly computable with binary analysis due to the fact that a day is either up or down, as is your P&L. Thus the count is set as a 2x2 contingency table of up days, or closes in high or low range in binary success or failure of the criteria. A test of the proportions using the Chi squared distribution and Monte Carlo simulation computes an exact p score. Here is another amazing thing: that computers can solve the equations and do massive number crunching in a blink.

             +     -
    oc+     31    21
    hi/lo   21    31
    The R script to test this follows.
     chisq.test(m,simulate.p.value = TRUE, B = 10000)
           Pearson's Chi-squared test with simulated p-value (based on
    10000 replicates)
    data:  m
    X-squared = 3.8462, df = NA, p-value = 0.078

    The result is not significant at the 5% level.

    What does it mean? According to the hypothesis, it cannot be rejected that the sellers are getting real exhausted. So there still may be some sellers left out there. The similar 12/29 study indicated significant low end selling going on on an intraday basis. The New Year's rally followed. In any case, a fun study with good lessons for further use.

    The Great One, from J. T. Holley

    I collect and trade baseball cards. The market has recently had an unexpected lowering (20-25%) of bids on cards. In some cases, cards on eBay, eTopps and other online exchanges have disappeared or been taken off the market. I follow these things closely and have never seen such a fall in prices across the board. I can only guess that Wayne, having one of the largest card collections, and being one of the most avid card collectors, has to be connected.

    The everyday liquid cards aren't the ones getting hammered. It's the rare ones, Mantle, Mays, Wagner, and older cards that are taking the biggest hits and disappearing. It's amazing that prices always seem to get a guy when he's down. It's as if the vultures are perched waiting for the Great One to be needy for some reason. I might add that it's not that Wayne isn't well off, it's just his card collection is his pride and joy.

    Gentlemen Prefer Bonds, by George Zachar

    There's no negative spin possible on the 30-year bond auction.

    It came more than 5/8 point higher in price than the middle of the market picture when bidding closed, is trading at a profit from there, has appreciated to its greatest premium yet over the nearest adjacent bond, and is a whopping one basis point over the funds rate.

    Jungle Fever, by Luca Coloso

    Colonel Spencer Chapman's The Jungle is Neutral, first published in 1949, recounts an Englishman's three years into the Malayan's forest during the Japanese' occupation in WW II. It's a story of endurance and survival: if you have the strength to react to the dangers and hazards, the Colonel says, well, the jungle will let you do it. But its neutrality is armed. He himself was on one occasion ill for two months, including a spell of 17 days of unconsciousness; at times, he suffered from black-water fever, pneumonia and typhus. Other than that, a fine day was when he could say he had only chronic malaria, for which, of course, no quinine was available. Most interestingly, he mentions that other British soldiers in the same conditions died "not of any specific disease, but because they lacked the right mental attitude".

    Mental attitude. Mental attitude. Do I have the right mental attitude to withstand the hits? In honor of Colonel Spencer Chapman, I hope I do.

    A Healthy Day, by Victor Niederhoffer

    The action on Tuesday, February 7, was one of the most cohesive and massive declines in markets in history. Every commodity on my screen, every stock market, and every bond market was down. Gold was down 4% and the Goldman Sachs Commodity Index was down 2.5%, one of the largest declines in its history. However, the massive declines in stocks, gold, and oil, a 20 + decline conjunction never before experienced, was truly shocking and cathartic. After extremely weak openings all around, most markets moved to new lows for the year. And some, such as gas, moved to six-month lows and set all trends into declining territory, while Google's massive 75-point overnight decline last Wednesday was looming in every weak longs sight. What a beautiful day for the shorts.

    Adding to the despair and trepidation was the forthcoming announcement by the West Virginian. Every countist in the land it seems had been sending me notes the week before that he was once more due to announce earnings and that the stock invariably goes down 2% on such announcements. But, of course, in such a situation the cycles are bound to change as the trainers tell the boys, "If that nag isn't too close at the stretch don't whip him too hard," thereby setting up the overlay for the next race, said master turf handicapper Robert Bacon.

    If only the public would realize that consistent price performance of a stock following its earnings' announcements is similar to looking for the runs of sticky numbers in roulette spins. And, that it's always possible to find a company that shows consistent price performance after earnings' releases (The earnings releases correspond to the different roulette machines in the casino, and the price performance corresponds to the sticky numbers). If the public realized this, then, in my opinion, they would not continue their Baconian tendencies to lose so much more than they have to.

    Rather than promulgate from the lofty heights, emphasizing that meals for a lifetime are the only food that I will try to serve, I feel an obligation to break the custom today, just the way I would in the past whenever a certain large speculator would berate me with doomsday scenarios after similar such days in the 80's. I would always tell him in such a situation. "Be happy. It was a very healthy day. The weaks were washed out. The forces of homeostasis will now come to the fore so that the feeding system of the strong eating the weak may continue." Today's action is a throwback to the 80's and 90's. It provides a catharsis, particularly because of the West Virginian and Mountain View fears mentioned above. It's a day that as of the close was particularly appropriate for caneology. Furthermore, I'll go further to opine that any of the usual morning attempts to recap the recent beatings, will provide ample overplus for caneologists to invest in stately mansions.

    Counting Words, by Rob Fotheringham

    Several years ago work on a word-guessing algorithm introduced me to a corpus of spoken and written (British) English containing some 85 million words. Do word frequencies reveal the topics of greatest interest?

    Top ten nouns:

    time (183k occurrences)
    year (164k)
    people (125k)
    way (113k)
    man (98k; woman was #13 with 63k occurrences)
    day (93k)
    thing (78k)
    child (71k)
    government (67k)
    part (66k)

    Three of the six most frequently used nouns deal with time ("time," "year," "day"). Whether that is due to the preoccupation with mankind's dearest (and often unpredictable) asset (i.e. time remaining before death), or the same differences that drive the oft-asked question in this forum of why a particular time period was used for analytical purposes (i.e. each assigns a different level of significance to a period of particular length), I'm not sure.

    The recognized tendency to overweight recent occurrences predictably manifests itself linguistically in the most frequently used adjective "last" (140k occurrences), which was followed by "other," "new," "good," and "old." While our preoccupation with things novel is likely not a surprise to those on this list, I wouldn't have guessed that "new" would occur nearly twice as often as "old" (116k vs. 67k). Yet "old" beat out "young" nearly 2:1 (67k vs. 37k). Maybe O'Rourke had it right when he said that age and guile beat youth, innocence, and a bad haircut. And maybe the optimists will always triumph: "good" beat "bad" nearly 4:1 (101k vs. 26k).

    Of interest, and with premeditated apology to the Palindrome, was the least used noun of all (of those deemed worthy of measure): "quantum."

    Hany Saad's Letter on Risk and Exit Strategies

    Meet Galt Niederhoffer, Author of Critically Acclaimed A Taxonomy of Barnacles!

    Feb 21 Tue   7:00 Joseph Beth              Lyndhurst       OH
    Feb 22 Wed   7:00 Books and Company        Dayton          OH
    Feb 23 Thr   7:00 Left Bank Books          St. Louis       MO
    Feb 24 Fri   5:00 Square Books             Oxford          MS
    Feb 27 Mon   7:00 Quail Ridge Books        Raleigh         NC

    Ringers and Rascals, from Mr. Ckin

    This may be a well-known story for the racing aficionados in our midst, but I had never before heard of the story depicted in a book that I recently acquired entitled "Ringers and Rascals - A Taste of Skulduggery," by David Ashworth.

    From the inside of the dust jacket:

    Peter Christian Barrie had a strange skill; he painted horses. Not with oils, on canvas, but on the horses themselves. The King of the Ringers disguised good horses as bad ones, and tricked bookmakers out of millions of dollars.

    Apparently, Barrie used a variety of henna tattoo techniques to give the impression of an injured horse. The implications (obviously) are reminiscent of writings on deception in the marketplace.

    Full Story and Victor Niederhoffer's Response.

    Counting Bond Issuance, from George Zachar

    The primary bond indexing house has published its estimates for 2006 debt issuance around the globe.

    Here is their forecast for govt. debt:

    United States  700 billion
    Eurozone       800 billion
    Japan         1050 billion

    Those are all in $US.

    Please keep this table in mind during the periodic hysterias about American profligacy.

    Sometimes We Forget It's Real, by Tim Melvin

    Yesterday I was sitting at my desk, on a pretty much normal day, trying to root the market a little lower for good entries into some stocks I like here, when I looked up and noticed that my assistant is crying. A bright, pretty, 24 year old and stunningly quick learner, she is quickly becoming one the best assistants I ever had. Normally she possesses a sunny disposition that I find almost annoying, especially on mornings after nights of over serving myself. These were not little tears of a bad day or boyfriend fight, but sobbing, shoulder heaving type crying, so I immediately went over to see what was wrong. Simple. Four soldiers from her brothers platoon were killed in Iraq yesterday and for a few terrifying moments they weren't sure if he was one of them or not.

