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14-March-2006
Probability, Markets and Decision Making, by Victor Niederhoffer

The theory of probability is at bottom nothing but common sense reduced to calculus: It enables us to appreciate with exactness that which accurate minds feel with a sort of instinct for which oftentimes they are unable to account. It teaches us to avoid the illusions which often mislead us. There is no science more worthy of our contemplation nor a more useful one for our system of education. -- P.S. Laplace, ~ 1800.

There is universal acceptance these days that knowledge of probability theory is useful in almost any field where decisions are made. The reason is that most of the things we are confronted with in life are not causal situations but common sense ones where our previous knowledge of circumstances and the intrinsic uncertainty of the situation calls for decisions based on probability. Thus, almost any scholarly field these days ranging from biology to economics to engineering to law  where the relevance of evidence, physics, computer science, networks, linguistics, is replete with probabilistic reasoning. See "Current and Emerging Research Opportunities in Probability" for nice summary of this.

There is also a general appreciation that probability has as wide a range of application in terms of its practical range as geometry. However, unlike geometry, probability theory depends upon a different way of thinking, one that's not intuitive to most of us, and one where we commonly make more mistakes in reasoning than in any other field.

To improve my own understanding of probability theory,  I have been reading some excellent books on it recently Understanding Probability Theory by Henk Tijms (a book of interesting problems with rigorous but easy to conquer mathematical reasoning), Elementary Probability Theory with Applications, by Larry Rabinowitz (a book with practical problems with worked out problems that just requires good reasoning and is completely assessable to anyone who likes numbers), Why Flip a Coin? by H.W. Lewis (an elementary non-mathematical tract with a discussion of the wide ranging areas where decision making under uncertainty comes into play from dating to war), Probability Theory by E.T. Jaynes (a thoroughly profound and deep work that breaks new ground in a philosophy of reasoning and decision making with highly technical statistical discussions), and Probability and Random Processes by G. Grimmett and D. Stirzaker (a complete advanced modern text along the lines of Feller but more modern and up to date and accessible). All accomplish their goals, and are highly recommended for those interested in such goals.

Needless to say, probability theory is crucial to correct decision making in finance and markets. Thus, it is not at all unlikely that I would find that many of the classical probability problems have direct applications to markets that to my knowledge have not been fully explored. I will consider two of these below the secretary of Sultan's Dowry problem (a problem in sequential decision making, and the Monty Hall problem (a problem relating to revision of beliefs based on new information).

Let's start with the Sultan's Dowry problem. The situation here is that a commoner is given the chance to marry one of say eight sultan's daughters. Each has a different dowry. And each will be presented to the commoner one at a time, with a thumbs up or down decision that cannot be reversed. The situation also comes into play from the other side as the dating game problem with the lovely lady being presented sequentially with a dozen suitors. How is she to choose the one that she wants to marry with or will have the best s#x with based on her previous experience. Or in more common terms, how does the boss choose the best secretary from a dozen that he's going to interview sequentially, or how dose he indeed travel from Austin to Dallas and decide how many gas stations to pass before choosing the one that has the lowest price.

Such problems are at the core that every market person is faced with. How does one decide when to sell a stock, especially if a need for money arises before the end of the period, or how does the day trader decide when to get out of his positions knowing that overnight positions are not accepted, or how does the pattern trader decide when to enter his trades given that he waits too long, he may miss the trade. How at a more general level does one pick the right time to sell premium of any kind considering that you'd like to sell at the high, but if you wait too long you might lose the whole thing.

The solution to such problems is very elegant and many of us in the office gained an appreciation for the closed form solution while the artful simulator, Mr. Downing, immediately went to the simulation solution and was able to work it out in about 30 seconds. As an aside here, all modern books on probability theory suggest that the key to gaining an understanding of it is to work with random number generators on the computer to simulate the answers to the common problems. I would agree except to say that's it's even better to work it out by hand with a random number table for the simplest one or two element formulations of the problems.

The solution to the problem is that with 8 wives, the commoner should interview 3 of the potential wives, find out her dowry. Okay, that means he's missed 3 . Then he should choose the first one that has a higher dowry than any of the first 3. I will present several solutions to this problem and they are well summarized by Wolfram.