    In today's all volunteer military, I suspect not too many readers' children are serving in the lines of the army or marine corp. Lack occasionally throws some comments in that carry a jolt of reality, but even that carries the force of fearful panicked tears on a friend or co-worker for the safety of a brother, a father, a husband. We look at the war as a geopolitical event that affects our market positions and the price we pay for gas. Without the direct impact of having our loved ones over there we gain distance from the actual events and have intellectual discussions about right, wrong, exit strategies and long term Middle East stability. The fear and loss is not shared across economic and social barriers the way it was in WWII or even Vietnam. This is not meant as a criticism or comment just a statement of fact. The war for many of us is blurbs on the evening news and scroll on a news ticker. For others it is a flesh and blood, fear and tears reality.

    It would, I think, benefit us all to remember that each time we read of new casualties there are mothers, sisters, fathers, brothers, sons and daughters crying real tears of real losses because of sacrifices made by young men and women for their nation. Agree or disagree, if you live in the United States those sacrifices were made in your name and in the belief it was for the benefit of us all. Honor that. See a soldier in the airport lounge? Pick up his check. Got a stack of books around you'll never read again? Donate them to one of the books for soldiers programs.

    Real people, real tears. They deserve our real respect and honor.

    Latest Commentary from Dick Sears

    The Perfect Game, by J. P. Highland

    While being in Houston, TX (a few years ago) for a short business trip, I used my free time to visit the former Enron Field to see Randy Johnson, pitch for the Snakes against the Astros. I had been lucky to see many of the finest pitchers of our time like Roger Clemens, Pedro Martinez or Curt Schilling but Johnson was missing.

    Johnson was impressive, delivering effortless strikeouts and harmless ground balls and some occasional fly-outs. It seemed that everything was going his way. But Johnson didn't look happy, he was constantly grumbling and yelling to himself and to his catcher. Despite that his performance was not perfect since the second inning, he kept looking for perfection in every pitch.

    I still remember his numbers, 8 innings pitched, 10 strikeouts, 3 hits, and 2 walks: not bad. It wasn't until May 18, 2004 when he achieved the Perfect Game, pitching for the Diamondbacks against the Braves. At the age of 40, he became the oldest pitcher to achieve perfection.

    After I trade I'm never happy, If I lose money I'm angry because I hate to lose money, if I make money I'm not happy because after reviewing my trades I realize that I could had made much more. I can't recall a single day which inspired me to sing Lou Reed's "Perfect Day".

    Pitchers have a benchmark to measure perfection, but which is the trader's benchmark? I would hate to learn the Soros' killing in the BP is the benchmark, thus there is no hope for small fish like me to accomplish a Perfect Game.

    A Hagiography, by Victor Niederhoffer

    The Google Story by David A. Vise and Mark Malseed, is replete with the kind of sentiments usually reserved for the Sage.  'The staff eats for free in a dining room that used to be run by a former chef for the Grateful Dead" and "Even as it rides high, Google wrestles with difficult choices that will enable it to continue expanding while sustaining the guiding vision of the Founder's mantra 'Don't Be Evil'". No wonder the authors, a Washington Post type collaboration, had "Extraordinary Access" to do their "Scrupulous Research" on the firm.

    Three vignettes call out for comment. Sergei Brin's father, Michael, devoted all his time in the Soviet Union before coming here to proving that "Russian Living Standards were better than America". The two founders, Sergei and Larry entered a Ph.D. program at Stanford where the President sought to encourage risk taking and entrepreneurship and allowed the profs to keep the financial rewards of being adjacent to Silicone Valley, and allowed the students to work on "potential commercial ventures using university resources". This led to a most amusing situation. All the students shared office space in the "William Gates Computer Sciences " building. One Sunday morning another student entrepreneur Ms. Tamara Munzner remembers at 3 a.m. in the morning "the offices were full. We are such geeks."

    The three incidents are related in that incentives and the profit motive provided the framework and trophies to induce the founders to form this colossus that has revolutionized the information retrieval business and now carried a market value higher not only than Disney and General Motors combined as the book jacket notes, but at 108.7 billion is within a hair breath of Intel's at 124. 6 billion, and ranks 4th in the Nasdaq 100 behind Microsoft, Apple and Intel.

    P.S. While it has nothing to do with this post, and of 1000 posts here, I doubt that I've mentioned an individual stock more than twice, except in the context of a scientific study, or a pasting of hubristic Sageology, and my normal business has nothing whatsoever to do with individual stocks, I mention that a former wife does hold Google and I was reading the book to see why her performance was so much better than mine. However, like everyone else, I occasionally don't put all my spare money into index funds and own a stock or two. Just as a coincidence , and having nothing to do with this post, I put some statistics on the table concerning the performance of companies that have registered comparable declines to Google's last week, and have a long position in Google . Also as a coincidence, I once read a hagiography of the training methods and wisdom of Jim Currier, a good baseline tennis player from the past who liked to put his money into Intel when it was being beaten into smithereens, and remembering that I recently went long Intel.

    Peel Some Time Away for this Onion Post from David Higgs

    The onion is the champion blender, be it in soup, salad, sauce or as a side dish. The onion in the vegetable world is that of the man in the world of parlance known as the "good mixer". It harmonizes ingredients, brings out the best in each, and runs them all together in a perfect whole.

    So today we barbeque him. What we look for is the onion with the most amount of  golden outer skin. The more the better. Size is also important, we want it be half the size of the palm of your hand. This will take some time searching the onion bend, allow for it.

    Simply place the onion whole on the barbeque pit. Have a mister handy to retard burning outer skin, but be reasonable, we don't want a soggy presentation!  Prepared a mixture of herb butter and dry vermouth. When the onion becomes soft, insert this mixture into the onion with a syringe. Continue cooking. When the onion yields easily between fingers, it's ready. Enjoy.  And the Aussies are  proud of their flower onion.....ha!!!!

    J.P. Morgan, Sr. and Harry Smalls, from Stefan Jovanovich

    Reading Art Cashin's tribute to Harry Smalls this morning (see below) made me think yet again about J.P. Morgan, Sr. and his fanciful notion that only character mattered.

    What I have concluded (at least for today) is that Morgan's notion was the elemental wisdom of a lifetime of game theory. Morgan thought that character mattered because it was, in fact, the one constant in a world of reliably unpredictable fluctuations. The best anyone could do was to use their best judgment about risk and honor their trades and trade only with people who honored theirs.

    Morgan was hardly a skeptic about accounting, but he remained a persistent agnostic about the ultimate value of numbers. His reorganizations always started with getting a proper set of books, but he seems to have thought that numbers had as much (if not more) capacity to lie as they did to tell the truth.

    What makes his attitude seem utterly alien to most modern minds is that it had no "system" behind it other than faith in something that could not itself be quantified.

    Here is the piece by Art Cashin, UBS:

    Monday morning I learned that a dear friend and a Wall Street icon had passed away over the weekend. His name was Harry Smalls and when I first became a member in 1964, Harry agreed to be one of my two sponsors. At the time, there was a very vigorous (and occasionally painful) admission process. The appearance before the Admissions Committee in those days was somewhat like being grilled before a grand jury.

    So here I am, twenty-three years old and about to be grilled by the senior partners of some of the biggest and most prestigious brokerage firms on Wall Street. That's where Harry came in as a "bonus". Harry knew everybody. More importantly everybody liked Harry. He had a ready smile and a quick wit and both the great and not so great found him gentle and charming.

    One of the reasons Harry knew everybody and everybody knew Harry is that he had worked at the NYSE since the 1940's.

    Aside from easing my admission and becoming my life long friend, Harry brought me other benefits. Given his decades of experience, he was a fabulous information source. If you wanted to know how the market reacted to some battle in the Korean War or to Eisenhower's heat attacks or the fall of Dien Bien Phu, Harry's memory was precise. Harry helped me found the Exchange Christmas Dinner Fund, which each year provides full Christmas dinners at home for those in need. They do not go to some armory or soup kitchen. They stay in their own home or apartment surrounded by family and love - even as you or I. Harry used to say - "We'll teach folks Scrooge doesn't live on Wall Street". He sure did.

    I could go for pages about Harry. His knowledge of arcane facts about baseball and his beloved Brooklyn Dodgers was legendary on the Floor. But it was his graciousness that will be remembered best. In the rough and tumble world of Floor trading things can sometimes get confrontational. But folks would always remark that "if you got mad at Harry Smalls, there was something wrong with you".

    Contango Tango, by George Zachar

    Spot checking the energy and grain complexes, it looks like most of the calendar strips went deeper into contango today, meaning the buy and hold commodity guys have even more negative carry to overcome. As noted earlier on the list, lots of funds are rolling, and it's got to be causing a fair amount of pain. Interesting that this spread price action is coinciding with the monster decline in gold, etc.

    The bizzaro-world explanation for all this? The announcement of a pregnancy in Japan's royal family sparked optimism on the Japanese economy in currency land, triggering buy stops on the yen, forcing the short "yen carry" geeks to unwind the positions they were funding in Tokyo. I mention that just so folks who aren't 24/7/365 staring at screens can see what kind of nonsense can be passed off as "a reason" in the markets.

    Risk, by James Sogi

    Years ago, a friend used to be a mountain climber and is a real go getter type of guy. He switched to sailing and we would go sailboat racing on weekends. Here is his explanation of why he quit mountain climbing. He told me," I'd been climbing for years in the Pacific Northwest. As got better, I sought more and more difficult climbs, with higher peaks, greater technical challenges. The tamer climbs didn't provide the same thrill or challenge. As the climbs became more and more difficult, however, a number of my friends and climbing partners died in climbing accidents and I started having some close calls. The weather can be unpredictable and contribute to the risk of disaster. I have a wife and a young daughter and have to think about them as well. Before I push my luck too far, I decided to switch to a safer sport."

    One aspect of risk is the initial aversion to risk becomes an attraction or even an addiction to risk of varying types where the actor does not feel engaged unless the risk is higher than the comfort level. At higher levels of performance, this often places the actor in life threatening situations.  In trading as one uses increasing size, there may be factors involved in the trade and risks which may distort strict money management principles. How to maintain a careful balance is a matter of life and death.

    Portugal Telecom Takeover Attempt, from Andrea Ravano

    Nice volatility building up in Portugal Telecom, which has received a unsolicited bid from Sonae, a diversified company with interests in lumber, construction and telecoms. Note that Sonae belongs to Portugal's richest man, Belmiro de.Azevedo, but it is a quarter of the size of the target company. Portugal Telecom's debt has been under pressure since late summer 2005. The spread against Bunds for its benchmark issue 2025 has moved from 60/70 over to 130 in late December. If the bid succeeds, Portugal Telecom's debt would plunge from an A- rating to semi-junk. Hence the spread against Bunds is now around 210. But, being a bit skeptical about the outcome of the bid and the fact that France Telecom has a 26.7 percent stake in Sonae, I have tried to lift some offers from the big boys -- M#rgan St#nley and others. Guess what! The offered price started jerking like a blue marlin caught by surprise, and from an initial screen offered price of 83, I watched my order being filled around the 85 level, down 8 percentage points from yesterday close. If I'm wrong, no new carbon bike for me this year!

    Upon Reflection, by Nick Procyk

    Victor Niederhoffer previously wrote:

    It is interesting reflect on the mysteries of the market, the amazing creativity with which she confronts you with problems of an extremely creative nature, the kind that remind you of a very good mathematical challenge, the kind that appear, for example, near the end of most standardized aptitude tests.  But a little bit of counting can help. Indeed, one of the best ideas I had was to bring Adam Robinson, the co-founder of the Princeton Review on board a few years ago to figure out just what the market wants you to answer in such situations. This is always a very good exercise in meals for a lifetime.

    This had me consider the questions to ask. In What Smart Students Know by Adam Robinson, the author recommends asking the following expert questions for Type III (math, finance, logic, economics, physics, et al.) subjects when solving a problem:

    Fifty Ways to Exit Your Trade, by James Sogi

    The surfer kicks out as the wave ends, or if, during the ride, the wave collapses, he turns quickly and flies over the top of the wave avoiding the crashing white water and reef below. Surf master Shane Dorian taught me a technique when riding deep inside the tube, pull even deeper, (as opposed to the inclination to try go in front of the wave) where the tube 'ball' of rolling white water is located, and then sit back in a ball, and pop out the back of the wave rather than get pitched over the lip, or hit by the lip. The question when riding the tube is whether to pull in under the pitching lip of the wave to ride inside the tube with the potential for an epic ride in the tube with increased risk of getting 'hammered', or bail out by diving off the board in ignominy. There are many good techniques to exit and it is good to know them when the time comes.

    In trading, we've talked about stops, but what about taking profits? Chair says, " Exit when the probabilities no longer favor the trade". This leaves unanswered the question of how to deal with the random element involved in each trade. Each trade has a probability but also a random range which must be read during the trade by a variety of techniques such as price action, price change, price levels, time of day, profit targets, time targets, liquidity, each of which affect the probability curves as well. Say you are past or before the maximum probability point but the market is rocketing in your favor. Or say the probabilities favors exiting but the trade continues in your favor, or the probability says stay, but the market screams exit.. Do you stay or 'kick out', go for the glory or take on more risk, or reduce size and risk incrementally? This is the execution aspect of the trade. Even the highest probability trades have a historical large draw down scenario.

    There are many exit methods: trailing stops (inefficient), sequential exits, phasing out in blocks, time stops, targets, buy and hold, dollar cost averaging, portfolio insurance methods, portfolio management techniques used by bond and option guys. The question is whether to continue to ride the trade, add, reduce, exit and either prevent losing all the gains, or miss out on a continuing gains. My father advised in the legal area, "Never look a gift horse in the mouth." Take a gift when it is offered. Reducing size and risk as probability decreases and as unrealized gain increases leaves profits on the table, but reduces the give backs. Trade the market, not your P&L. The Senator suggested time and profit targets, (First profitable open). The Day trader is looking at 5 cents. The Expert seeks 24 sigma wings. I wonder if other experienced specs might elucidate on the 50 Ways in 50 markets to exit your trade.

    Dr. Kim Zussman adds:

    Another variation of Jim's question is based on upward drift: If stock movements are non-random at long intervals, how can they be random over short intervals? How much of upward drift comes from "random intervals" as opposed to intervals with statistically supported positive expectation?

    Bruno Ombreux comments:

    I am leaning towards Chair's advice. I need an example that doesn't disclose anything, so here is one from Google's past runs.

    Conditional runs (10 minutes sampling period)
                   2 if 1    3 if 2    4 if 3     5 if 4      6 if 5
    frequency       0.46       0.48     0.46       0.49        0.57
    p-value %       1.04      23.65    16.91      45.31       84.47

    We can see some mean-reversion in 10 minutes returns, but it is only significant after one run. So I would fade a 10 minute upmove, and close after 10 minutes no matter what.

    In addition, I think one edge should be selected so that statistics clearly tell when to exit, based on a p-value stop. "p-value stop"? I guess that translates into the more familiar term of "time stop". For instance, if the statistics show mean-reversion getting stronger the longer the previous run, it can be dangerous. Because you end up in a losing position to which you should theoretically add. This is good statistical trading but poor money management.

    In this example, it is better if mean-reversion is not significant after a while, so you know when to exit. Else you can add as it moves against you, if statistics say so, but you need to overlay strict money stops to avoid big problems.

    Dr. Phil McDonnell says:

    The ideal trading model would emulate the owner of a casino. A casino plays the odds. The games are very much their games. They set the rules, set the minimum and maximum odds and collect and pay the bets. Everything is carefully arranged, rules and strategies never vary. It is all carefully monitored by at least three levels of eyes. If the reader will pardon the expression - nothing is left to chance.

    Most smart traders enter trades with an edge of some kind. For a counter this is usually some sort of back tested strategy which he has verified will give him a statistical edge. The trade is usually the result of observing some event and how the market performed subsequent to that event. An edge simply means the average amount won exceeds the average amount lost during some recent time frame after the event was seen. The event can be as simple as the approach of a round number, a new high, low, moving average crossover or Fed meeting date.

    A good analysis will do a multi-time period work out of what happens after the event. One such analysis might show the following returns per period:

    Time        1           2           3         4        5
    Event    +.17%       +.15%       +.10      +.05     +.04

    Clearly all five sub-periods are up. But if the average of all periods is say 05% because of drift then we can say the last two are simply random. So our normal trade based on this would be for three time periods and we are out.

    If the above study was based upon a single event then it includes all cases in the past where that event occurred. Those who believe they can second guess the study when the market starts to turn against them should seriously question why. Do you have a study that says the above is true but when the market goes down by .2% it will no longer be true? Very well then that's acceptable. But if the early exit to the trade is driven by a queasy stomach or a hunch you may be falling victim to another of the market's many deceptive moves.