The correct decision making to make is to go through interviewing three daughters just to gain information and then to start searching for the first one with a higher dowry among the remaining five.

The solution in brief starts with the knowledge that any daughter looked at has a chance of 1/8 to be the highest dowry of the eight daughters. However, to correctly choose her, she must not only be the highest but the highest of the first three that you interviewed to form a base that had no chance of being chosen must be higher than the subsequent ones you interviewed and passed over because they did not contain a higher score.

Thus, after going thru 3 dowries, the chances that the fourth one will be highest and correctly chosen is 1 in 8. The chance that the fifth one will be highest and correctly chosen is 1/8 times the chance that the highest of the four previous scores came among the first 3, i.e. 1/8 x 3/4. The chance that the sixth one will be correctly chosen is 1/8 times the chance that the daughter with the highest dowry was among the first 3 of the 5 daughters considered, i.e. 3/5 x 1/8. The chance that the seventh daughter will be correctly chosen is 1/8 times the chance the daughter with the highest dowry thru daughter 6 was among the first 3 of the six daughters previously considered, .i.e. 1/8x 3/6. The chance of winning by choosing the last daughter is the 1/8 chance that she's highest x the chance that the highest dowry of the first 7 was among the first 3, i.e. 1/8 x 3/7. In order to be correct, the commoner must choose the one and only that is highest of the 5 chances he has to be correct. Thus, each of the 5 chance calculations if exclusive and the correct answer for the probability of being correct is to add up the 5 probabilities. Such a sum has a beautiful closed form solution which for large numbers of daughters comes to 1/e (of course e), or 0.37.

The application to when to put on a trade is rather direct. Divide the day into 8 intervals. Let 3 of them pass to give you a foundation for choosing the best of the 3 that you let go. Then choose the next one that gives you a better entry (lower if you want to buy, or higher if you want to sell). The chances that you will be right according to the closed form solution verified by Mr. Downing is about 0.40. Indeed, the chance of finding the daughter with the greatest dowry out of 8 daughters is 0.32 if you stop after the first daughter and then look for the next one higher, 0.39, if you stop after the second daughter, and look for the next one higher, 0.41 for 3, 0.39 for 4, 0.32 for 5, 0.24 for 6, and 0.12 for 7. Thus, it doesn't make much difference if you wait to interview two, three, or four secretaries or brides or lovers out of 8, before you begin to clear for the action of choosing the next one that's higher. But there's quite a fall off if paralyzed by the fantastic potential of it all you wait for 5, 6, or 7 of the beauties to pass you by. A more realistic version of this problem might take into account the cost in time of interviewing all the candidates, and the chance that conditions might change.

Such reasoning is easily transferable to a wide range of trading decisions during the fray. (to be continued with the Monte Hall problem applications).

Dr. Kim Zussman questions:

But doesn't the daughter problem presuppose that they are in random order? If so, then application to entry or exits should refer only to periods that are presumed to be random-as opposed to those for which there is evidence of non-randomness.

What about when the non-randomness is unknown (or worse, unknowable) to the suitor? For example, say there are 100 daughters for which the solution is highest after 37. But what if there was a pattern missed by the suitor? For example, the dowry for even numbers is random and odd increase monotonically, which if unnoticed would result in losing the beauty and the booty.

Gary Rogan mentions:

There is a new prime-time game show on NBC that is the first purely probabilistic game show that I have ever seen. The rules are simple. You start out with a number of briefcases containing amounts from \$0.01 to \$1,000,000. Choose a briefcase. Then as each round progresses, you pick a particular briefcase to open to reveal it's contents. You then must either stay with your original briefcase choice or make a "deal" with the "banker" to accept its cash offer in exchange for whatever dollar amount is in your chosen case.

I've watched a few episodes and observed the following: (a) contestants don't recognize that this is a purely probabilistic game that has a simple optimum strategy for which they can prepare in advance (b) as long as there are large numbers on the board they usually continue to play and eventually give up once all the large numbers and the incentive they provide are gone (c) the friends contestants bring, usually help form a consensus to continue longer than indicated by the optimum strategy by encouraging the contestant to be "daring". The family usually has a somewhat more moderating effect because they can use the money, unless some kid becomes the "decision maker", in which case he usually acts like a "friend".