    My advice would be to think like the casino operator. Does the casino tell its black jack dealers to hit to 17 except when the cards are running hot or cold? Certainly not. Nor does the casino close a craps or roulette table because of a brief run of luck. For trading we should be just as systematic and disciplined. We should only exit a favorable edge trade when we see an event which contradicts the earlier edge. In the above 3 period trade we may see an event which we have studied which indicates a next period return of -.20%. In that case it is time to get out even if it is before three periods.

    For my money the best trades are ones where the outlook is for multiple periods of favorable returns. After entry the trade should continue to be tracked using multiple tested indicators or signals so that if an early exit is indicated it can be executed without resorting to hunches or feelings. Every time you pay some vig it should be to take advantage of a positive edge or to avoid a negative edge.

    A Few Lessons from The Circus, by Allen Gillespie

    Yesterday, I attended the "Greatest Show on Earth" and I encourage every spec to attend because of the things that could be learned. As the chair says, cycles change, and so does the circus, which now uses big screens to give the audience better views and to add special effects. There were performers from all over the world (horsemen from Russia, acrobats from China, a ring master from Broadway) - look broadly for ideas. There were, however, the old stand-bys of circus entertainment - the elephants - don't forget interest rates and earnings. A hummer drove over a strong man's stomach, but I suspect the tilt helped keep him safe - use leverage wisely. Birds, cats, and dogs learn amazing tasks in return for a reward ( a little catnip, a biscuit, seed, and kiss) - reward yourself and your children for acquiring new skills - also companies with properly aligned compensation systems make better investments - just read the book on Enron. Finally, as the clowns and ringmaster say, have fun.

    From The Dept. of Philosophic Thoughts, from Henry Carstens

    I found this Paper on patternless anomaly detection. Patternless anomaly detection appears to be based on statistical mechanics. From the same paper:

    We have presented a novel approach to characterizing the conversation flow of a computer network.

    I wonder what the conversation between stocks and bonds looks like.

    And a role reversal question:

    If the computer were the trader, and the trader were the markets, what would the computer do?

    In other words, I'm noticing that I use the computer not so much based on the computer's strengths but more as an extension of my own weaknesses.

    A Story on Personal Living, from Dr. Mark Goulston

    You can short the market, but you can't short death.

    I recently returned from a trip to the east coast of Florida helping to move my 88 year old mother from her home to an assisted living place closer to my older brother a couple hours away in Naples. I hope it goes well and she does make friends easily. But I am not optimistic.

    One of the smartest lawyers I know, who has never admitted making a mistake in thirty years, recently told me he just made a big one. That was to relocate his parents in their late 80's from their too large and too distant home to an assisted living (what a euphemism) place near where he lives after his dad developed Alzheimer's and became difficult to control. His dad deteriorated over a year and a half, finally dying after having all kinds of horrendous episodes with interventions that savaged his dignity. And now his mom at age 90 says she's ready to die.

    Here's what he said he wished he had done and I'm planning to follow his counsel. When you're in your late sixties or early seventies and in good health (earlier if you're not), downsize to a house or place you can live. Then get whatever help you need so you can die there. If you make the move at that time, you're still young enough to develop a new community (who are in a similar situation), get your health care ducks lined up in a row, and avoid the disorienting disruption to your life of going to a place that may be caring, but still won't care about you the way you'll want.

    One of my favorite quotes of all time is getting too close for comfort. It comes from a supervisor, Dr. Milton Greenblatt, one of the great community psychiatrists in Los Angeles early in my career when I was in my late twenties and is the first chapter of my first book, Get Out of Your Own Way: Overcoming Self-Defeating Behavior.

    First we are children to our parents,
    Then parents to our children,
    Then parents to our parents,
    Then children to our children.

    P.S. LivHome is a great company that helps people stay in their homes (and is doing so with one of my mentors after his wife died) is in Los Angeles and would probably know of other such companies across the country.

    Some Thoughts on Roulette Screens, from Victor Niederhoffer

    All Casinos show a lighted screen indicating the colors and numbers (but not the sectors) of the last 18 or 20 spins on modern roulette machines. The idea is to encourage players who believe that the past spins are indicative of the future. The screens provide a nice exercise in probability theory, the influence of multiple comparisons, the decisions between patterns and randomness and the revisions of hypotheses based on subsequent events; all areas very close to proper decision making in our field.

    I am just back from Las Vegas and do not wish to work out the numbers in my head, so a complete post on this subject will have to wait until I get out my binomial tables, however, the first question is: What is the probability of a unusual occurrence, say three of the same number -- a sticky wheel -- in 18 spins? Since it's 1/38 that a given number will appear, the chances of three or more of a given number is the binomial probability of three successes or more out of 18 with a probability of 1/38. That chance is 0.011. The second stage is to compute the probability that none of the 38 numbers will occur these three times or more. That would be (1-0.011) to the 38th. That gives is 0.65, thus the chance that there will be at least one number with the three or more hit rate will be 0.35. But of course there are four roulette machines at the average casino and a counter is likely to pass by the machines 10 times each to find the one that's not true. So that's 40 times to find a event that has a 0.35 probability. For that not to happen is a 1 - 0.65 to the 40. That is so close to zero that finding something is practically certain. Let's call it 95%.

    Now assume you have found that that event happened. Let us compare the possibility that it occurs by randomness to the chance that the machine is biased and that there is a defect somewhere. Let us say if there is a defect that the chances are 1/20 that 14 numbers will occur and 1/100 that the other 24 will occur. With such a machine the chances of finding a run of three would be say 99% with the same searching pattern as before. Before you start you figure out that it is 90% that no machine will be defective and 10% that it will be defective.

    Okay, you have observed a success. Which hypothesis is now more likely? The likelihood of the first hypothesis is 95/99ths as great as it was before, and the likelihood of the second hypothesis is now 99/95ths as great as before. That brings the first hypothesis down to 85% and the second one up to 15%. You can see that you would need about 8 separate instances of a given machine in independent trials giving 3 or more successes before you reached 50-50 chance that the machines were defective.

    Similar reasoning is appropriate for using patterns to conclude that non-randomness occurs in the market, and that it will continue. The key is repeated instances of seemingly non-random behavior.

    From the Chairman of the Old Speculators Association:

    Reading your piece on Las Vegas and roulette wheels reminded me of a curious story. When I was 23 or so and working as an actuary at a large insurance company, I had a kid working for me as an actuarial student. I say kid, though he was probably a couple of years older than I. Anyway, he went to Las Vegas on vacation and returned to report on his activities at the roulette table. Being of an actuarial bent, he had watched the table for some while before starting to bet. During that period, he had kept track of what numbers came up. I naturally assumed he was looking for a bias in the table. No, as it turned out, he was looking to determine which numbers had not come up, because he figured they would be overdue. I kid you not. The punch line here is that he wound up as CEO and Chairman of the Board of the company. It's an interesting commentary on large insurance companies.

    A Letter on Rogue Waves, from Michel Olagnon

    For a Biography of Michel Olagnon

    Last spring, I had some discussions with Bruno Ombreux on statistics, processes and rogue waves. At that time, he pointed me to your site and to the discussion that you had on rogue waves.

    Rogue waves can be characterized as being "higher and/or more severe than expected". Such a definition questions above all what our normal expectations are. Recently, a number of researchers, especially in the MAXWAVE project, have taken laypersons' (and at the same time, naval architects') expectations as the reference, and found that there were many more rogue waves than those expectations would suggest. They thus went on investigating theories to explain those freak waves, the "ones from nowhere".

    A few other groups, including my own, have analyzed those expectations as well as some theoretical results of the mathematicians, and the results are:

    1. Most expectations are wrong, without the need to call for advanced theories. There are no more high waves than the simple theories predict. Seafarers, and probably traders as well, just wrongly put some sort of implicit bounds on extremes that might occur at a given time when they are observing the ocean surface (or the markets). According to conventional theories, there are no bounds whatsoever on what may happen, and in fact observers should rather expect to be surprised.
    2. Though there are no more freak waves as a whole than simple models predict, it is still possible and even likely that their occurrences are not purely random, and it is of utmost importance to understand where and when is going to be the next wrong place at the next wrong time, and why.
    3. Theories such as Non-Linear Schroedinger (NLS) are consistent, they may even be perfectly correct models at the time and location of a rogue wave, but their extent of validity is limited in time and space to a small neighborhood. They thus should not be used to derive statistics.
    4. A freak wave does not suck energy from its neighbors. It looks as if, but the energy gets concentrated at the time and location of the wave by pure chance and determinism from the initial conditions, there is no active transfer originating in the wave.
    5. NLS is governed by Benjamin-Feir Instability. An analog of that instability index can be computed for markets. Instability is driven by spectral width (how similar the wave-lengths of the various wave trains are) and by wave steepness (how short the waves are with respect to their heights). I have found some plots showing Benjamin-Feir Instability for the Nasdaq100 on to 2006/01/27, at one-minute rate and for the Nasdaq composite over the last 20 years or so.

    As far as I can tell, the results are very similar to what we see with ocean waves: "unexpected waves" are correlated with excursions of B-F instability from normal, but there is no clear causal relationship. I would compare B-F instability levels to avalanche warnings in the mountains, as avalanches and warnings are correlated, but an avalanche does not mean a warning was issued nor a warning that an avalanche will indeed occur. In addition, many warnings come too late.

    An Astrophotography Forecasting Model, from Henry Carstens

    My son and I recently began taking pictures through our telescope. At its most basic, Astrophotography consists of taking a time series of exposures of an object, choosing the highest quality images from the series and stacking them to create a single composite image. From this we derived the following Astrophotography forecasting model for trading:

    1. Define a target pattern.
    2. Collect all the historical patterns that match the target.
    3. Choose the best matches.
    4. Build a composite forecast from the best matches.

    The definition of best matches might be anything from fundamentals to volatility regimes, and composite forecasts anything from average to weighted to the esoteric.

    A Perspicacious Spec Reads the Newspaper, a Continuing Feature

    Bono's Elevation Partners May Buy Take-Two, N.Y. Post Says Feb. 6 (Bloomberg) -- Elevation Partners LP, a private equity firm whose partners include rock star Bono, may bid on Take-Two Interactive Software Inc. in a deal that may be worth more than $1 billion including debt, the New York Post reported, citing unidentified people. Elevation may join Pequot Capital Management Inc., which owns shares in Take-Two, to buy the New York-based developer of the "Grand Theft Auto" video game series, the newspaper said, citing the people.

    Note you don't see him investing in Africa (that we know of). "Do as I say, not as I do!"

    A Paper on Corporate Spreads as a Proxy for Ex-Ante Stock Premia, from Dr. Kim Zussman

    Briefly Speaking, by Victor Niederhoffer

    A Dow January Barometer

    The five Dow stocks that performed best in January 2006 were: General Motors, +24%, Caterpillar, +18%, Exxon, +12%, Pfizer, +10%, Hewlett Packard, +9%. Is there any statistical reason for thinking that they will perform better during the rest of the year than the other 25 Dow companies? I computed, with the aid of my hard-working associate Vince Fulco, the rank correlation between the performance of the 30 Dow companies in the first month of the year versus the last 11 months of the year, for each of the last six years. I found negative correlation coefficients in each year, insignificant ones on the order of -0.05. Thus, I conclude that there is no tendency for the January barometer to work for the 30 individual Dow stocks.

    James Taggart and Mysticism in our Field

    I heard a nice analysis of Atlas Shrugged by Edward Hudgins of the Objectivist Centertoday in which he concluded that not only did Taggart eschew the use of reason, but that this necessarily led him to a death wish for himself and all others. I couldn't help but think that the blind abuses of reason in our own field of market analysis must also lead to that end. After all, what reason is there to think that by drawing a straight line between two points (which you can see clearly from across the room according to a great exponent), will lead to movements in the future in the same direction. For sure, there are transactions costs involved. And for sure, there are fees taken out for the experience. Also, there are people on the other side who are flexible and would have a tendency to trigger exacerbated movements in the entry and exit. Finally, there is the query as to whether there is any amount of evidence that will convince a proponent of same that no predictivity will occur in the future sufficient to offset the frictions and vigs mentioned above. Where can it all lead, but to a situation and condition similar to James Taggart at the end of Atlas. I would like to acknowledge that the sportswriter of a recent article in the sports pages of a Boston newspaper seems to have a feel for this ultimate resolution of faith in the market trading world.

    A Mere 24 Hours

    What a difference a mere one day of trading can make. At 1:20 PM on Feb. 1, crude oil trades at $69.00 a barrel, at a four-month high. In the last hour, it moves down $2.50 a barrel and then on Feb. 2, fell another $1.90 a barrel. A decline of 6.3% in 24 hours is enough to bring it back to the levels of the beginning of the year. There was a comparable move from $1.85 a gallon to $1.66 a gallon in gasoline prices. Both moves seem to have occurred out of the clear blue sky with no news of any kind to account for them, they are reminiscent of the squalls of the 19th century talked about in Ed Spec, and in 50 Years In Wall Street by Henry Clews. The moves were also a harbinger of Thursday's swoon in the US stock markets, typified by the 15-point swoon in the S&P. Such moves dashing the hopes of those that enthuse over great expectations for a market at the beginning of the year, with January Barometer type of hopes, and more importantly putting the fear of the Market Goddess in those that are weak holders, seem to me to occur with inordinate frequency in the first part of a year. But this must be tested.

    A New Kind of Conference

    There are conferences on every conceivable aspect of the investment business. And my good buddy the expert spoke at more than 50 of them last year. It seems to me that the time has come for a conference devoted to losing strategies, fast operators, deceptive practices, gilding the lily, how to be led astray by past results, excessive fees, mistakes investors have made, hubristic practices among the stars, conflicts of interest, past present or future actions contemplated against the guilty, and recovery strategies. The idea for this is not mine. It came from a good friend, a former investor, who recently withdrew from my fund with a nice profit, but told me that I should be thankful for his withdrawal because he always withdraws at the wrong time, and that means that I am due for a great windfall. He was kidding. But when I volunteered to be one of the keynote speakers at such a conference, with an enumeration of lessons and 20 errors from my 1997 debacle, his demurrals were none too great.

    An Edge, an Education, a Beer, and a Burger. A post from Gordon Haave on poker and the markets, and how to win an edge.

    January Barometers, Super Bowls and Part-Whole Fallacies, by Dr. Victor Niederhoffer and Dr. Alex Castaldo

    This is the time of year when the tendency to use the beginning of a period to predict the end of the period runs amok. For one, there are the proposition bets on the Super Bowl. The team that scores first in the Super Bowl is 27 of 38 to win the game. Thus, many of the sports gambling books will offer a dollar bet that equates to 71% (before their vig) that the team that scores first will win. Similarly, the team that scores first in soccer is 80% to at least draw the game. And if you're a confirmed gambler, you can get similar proposition bets on the team that scores first in a basketball game.

    Gamblers know that such statistics are purely random phenomena due to the part-whole fallacy. Similar statistics would apply to the team that scores the last point, or any point in these games. As Doc has shown in a widely referenced article the part-whole fallacy occurs because:

     The correlation between x and x + y is  Var(x) / SQRT[ Var(x) (Var(x)+Var(y)) ]

    Regrettably, stock market people aren't as sophisticated as gamblers. And they often refer to the January effect, where if the first month of the year is up, the whole of the year is likely to be up as if it's a non-random phenomenon. However, as Doc has shown, and as I showed 40 years before him in my correction of a similar error that a future Nobelist made in his research showing that first-quarter earnings were not predictive of the full year's earnings, such correlations are guaranteed to exist by randomness. Indeed, the correlation between January, and the whole year is 30% by randomness.

    Let's look at some actual results to put this in perspective, considering first what happens in the next 11 months after January is up, and comparing that to what happens in the next 11 months when any month is up.

    January as Predictor 
    (S&P 500 Point Changes, 1980-2005)
                                           Avg Pt Chg 
                                         SP500 Cash Index
                                  Obs.     Next 11 mos       Stdev.
    January up                    17         56.9            105.1
    Any non-January month Up     168         48.6            103.0

    Thus, after an up January, the average move the next 11 months is 57 points. But after any other month is up, the average move the next 11 months is up 49 points. The difference of 8 points between them, less than 8% of the standard deviation of the point move, is completely consistent with randomness.

    January as Predictor 
    (S&P 500 Percentage Changes, 1980-2005)
                                            Avg % Chg 
                                         SP500 Cash Index
                                  Obs.     Next 11 mos       Stdev.
    January up                    17         12.2%            12.6
    Any non-January month up     168         10.2%            14.0
    Any non-January month down   107          9.9%            18.2

    Looking at the expected change in percentage terms, and after a any month is down, the results are again consistent with randomness. But they show clearly that after any month is up, there is a very high expectation of some 10 to 12% for the next 11 months. Regrettably, the expected move for the next 11 months after any month is down is 10%, quite consistent with the 10% to 12% average following the up months, so there is no evidence that moves following up months, January up months, down months, or for that matter any other months, are any different in expectation from the others.

    However, comparing the standard deviation of 18% for the moves following the down months to the 14% standard deviation for the moves following the up months (using a variance ratio test), we notice a slight tendency, perhaps a 10-to-1 shot by chance alone for the variability to be greater following down months than following up months.