While the game is utterly devoid of any intellectual content outside of the realm of probability, I found it a useful lesson in market-like pricing mechanism in action. It's superficially similar to the "Sultan's Dowry" problem but simpler because no initial discovery is needed.

I found this very educational, especially the Sultan's Dowry problem. In addition to the 0.41 probability of getting the highest dowry by stopping after the third daughter and looking for the next one higher, there are additional 0.20 and 0.11 probabilities of getting the second and third highest dowry, based on my random number experiments. If stopping after the second daughter and looking for the next one higher, these two additional probabilities are 0.22 and 0.13, respectively, giving a higher probability of landing one of the top three daughters.

Kim contributes:

Here is another test of the Sultan's daughters.

SPY from 1993 to present was divided into non-overlapping 20 day periods. Since theory says to buy below the low of the first 37% of opportunities after they elapse, this can be approximated by checking the daily minimum of the first 7 days of each period. If on any day between 8 - 20, price drops below the low determined in the first 7 days, buy at that price. Then hold to the end of the 20 days and sell at the close.

This arrangement means you do not buy all 20 day periods, since some of the 8 - 20 day periods will not drop below the low of the first 7 days. Also, it does not specify how long to hold; you might buy on day 8 or day 20.

In any case these returns were tabulated, and the next question is how to test significance. Since buying during {8-20 if < low 1-7} requires waiting out the first 7 days of each period, it made sense to test against the mean return for the 8 - 20 period of all 20 day periods. This compares mechanically buying these periods (and staying out of the market 7-days each 20) with a sultry buy-point based on early lows.

The results from buying such lows, however, were not different from simply owning days 8-20:

t-Test: Two-Sample Assuming Equal Variances

```               Buying at low            all days 8-20
Mean              1.00339                  1.00339
Variance          0.001459047              0.00142533
Observations      88                       165

Pooled Variance:                           0.001437017
Hypothesized Mean Difference 0 df:         251
t Stat:                                    0.00065853
P(T<=t) one-tail:                          0.499737546
t Critical one-tail:                       1.650947026
P(T<=t) two-tail:                          0.999475092
t Critical two-tail:                       1.969460171```

But it is worse than that. Having to wait for 7 days each 20 (to determine the buy signal) means skipping about 1/3 of the upward drift obtainable with a simple buy and hold. Testing the 13 day period returns against all 20 days verified this, with the shorter period having lower returns (short of significant difference p=0.12).

"Iacta alea est" quoth Julius Caesar as he crossed the Rubicon. The die is cast.

And from Ecclesiastes, "The race is not always to the swift, or the battle to the strong, but time and chance happen to them all."

From Hamlet, " ..the slings and arrows of outrageous fortune..."

I had a delightful browse, reminiscent of headier times in the early 70's, through Cody's books on Telegraph on a recent trip to Berkeley, and I uncovered a treasure trove of books. The source of the quotes, Probability and Random Variables -- a beginner's guide, by David Stirzaker, is a wonderful introduction to probability with many of the classic problems presented and worked out, in what I am discovering to be typical of the delightful publications of Cambridge University Press. Cambridge's editors hold their writer's feet to the fire and require them to write about abstruse subjects in a straight forward and clear English style that is understood by the hoi palloi, avoiding the gobbledygook and reliance on algorithms without explanations, which litter some other publishers texts with all too much frequency.

Another great discovery was, S Programming by Venables and Ripley, with code for many problems such as porting dde and ActiveX to R, or calling R from E***l, or VBA routines or batch files. The authors wisely state, "Programming ought to be regarded as an integral part of effective and responsible data analysis. ...The exercise of drafting an algorithm to the level of precision that programming requires can itself clarify ideas and promote rigorous intellectual scrutiny." This is where the the code meets the road. Sloppy thinking leads to losses.

The treasure continues with Introduction to Statistics Through Resampling Methods and R/S-Plus. Computational statistics is the cutting edge with computers that can do things impossible a few years ago and opens up the power of statistical analysis to a more widespread audience. The treasure trove of R code is of course the big bonus.

A few of Chair's always wonderful citations were there for the taking and served to fill the return trip well. Upon returning, the garden vegetables have sprung to seed on the Vernal Equinox as the entire world shifts seasons in its trip around the sun, and the days themselves begin to lengthen. This changing cycle affects the entire world and all in it.

Lastly, I leave you with the problem of 12 balls. There are 12 balls that all look the same. One is a different density, either lighter or heavier. You have three measurements on a balance beam. What is the method to find the odd ball?

14-March-2006
Price as Ultimate Arbiter of Winners and Losers, by Jared Albert

The current issue of Trader Monthly has an interview with two long/short equity PM's. They did their research and were short a legitimate fraud stock. This company had a habit of putting out fluff releases that would assert all sort of great prospects, none of which amounted to anything. Needless to write, eventually the stock went to zero, but not until after forcing the fund to cover at a loss.

What struck me about this article was this quote, "the company issued another press release, this time obliquely referring to a big deal with IBM. Within half and hour the major newswires had picked up the story. Wave got its 15 minutes of fame and the day traders piled in, creating a short squeeze. The fact that the little company had issued many similar press releases in the past and that none of them had ever amounted to anything seemed to escape everyone's notice." Seemingly, the PM's don't believe that the price action is the ultimate arbiter of the value at that moment. In fact, they were correct, but not then and since they lost net, not ever in this trade. Instead they take the "longer view". This doesn't stop them however from covering at a loss when faced with the reality of the price.

I day trade equities during the day. And two nights a week I go to B-school. Most of my classmates can clearly and quickly explain their exact job description and make it make sense. When pressed, I used to tell people that my job function was adding liquidity. But recently, I've started to think that what I actually do is help set the price even if that price only stands for 100 shares worth of time.