    We turn now to another aspect of the January effect. Do the stocks that tend to go up the most in January continue to go up to an inordinate extent in the next 11 months of the year. The results will tend to vary with the sample chosen. Mr. Dude Pomada has shown in a survival-adjusted study for the last 10 years that there is a small tendency, about 10 in 100 to be consistent with randomness for the stocks in the S&P 500 that are in the highest 10% of performers to continue to outperform during the next 11 months, with their expected gain being about 3 percentage points a year better than the average. We note that the 10 best performing S &P 500 companies are Broadcom, Allegheny Tech, Adv Micro Device, Ciena, Engelhard, JDS, Schlumberger, Halliburton, Applied Micro Circuits, and Archer Daniels. However, there was much variability in the results between years, with down market periods like 2000-2002 showing completely opposite results to the main finding of continuity in the study. Thus, the results are highly likely to be spurious as well as useless, and we can pass them safely through the minister.

    Inspired by all this beginning-of-period, end-of-period correlation melange, I completed a hand study of whether superior performance in the first month for individual companies of the Dow might be predictive for the rest of the year. I will report the results tomorrow morning as I am preparing for a trip to Vegas with daughter Victoria.

    A Statistician Goes Surfing, by James Sogi

    Today the big surf came up. One thing we always watch out for in rising surf is stacking sets. That is a phenomenon when you go out and the waves are a nice 5 or 6 feet, but then every wave becomes bigger and bigger and bigger, and you just start paddling for the horizon for your life to avoid being crushed by ever growing waves, and can't get back in. Its very dangerous. It's like those days that start with a small drop, then the drop starts to build up speed, breaks down, and then, it really freefalls in the afternoon.

    A statistician would describe big waves to have a higher standard deviation as well as the greater amplitude of the waves. At least once during the day, a wave triple the size of the rest of the waves that day will roll through and clean everyone out of the line up, and roll them around in white water. So on a big wave day, you can never sit inside, that is closer to the shore, and catch the nice looking inside waves because if you do, you will get smashed by a giant outside wave that comes with regularity during the big wave day and get "caught inside". Its like entering a trade too soon, before the drop stops and get fooled by the little intraday moves. For long periods, say 30 minutes or more, during a big wave episode there will be dead calm. This is dangerous for tourists who come to watch the waves. It gets calm, they think, " Oh it's calm now. I'll go walk along the water." Then a 30 foot wave comes and washes the hapless tourist out to sea never to be seen again. Very sad.

    Waves cluster. They come in sets of between 2 to 20 or more, then there is a lull between sets. The wind that blows across the water builds the waves up and the faster ones out run the slower ones, and then some join together creating sets of waves of different sizes. In the open ocean this causes the rogue wave effect of both the giant "freak" peaks, (they are not really freaks, but a regular thing), and also the "holes", where the bottoms drops out of a waves, the boat falls down into the hole, is damaged, or the following wave fills in and crushes and floods the vessel.

    McDonald's 50th Anniversary, by Nat Stewart

    I have recently been having wonderful experiences at the flagship McDonald's at the corner of Clark and Ohio. The building is spectacular, completed in April of 2005.

    A phenomenal job was done integrating McDonald's trademarks (such as the arches) into the modern architecture. The arches are actually structural elements of the building, and must be quite strong because most, if not all, of the rest of the exterior walls of the building are glass. The building is furnished with fashionable, (I am sure durable) versions of high end modern furniture. On the top floor, in a central atrium like area, is a pictorial, wall size history of McDonald's. As you wander through the store and pick your seat, you will find a wide mix of people enjoying the environment, their meals, books, newspapers, or just a little bit of private space and conversation in one of the less trafficked areas.

    It is also meticulously clean and well run. There seems to be a task force that is continually cycling through different parts of the building. Last time I was there, I watched a worker spend 15 minutes meticulously cleaning a large dispenser of some sort. It was the act of someone who really cared about what they were doing and doing the job properly, it felt good to watch.

    One interesting observation I made is that the entire staff, including the managers appeared to be Mexican or of Mexican heritage. It left me with a good feeling about the power of trade and mutual gain, people moving to opportunity and striving to improve their lives, and in turn making everyone's life better.

    There are many reasons to visit this McDonald's. Make sure you fully explore the upper level and check out the history area on an interior wall. My favorite time to go is early evening, when it is not fully dark, yet the interior lights through the glass make it seem the building is really glowing.

    Neil Raphel on Selling Techniques

    Victor recently discussed some successful selling techniques in Some thoughts on Selling. I think it is important to add to that discussion some consideration of the speculative bonuses of selling to the right audience.

    For instance, studies in the supermarket industry have demonstrated that the top 20 percent of customers spend 50 times more than the bottom 20 percent of customers on groceries in a particular store (an average of over $2,500 per year for the top 20 percent as opposed to only $50 per year for the bottom 20 percent). Moreover, the profit margins on sales to the top 20 percent are much higher than those to the bottom 20 percent (who presumably just come into the store for specials or filler items). In fact, for many stores there is a negative return on sales to the bottom 50 percent on customers.

    Contrast those findings with the fact that American businesses spend on average six times as much to attract a new customer than they do marketing to existing customers. And those new customers are not profitable. More than half are gone after six months, compared to about a five percent defection rate of top 20 percent customers. And new customers who stay are by and large not spending enough to quality for top 20 percent status. In fact, the best source of new customers is recommendations from existing customers. Word of mouth can add more good customers to the fold than costly mass media advertising campaigns.

    Most supermarket operators tie purchases to particular customers through so-called "loyalty cards" which scan a bar code attributable to that customer when she buys goods at the store. Supermarkets who market only to their top tiers of customers significantly reduce advertising expenses without jeopardizing gross volume figures. (Gross volume may suffer a little but net profits are much higher).

    These findings apply to almost all businesses (even non-profits). Our daughter's private high school loses money on the 800 day students who pay $10,000 per year tuition. They more than make it up on the 200 boarding students who pay $30,000 per year tuition and room and board. If you were the private high school, where would you direct your marketing effort? (Assume for political and demographic reasons you couldn't raise day school tuition very much).

    We like to think of customers as being on a "loyalty ladder." The bottom rungs are occupied by "prospects," who don't know anything about your business, "shoppers," who have visited your business, and "customers," who have bought at least one item from you. A business should direct most of its selling effort to the top two rungs of the loyalty ladder. These rungs consist of "clients," who try to buy as much as they can from the business, and most importantly, "advocates," who not only buy as much as they can afford from the business but also try to convince other people to buy from that business.

    By using customer segmenting and selective advertising to "clients" and "advocates," a business will have a competitive advantage over businesses that disperse advertising resources and dollars to the general public.

    Tides, by James Sogi

    A big part of my day is to check the tide chart, to plan the day around when is the best time to surf, where will be the best condition for a given tide and other conditions. The tide chart is only a prediction, an estimate, not a set schedule, as I had previously erroneously believed. The tide comes in a rush, in a series of 4 or 5 waves, not smoothly like the polynomial curve shown on the chart. The actual high and low varies by weather, waves, bottom, current temperature, and wind. Every 20 years or so there is a tsunami wave, but that is a different mechanism. Notice how the tides cycles through the times of day. The high is at different times during different days and it goes through these cycles. Even though the prediction is for high tide, there are a number of variables that affect the exact time. This is similar to the market, the time when you might expect a high cycles though the days, weeks and months in cycles depending on the daily, weekly or monthly cycles. It is not the same time every day, every month or year. It is important to keep that in mind and keep the schedule flexible in order to be at the right place at the right time in the surf and in the market. You never know when you might be called to an important "board meeting".

    To Be Long or Not To Be Long, That Is The Question, by Tom Ryan

    Inspired by Dr. Castaldo's excellent post, I thought I would write a bit about Elizabethan theater. In 2004 and 2005 I undertook in the spirit of self improvement a renewed study of Shakespeare which culminated in a part in the Arizona Theater Company's production of Macbeth. To prepare, I re-read most of the plays, read Norwich's Shakespeare's Kings, rented and viewed 11 of the film productions, and listened to 36 hours of lecture by Dr. Peter Saccio of Dartmouth. I highly recommend the lectures on CD/tape by Saccio; not only are they highly informative and insightful but are engaging and easy to listen to as well. My favorite screen adaptations are the 1935 version of A Midsummer Night's Dream, the 1953 version of Julius Caesar, the 1965 film of Othello starring Olivier, the 1966 version of the Taming of the Shrew with Richard Burton, the 1979 version of Macbeth with Ian McClellan and Judi Dench, and all three of the 1990's films by Kenneth Branagh, in particular his Henry V.