I'm sure that I don't see the big picture to the Chairman's comparison of insects to market behavior. But if one watches the screens for a while, one might conclude that prices are set by crazy people, the way one might conclude that ants randomly seek for food. Of course, if ants randomly sought for food, the species would never have lived to reproduce. The ecosystem that the ants developed in is now codependent even as it evolves on the ants for its survival. They help release nutrients through decomposing organic material, they aerate the soil, they spread seeds etc. The stock market reflects the continuing advancement of human endeavor; the way ant colonies reflect the sum total of the effort made in their creation. The market must have a reasonable, nonrandom structure to ensure participants a fair medium in which to transfer risk and thus allow them to continue to contribute to the system's increasing complexity. Most of the participant's expended energy goes into our world's increased complexity; some is siphoned off as heat's transaction costs. The participants are interested in increasing the value of the market ecosystem and this is why the market pays people who can correctly set the prices. Just as ants are fed to aid in the decomposition of a forest floor.

In the very short term, the crazy people move the price around so much more than can reflect anything in the real world other than the illiquidity of the stock. In the long term, the consensus of the crazy people gels the price to an "efficient" range. But if this range is looked at in the short term, it still looks like individual people are setting the prices not groups. Does the ant see it's own action as complex, even if we need fancy models to anticipate its action? Do the crazy people have a plan, or are they legitimately crazy? And if they have a plan, is it complex to them, or are they just responding to the price action? And as one of the crazy people setting the prices, do I need to worry about each other participant, or just where the group consensus lies?

If a return on an investment if a function of risk and time, then while price is the ultimate aribiter of winners and losers, it is meaningless without a reference to a time frame. In the sort term, prices fluctuate is an apparently random manner, though some believe that there are patterns in the very short term and that money can be made. Regardless, there is a general consensus that prices are less random in the long term than they are in she short term.

Thus, if I buy a stock for \$10, believing that it will be \$15 in a year, the fact that it goes down to \$9 tomorrow does not mean that me original investment has been judged to be wrong.

Now, the further out you go in your time frame, you may believe that you have more of an advantage over what some people believe is strong market efficiency, but you also start taking on other risks.

For example, you can short a stock, believing that it will be zero in a year, and still get driven out of your position by a short squeeze. In this case, the ultimate price of zero proved that you were correct in the analysis that the stock would go to zero, but the volatility of price changes to get to zero proved the investment strategy that you implemented to take advantage of your analysis proved you wrong.

A similar thing often happens to deep value investors, an area that I have personal experience in. You might find a distressed company with a terrific opportunity to more profitably employ their assets. You might be willing to wait three years for this to happen. However, other shareholders, bondholders, and credit banks might not see the same thing that you do and pull the plug on the turnaround before it happens.

This is in essence what happened to Knight-Ridder. The Knight-Ridder board did not see the prospects for its assets that some of its major shareholders did, and thus did not want to use their cash flow to head in a new direction. The major shareholders who had a more visionary view of what KR could do may have been right, but it didn't matter and in the end the plug was pulled before anything could happen.

Jared Albert replies:

I can't disagree with anything that you've written. And admittedly 'price as arbiter' is a tautological measure of winners and losers. But as traders, don't we question the value of good ideas that don't make money. Is it fair to claim that the idea was right eventually, but the implementation was wrong. After all, we have to do nearly everything correctly to succeed.

In the Trader Monthly article for example, the PMs blamed the price action for driving them out of their short position at a loss. They felt that the market was wrong at that moment because it wasn't properly discounting the fluffy history of the company's PR's. However, since they were forced out, and the ignorants saw higher prices, it seems that the market priced correctly and they were wrong--as a guy who loses a large % of my account each day, believe me I'm not bashing these guys, I'm only using the article as an example.

That the volatility is so much greater than the expected return, combined with the changing cycles, is clearly what makes trading so tough. I know that this is out of my league to discuss with any sort of knowledgebase other than my own observations, but I think that most traders actually know what to do to be net profitable, but because of the seeming random nature of the price action, they are unable to develop enough confidence in their decisions to see their ideas through. Hence they are forced to cover when they know it's a zero or sell after such and such a drawdown. It's why the Chair's Stochastic (though I recognize I have no idea how it works in fact) approach seems to offer a solution to confidence and decision making for example.

As I try to extend the time frame that I trade in, I've been wondering: do the crazy peoples' current actions lead to 'efficient' prices at some time in the future or is the market so segmented that the crazy people only set prices now, but the sane people set prices then? Are the crazy people different from the sane people only b/c of the size that they can move over a short time? etc.