    While refraining from praise, criticism, or analysis, I would like to point out that there are some interesting structural parallels between speculating and the plots of Shakespeare's plays. Although the plays have traditionally been characterized as "Comedies", "Histories", and "Tragedies", these distinctions are quite arbitrary in many respects as the comedies can have humorous (Taming of the Shrew) and tragic (12th night) endings, the histories can end in calamity (Richard III) or victory (Henry V), and the tragedies can be resolved heroically (Malcolm regaining the throne in Macbeth) or terribly (Othello's suicide). The much better description of most of Shakespeare's plays is that they are "test of character plays"; even where the plot involves mainly farce there are usually several important underlying issues that are examined thru the actions of a few main characters. All of the plays occur in five acts, and in each play the first act introduces us to the problem which must be resolved before the end of the play. Much like Beethoven's first movements often set the stage for the remainder of the symphony, Shakespeare does likewise in all his plays. The themes involve desire and one's ability or inability to fulfill that desire whether the desire is for a lover, political power, or money. Obstacles to fulfillment are placed within the plot, sometimes these are external, but mostly they are internal as hard choices are forced upon the main characters as events unfold. How the characters respond to situations and what choices they make is what makes all of the plays interesting and relevant to us 400 years after their first production.

    One of the principal techniques that causes us to come back to these plays time and time again is that Shakespeare simultaneously uses both private and public dialogue. Shakespeare explores in nearly every play the dichotomy between public and private behavior (Romeo and his secret love for Juliet, Angelo publicly punishing people for the same sins he conducts in private in Measure for Measure). This allows the audience to see into the inner workings of the characters minds while following the overall external action as it unfolds (for a notable example we have Hamlet). Technically, Shakespeare invented the individual soliloquy which really does not play a role in classical Greek theater, and often he intermingles within the same scene private conversation on one part of the stage with public dialogue on another.

    The reason why this technique is so important and should be of interest to speculators is that it facilitates the main theme in all of the plays no matter what category they might be placed, which is an awakening, or self realization (anagnorisis) by one or more of the main characters during the course of the play. It is also a reason why the metaphysical references (ghosts) to heaven and hell exist in many of the plays, as the changes and self realizations are presented literally as soul defining moments. One of the distinguishing characteristics between the tragic endings and the heroic endings in the plays is often the timing when this sudden anagnorisis occurs, usually too late in the tragic cases. To emphasize the importance of the anagnorisis, Shakespeare also uses other contrasting characters who make no progress at all in their personal growth, including some of his more famous supporting characters such as Iago in Othello, Malvolio in 12th night, Shylock in the Merchant of Venice, and Falstaff In Henry IV.

    The captivating feature with these plays is that the audience also undergoes a type of anagnorisis in parallel with the plot and develops a clearer picture of the true nature of the main characters as the plays unfold. More importantly, this understanding always occurs for the audience before the characters actually come to the see it in themselves. Hence this tension is what creates the buildup and drama no matter what category the play might be in. By the end of Act V some version of this self realization finally occurs on stage resolving the plot one way or another, with one of the more famous being King Lear on his death bed after havoc has claimed his kingdom, "Oh I am a very foolish fond old man".

    I find the parallels with speculating almost too numerous to mention, what with the daily themes generally presented at the open, the numerous obstacles that accost us at each turn during the course of the day or week and then the final moment of truth at the close. The key note here being that in speculating, there is also both a public and private dialogue going on between the speculators, the news, and the market price, and the process of price discovery is not unlike the process of self realization presented in the plays. As speculators and traders we are always on a journey of self realization as to whether we are correct or false in our positions, whether we are deluding ourselves with false beliefs or if our compass is properly aligned, and whether we can be remain humble in our few victories and resilient from our many mistakes. All the traders are indeed on a big stage yet trading is a very personal business, and we feel the same arrows of fortune as people in Elizabethan times felt.

    Flat Land Revisited, Matrix Reloaded, by James Sogi

    I sometimes bemoan the limitations of the plain two-dimensional charts with drab bars and a dark background. The world of finance was a dark flat dreary place with no life. I wanted to decorate the bars, to add dimensions, when in fact the limitation was my own lack of vision. Now, thanks to the Chair's vision of the rich allegorical land full of life, color action, people, animals, sports, war, the charts are now ... matrix reloaded. Like when Tank is looking at the grey lines on the matrix, when you know how to read it, the images jump out. Like the miracle of reading ... gazing at little dark lines on a page magically creates a rich and wonderful world full of visualization, imagination, life. Like Sendak's "Where the Wild Things Are", the screen is now a multidimensional tapestry of color and rich and royal hue with the elephants of Lobagola, trolling the deep sea for big game, fly-fishing for catch-and-release in the rivers on light tackle, laying net below the surface waiting for the schools of fish to dive deep into my net, the images of my beloved ocean, surfing, sailing, sports, waves, tuna, bait fish and predators, dinosaurs, bridges, hotel rooms, sparring, spy craft, Einstein, Schroedinger, Bruce Lee, Sun Tsu ... all populating my new world of markets. It's no longer flat. I extend my appreciation to Dr. Niederhoffer for the keys to the magic kingdom -- the keys that I, and we all, already had.

    Google's Next Day Returns, from The Minister of Non-Predictive Studies

    Google's next day % return stats as a function of its 10's digit at today's close. (E.g. if price is 380, tens digit is 8.)

      Tens Count   Avg   StD   T-score
         1    37   0.3   2.2     0.8
         2    26   0.4   1.8     1.1
         3    23   0.0   2.4     0.0
         4    13   2.0   5.1     1.4
         5     7   1.8   1.6     2.9
         6    16   1.1   3.1     1.4
         7    40   0.8   2.4     2.1
         8    73   0.0   2.1     0.0
         9    79   0.3   2.2     1.0

    I thought there might be something systematic here, but it looks pretty random. No reason why 40's, 50's, 60's, and 70's should be especially good.

    Some Thoughts on Selling, by Victor Niederhoffer

    A Great Compliment

    Almost nothing in this world happens until a sale is made. Goods get introduced, old goods get sold, factories get built, retail stores get opened, new businesses take hold, accounting transactions start; all beginning with the sale.

    In Ziglar on Selling by Zig Ziglar, a man who has sold more than two million books and taught thousands, there is a salesman's credo on page 14. After talking about all the problems salesmen cause, the difficulties they face (living out of cars or hotels), the return on investment they create, the wheels of business they lubricate, he ends with:

    With all their faults, they keep the wheels of commerce turning, and the currents of human emotions running. More cannot be said of any man. When you call a person a salesman, you flatter him.

    I fully agree.

    Buyside and Sellside

    Wall street personnel and firms are often divided into buyside and sellside. The sellside offers new stocks and bonds, facilitates mergers and acquisitions, maintains an inventory of securities to provide liquidity for existing and prospective holders, and provides research so that decisions in a customer's interest can be made.

    If you're going to understand anything about transactions that emanate from the sellside, which essentially involves all of Wall Street at one stage or another, it's good to know how salesmen are trained, what techniques they use, and how they best gain advantage from their activities.

    Indeed, every transaction on the Street involves your own sale or someone else's. What preparations have you made for that sale? How have you achieved the proper balance between price, quantity, convenience and quality? What is the risk of a dud or reward from something new? Do you have confidence in your salesman and the commission you pay him? These questions call out for answers.

    Last week I read some good books on sales, like Ziglar on Selling, Magnetic Selling by Robert Bly, ROI Selling by Michael Nick & Kurt Koenig, The Sales Advantage course by Dale Carnegie, Selling Rules by Murray Raphel, Stephen Schiffman's 101 Most Successful Sales Strategies , and The Little Red Book of Selling by Jeffrey Gitomer. This seemed a good start to improving my understanding.

    Birth of a Salesman

    The best book for a foundation for what's going on in selling is Birth of a Salesman by Walter Friedman, a Professor at HBS. A most informative interview with Walter Friedman about the book was conducted by Laura Linard for HBS Working Knowledge.

    In his book Friedman reviews the salesman throughout history and points out that salesmanship is a particularly American virtue. America has traditionally been the most open and innovative county in this field. This and other factors, like a stable currency, a democratic tradition, no established nobility or religion, a proper legal framework and an openness to change, provide a proper foundation for salesmanship. This led to sizable American businesses in the 20th century that needed large sales organizations to sell their products: National Cash Register, Coca Cola, Pepsi, Kodak, Burroughs, IBM, Wrigley's, and the pharmaceutical companies J and J, Novartis and Pfizer.


    How do companies perform, relative to the emphasis that they place on sales in their operations? Companies like Ikea, Wal-Mart, Proctor & Gamble, Whole Foods and Apple are generally seen as modern paragons of the importance of sales. The key distinguishing feature is the emphasis they place on providing benefits to the customer: selling what the customer wants, not what the companies produce.

    Selling is Ubiquitous

    Selling begins at home. You must sell the kids on taking their lessons, the spouse on facilitating your relaxing or watching of the ball game while she types the college applications, the swain on knowing that unless action is taken now you're going to be taken up by a more interested party, the boss on giving you a promotion, the interviewer on offering you a job, the college on accepting you, the co-workers on listening to your pitch, the accountant who must sell the company on keeping the inventory numbers to a reasonable level. These are all situations where good selling is required and the same technique as is used when selling your product. As Ziglar says:

    "If you are just beginning to understand the concept that everyone is a salesman, you are new to the field of selling, and by taking some training you'll have enormous advantages."

    A Missing Ingredient

    As good as all the sales books are, and there a million things to learn and implement from all the above, there is a conspicuous omission in that none have an analytical framework for modeling how much selling should be done. The standard economic analysis is that selling should be continued until the marginal revenue from the additional sales effort equals its marginal cost. The concept of opportunity cost, i.e., how much the salesman's time is worth, or how much an alternative activity besides selling, such as producing a better product, is not adequately covered. Nor is the selling function fitted into the concept of the economics of search and information where the marginal benefits of additional units of prospecting and asking for the order are measured against the associated opportunity costs.

    Another area that might put selling into the context of established knowledge is signaling theory, drawn both from animal behavior and economics. The salesman's signals, such as dress and attentiveness, show what the customer can expect from the company and the product,, just as a suitor's solicitude to his swain signals his ultimate performance after the suit has been pressed.

    The Most important Lessons

    All the books emphasize the importance of constantly improving the frequency and extent of your prospecting. As Zigler puts it:

    Prospecting is the key to sales success. Until you have a prospect you don't have a chance of a sale. Without prospects, you are out of business, with prospects you have a chance to change the world.

    The key to starting a business is to know whether there's a list available of potential customers who might buy the product. If there is, then you know that at least there's some homogeneous group that can be offered the chance to benefit from your product once you find the right message.

    Another common thread in all the books is the importance for the salesman of building up trust. The good customer is generally more interested in the reliability of your product and your company than your selling price. You have to show the customer that you meet your commitments by getting to the meeting on time, dressing as if you care, having clean shoes, shirts and fingernails, asking questions that show you're trying to find out the customer's needs, listening carefully to what the customer wants, and promptly following through on the little details that signal your trustworthiness for earning the customer's business.

    Formulas for Success

    Many of the books contain formulas for success that provide a framework for the selling process. A helpful one is in Stephen Schiffman's 101 Most Successful Sales Strategies. The formula is to divide the sale into four stages:

    1. Prospecting: getting in front of a customer who might benefit from using your product.
    2. Interviewing:  finding out what the needs of a customer are by asking some good questions.
    3. Presentation: show how your products solve the needs of the customer, give testimonials of past success.
    4. Closing: asking for the order (and then getting a million referrals).

    That's a good framework, but I like the practical technique of Murray Raphel, which he first demonstrated to me 32 years ago in an impromptu selling seminar he gave to 15 portable building dealers at Connell in Harlingen, Texas, a company Dan Grossman and I owned.

    Murray Raphel's Formula for Success

    Every day, choose one of these four options:

    1. Make four phone calls or send out four emails telling your customers of a benefit for buying from you now.
    2. Write four letters a day to thank customers for recent purchases. (If I had enough customers I would do this immediately.)
    3. Give out four cards a day, and make them worthy cards as the Asians often do, that command respect. Of course make them miniature billboards also, and hand them out to waitresses, the person sitting next to you on a plane, or best yet, a fellow Rotarian.
    4. Ask for the order four times a day. Call up an existing client first -- they are the ones 10 times more likely to say yes -- and when you run out of orders and referrals from them, move to the next level of probability.

    As Murray says, do one of these options every day and that is 1,200 contacts a year. With a normal 10% yes-rate that's 120 new customers a year.

    Hanny Saad comments:

    The one thing I would like to add to this great post is that even the trader locked up in an empty room on the other side of the universe from everyone he is dealing with and with no one to even talk to, is a salesman in his own right. Sometimes a deceitful one at that. Let me explain.

    When you trade in size, you are expecting/hoping as a buyer to be able to sell your merchandise, (your stocks), at a later date and a higher price than you paid. Sometimes you have to be deceitful in the sense that you use every trick in the book to give the impression that you are buying while your actual intention is to sell what you already have.

    It reminds me of the old car salesman trick that every car on the lot is for sale except this one, (the one he actually hopes to sell).

    J. T. Holley offers:

    One book by the author I mentioned last week, Nick Murray, is called The Excellent Investment Advisor. It has your "missing ingredient" in that it very competently analytically breaks down the art of selling financial services in this century. He is also an Equity Zealot! I highly recommend this wonderful, empirically laid out text.

    J. P. Highland adds:

    Latin America is a fun place to be a salesman, success depends on being able to develop a good personal relationship with your customers. In countries like Mexico you first get along with the potential customer and then you make business. No matter how good your product is, the price or the service, if Mexicans do not like you they won't make business, while in places like NYC you first talk about business and you later get along.

    High level business meetings in Mexico take place in expensive French restaurants, for the first hour and a half you don't talk about business, the key is to establish a personal relationship with the client talking about family, politics, TV shows, soccer, bullfighting, women, (In Mexico people like to talk about feminine beauty in business meetings and no one gets offended). This trivial chat has the purpose of knowing with what kind of person you are dealing. When dessert arrives is when you talk about business, if the first phase is successful you have 75% of the deal done.

    A good Mexican salesman reads the whole newspaper every morning, he has to be updated on every subject because he never knows what topic will be of interest to the client. Even the most stupid thing can be a topic during a business meeting.

    Ken Smith (a Gentleman) adds:

    Of course the Motto of the Ritz "We are Ladies and Gentlemen, serving Ladies and Gentlemen" has helped too.

    Good reminder for self, just remember to be a Gentleman. I see young men wearing baggy pants and have pity for them, knowing they are in a peer trap, never going to get anywhere.

    Sushil Kedia comments:

    A recent Mutual Fund advertisement in India cajoles investors to buy the New Fund Offering such that it will help them achieve their goal of buying a personal jet in the future. Some dream that is selling!

    A Word from Steve Treglia

    Run a Google search on selling/goal setting/vision and you see the following: Zig, Covey, Carnegie, Suzy, Dr. Phil, Maxwell, Tracy et al. All help readers in thinking of framework for personal success. These days QVC and PBS also have skin in game with Roberts, Suzy and up and comers. All profit well by helping others help themselves. And this is o.k. I wonder if closer look into this field may explore discussion much like your writings re: B.G. or Bearableson?

    For me Godfather speaks to trust, likeability, persistence, hope, hard work and ..... use of power. All play important role in development of sales professionals. In terms of power, star personality does impact success along with "power" over your own thinking when dealing with ambiguity. As when a client postpones their decision to "talk it over with the Mrs." or "just looking" or "we've made a change to our RFP."

    In working with 100's of sales professionals over the years, likeability/trust/persistence go hand in hand in defining greatness in selling. These are characteristics one respects when found in others.

    Dept. of Sports and Games: Sudoku, suggested by Dr. Janice Dorn

    Read about Sudoku the latest puzzle craze that's overtaking jumbles and crosswords.

    The Wacky World of Round Numbers, by Sushil Kedia

    Yesterday, the BSE Sensex came whiskers away from--just 6 points under--the round number of 10000 (that it has never seen so far in its life) but then it slid down to close 175 points lower.

    However, a headline story in the Times of India today carries a wacky picture of snoozing members of the wackiest band party in town, waiting-in-sleep for more than two days on the pavements outside the exchange main doors to break into a rapturous performance with their banjos, drums, electronic keyboards et al the moment 10000 is flashed. If exchange authorities are finding the round number of 10000 a moment to celebrate with the performance of a band-party, surely it's one more reason to pay serious attention to the dynamics that may be governing the waiting and eventual achievement of such rounded price numbers.

    Such is the anticipation that the picture carries an appropriate caption "waiting to exhale - the Bombay Stuck Exchange".

    Prof. Ross Miller Talks Briefly on Optimization Programs

    Blindly using an optimization program gives one about as good results as using a spyware-encrusted Windows computer. A customized and tweaked optimization program that does not employ the 1950s-vintage assumptions is still imperfect, but does a good job of narrowing down the investing universe. Anyone who directly inputs past performance as the projected future returns in such a model is a total fool.