Sane people set the floor in the long run and the reason is this: if an economically viable company is priced by the market low enough it will be bought out by a small group of savvy and calculating people. Prices for companies with no economic value have no floor, and that is how it should be. Tops are set by crazy people who will keep bidding up prices until stopped by some event. Then they will turn from the manic to depressive mode, at least for a while.

Thanks God for the crazy people! If it were not for them, how could you have any advantage over knowledgeable insiders, or anyone with more information and resources than you? The only rational thing to do in the absence of crazy people would be to go for the indices. Ants do what they do (including cooperating) because they have been selected by evolution to do what works. Crazy investors have not been selected by evolution to deal with markets in any particular way, their evolution occurred over five million years mostly in the African savannah to deal with very different challenges. They react to what they perceive as immediate threats and opportunities with emotion, because that's how the human brain processes these stimuli in the absence of proper training. I'm sure some of them have a plan and others do not. They use price as a short-term signaling mechanism to organize into herds, especially under stress, because that is when emotions take over. They do other irrational things under stress that have been documented in numerous publications over the last decade. When the stress goes away they recover and become sane, other than the irrational things people do even when not under stress. Being crazy is just being human.

13-March-2006
Old Nags and Racehorses, by GM Nigel Davies

Some trouble with a recently purchased second hand car got me thinking about Ben Green's Horse Tradin'. Green's stories are mainly about old nags that have been made to look better than they are, but S&P traders are dealing with a different kind of trade. Our problem is in picking what appear to be old nags but which are ready to dash out of the starting gate and reveal themselves as racehorses.

Friday was a case in point; bonds sank to new lows and the Naz started selling off like crazy. Who would have thought that this old nag was about to travel 10 miles in record-breaking time? Certainly not me, in fact I was convinced I'd pick her up really cheap by the end of the day and sell her on quickly to the cat food factory.

Anyway, let's consider the different trades as follows:

1. Buying/selling a 'race horse' after a win.
2. Buying/selling a 'race horse' after a loss.
3. Buying/selling a 'nag' after a win.
4. Buying/selling a 'nag' after a loss.

I hypothesize that the public are most likely to buy after a win or series of wins (greed triumphing over reason), which means they are buyers mainly in situation 'a' and to a lesser extent 'c'. They've got to get their stock from somewhere, so I'll further hypothesize that it's 'the professionals' who are selling to them.

On this basis it would appear that most money is to be made meeting the public demand in situation 'a', but here there is an important qualifier. Whereas individual stocks may actually be nags, the index itself (the sum total of all horse flesh) can not by definition be a nag, there will always be good horses within it. Therefore I hypothesize that for buying individual stocks we should go for trades of type 'b', whilst for the index either 'b' or 'd' would be good.

Unfortunately I don't have any numbers for this theory vis a vis individual stocks, but there's a comparable situation in chess where I'm on surer footing. One can describe four different ways of selecting one's openings:

1. Playing good variations which are fashionable.
2. Playing good variations which are unfashionable.
3. Playing bad variations which are fashionable.
4. Playing bad variations which are unfashionable.

Once again I think it's the public who will go for the fashion ('a' and 'c') whilst the professionals will opt for unfashionable lines which have been partially forgotten. Bent Larsen, one of the most successful tournament players of all time, made a good living from winning single races on old nags and then selling them on through books and pamphlets. The public, on the other hand, would saddle up the nags just in time for them drop dead or they get up on the racehorses just before they develop a niggling injury which hobbles their performance in future races.

13-March-2006
Latest Desert Story from Hobo Keeley, "Ken Smith Drops his Jaw in Sand Valley"

Contrarian Ken Smith came to Sand Valley for repose of his sole, so I thought to introduce him to my neighbors. First one rambles from the nearest oasis, Blythe, Ca. for an hour along sand tracks out to the tri-section of California, Arizona and Old Mexico. Ken arrived with a state-of-art Global Positioning System and rented a Jeep, but Hertz substituted a tank-like Blazer claiming it was 4-wheel drive. The first stop was surprising.

He wheeled out of Blythe straight up a hill in the open desert before the wheels spun and the car tipped backwards. Let's try the sand next,  and he slid alongside the Colorado River where we stuck. "The Hertz bastards", roared Smith crouching at the front end. "There is no front axle; this is a 2-wheel drive!" The sun sank over us scraping sand by hand from around the wheel hubs. The tires, again and again, spun deeper in the sand until we feared striking water.

13-March-2006
From Dept. of Fixed Income: Yellen 'Bout Nothin', by George Zachar

Janet Yellen's eyeglaze-inducing lunchtime stemwinder broke no new ground, but had two tidbits worth highlighting for market participants.

First, she very specifically casts her lot with the Taylor rule (which requires the Fed to divine and target the economy's "potential" GDP) and the Phillips curve (telling the market to hike rates "for" the Fed as the unemployment rate declines).

Second, she comically sucks up to the new chair:

"...the context of clear and effective communication of the Fed's multiple goals. Here, I am drawn to some specific language proposed by Chairman Bernanke while he was a Fed Governor..."

Certainly, this represents a textbook-worthy example for how a second-tier board member can ingratiate herself with a new chief.

12-Mar-06
Book Review by Victor Niederhoffer: Winning Ugly

After my recent writings on such things as social insects, evolution, classification, hydraulics, technology, roulette, marketing, herding, communication theory, piracy, military strategy and opera, I felt it was high time to return to the one thing that I really know about -- the lessons from racquet sports. Thus, it was a pleasure to come across the 1993 book on the mental game of tennis, Winning Ugly by Brad Gilbert and Steve Jamison. We all have much to learn from any book by a player who beat Connors and was confronted by him in the locker room afterward in his jockstrap shouting, "You shouldn't be on the same court with me!" and whose victory over McEnroe prompted McEnroe to vow to quit the game forever at the age of 27 (and actually do so for six months) or who beat Boris Becker while Becker cursed in German about the humidity and the low-flying planes.

Indeed, the subject of the lessons from games is one of the most valuable for all spec-investors because games are developed to teach us through childhood play the universal things that will help us become competent in our life. To keep it simple, here are 11 useful lessons that I learned from Winning Ugly:

1. Keep the eye on the ball. Gilbert recommends forgetting about the player and following the ball on the serve. I tried it and found that it gives you a split second of extra starting time that is key to proper positioning. I would suggest that this is analogous to watching the open rather than the call. So often , we wait for that great or terrible opening call to be realized, or that terrible reaction to the number that you know should ensue, and miss the trade entirely.
2. Bring proper equipment to the game. Gilbert has a list that for openers includes water, eight rackets (including two with lower and higher tension), energy food, Ibuprofin, Flex-All, chemical ice, towels, sweatbands, extra grips, shoelaces, Band-Aids, cap with visor, dry shirts, socks and sneakers, and pen and notebook. What do you bring as a trader to the opening of the game? Might I suggest that if Gilbert will go all out to win \$5,000 in a match, your own efforts to prepare for the trading session might be just as careful? Be prepared with everything you conceivably might need -- make up your own list -- but strangely, many of the same items that Gilbert mentions might be useful. I would add such things as studies, financial numbers, position sheets, previous games against your trading opponent, a plan for the day, a limit as to how many and where you will trade, alternate communication links, a backup personage for when you leave the room, a phone intercept, music and food.
3. Keep a notebook handy at all times to record your thoughts about your opponent. Gilbert does this during the game, and I would suggest that this would be an excellent thing for specs to do -- but your good ideas will come to you at all times. Carrying a notepad has the further advantage of convincing those you have contact with that you are a man of respect.
4. First points are key. Gilbert says that among top players, the person who takes the lead first wins 85% of the time. He believes that an early lead gets the adversary to play defensive and overly pressing tennis. I believe that in trading when you start out with a profit you become much stronger during the rest of the match as you can withstand a greater loss, and the adversary has to extend himself much greater with his mini-booms and busts to squeeze you out.
5. Practice hard before you play. Gilbert has a most unsportsmanlike workout he likes to go through which I deplore, involving getting your opponent to hit it to you first at the net, then hit you lobs and cross-courts and serves so that by the time you play the game you're thoroughly warmed up. I like the idea of preparing everything in advance, even to the extent of entering your orders before the session starts so that you won't, in the heat of the moment, miss the big ones. Certainly you should go over all conceivable contingencies before the game starts.
6. Some points are much more important than others. Gilbert believes that these are the advantage points and the points that lead up to them. My friend Martie Riesman, the champion table tennis player, believes the same thing, and so did Christy Mathewson in Pitching in the Pinch. To me, every point is key, but who am I to argue? Certainly there are key times in the market, I would include the first 20 minutes, the intervals before 11 a.m., and the opening relative to the call as key points here. Also what the market does at the beginning of a period versus the end.
7. Recognize your opportunity. Analyze what's involved, then capitalize on it. That's the Gilbert formula that he applies before, during and after the match. I guess this would be similar to what I consider the key to the spec world: Ask the right questions and then test. But the recognition part, trying to keep an open mind as to when, what and where the questions come from, would augment my guidelines, and it's something that I'll try to improve upon.
8. Be your own doubles partner. Partners in a good doubles team talk to each other about 90 times during a match. Do remind yourself to do the right thing, to prepare for your opponent's strengths, to move to the right position, to give the key points your all during the trading day.
9. Play to your opponent's strengths and weakness. This is key to Gilbert's success. And he has guidelines for playing against the retriever, the player with speed, the attack to your backhand, the good server, the excellent return of serves, the serve volley player, the weak server, the lefty and the heater (the player who makes the point last less than 3 seconds the way they do at Wimbledon). Think of who is on the other side of your trades -- is it a dealer or a market maker, a chronic, a charlatrendist? -- and act accordingly. Have a plan for dealing with each.
10. Learn from the experts. Gilbert has a chapter on what he learned from Agassiz (hit them on the rise), Lendl (vary the pace), Connors (go for the opponent's weaknesses and return serve properly) Becker (go for the lead and be aggressive). There are many books about how the experts trade. I would think that most of the material in such books is promotional or misinformation, but occasionally in an interview or by analyzing their objective actions, say in the positions of trader's reports, you can glean some information that is not out of date or designed to mislead.
11. Be tournament-tough. Here's a potpourri of catchwords from Gilbert: desire, dedication diligence, mental management, get the early edge, play smart, don't let the other player upset you, have a plan for every aspect of your tennis, mental preparation, stretching warm up, the start of your match, don't rush. All these things are key to success.

Gilbert is to be complimented on a masterful book. Everyone who's seen Gilbert play has the same reaction: "How the Hades did this man win? He hits like a caveman!" I can think of no type of player better to learn from. Anyone who reads Winning Ugly and applies the lessons to his own games and pursuits will find many beautiful outcomes arising from this ugliness.

I love to trade from 9.30 to 10.30am, this is the time of the big swings, of the crazy movements in stocks, that can pay big rewards if you are on the right side of the trade, or wipe you if you are in the wrong one. No wonder why more often than by chance the low or the high of the day is made in the first 30 minutes.

The opening is so important for me that even though I make a long commute to get to Union Square I always arrive no less than one hour before. A strong start sets the tone for the remaining of my trading day. This is my most productive time and when I make most of my money, from 10.30 to 4pm is when I make money for my broker.

For the B- or C-level players, like myself, having a knowledge of "swing points" (i.e. 30-5) and actually thinking about strategy during a match can have a large impact over outcomes. While all points are no doubt important to professionals, most lower level players (hackers) do not have the ability to sustain concentration or execute on every point and must allocate their quota of good shots for the right moment.

A trip to Nick Bollettieri's over in Bradenton many years ago (Anna Kournikova was about 10 years old and practicing 5 hours a day or more) was a very instructive experience. Mr. B's teaching system was all about percentages and keeping the same swing fundamentals for all shots (follow through, follow through) but increasing the margin of error (hitting higher over the net and with more top spin) when in a disadvantageous position. And there were little tidbits of film showing Agassi running Lendl on a string and not finishing the point but letting Lendl exert himself a little more (making him lunge) and letting the poor fellow use up energy (Agassi they said actually kept count of lunges)--pure Machiavellian tennis. My instructor, Ian, was a former Rhodesian paratrooper, who immediately identified a bad habit of "floating" my left foot before making contact on the backhand--a bad thing as footwork directly impacts racquet position and a couple of degrees on the racquet face means your ball is going long or into the net. Bad habits and ingrained muscle memory are hard to break and sometimes it takes the outside observer to see them. The funny thing about Nick B's place was that you spent a bunch of money and 3 days later your toenails were falling out and your tennis game had been deconstructed to the extent that you were actually playing worse than when you started!! A German banker in my group was exuberant however at the physical abuse since he was taken out of his normal 80 hour a week work routine.

Many club players are blissfully unaware of game situations and are quite happy to hit the occasional good-looking winner down the line (the lower percentage play) or the big serve and rare ace--it provides a wonderful feeling of power over the opponent and temporary euphoria but doesn't do much for the overall record or add to improvement in one's game. It would seem to be somewhat similar to betting on a long shot and being rewarded every blue moon but losing money over time. A VHS tape from a tournament many years ago on an indoor, hard surface where Mr. Gilbert gives the young Sampras a lesson in percentages is the perfect example of "winning ugly".

But as Vic Braden used to say if you can keep the ball going over the net about 5 times your chance of winning the point against most players rises quite a bit--average players start to loose patience at that point and then go for ill-advised shots. One is reminded of Borg and Vilas at the French on slow clay where rallies went over 20 hits on a regular basis and it was a war of mental and physical attrition. Borg with a resting heart rate around 35 bpm and a mind trained on 1000s of hours of hitting against a wall was just too much--I would have to take him against any player at any time on a slow surface using the older, wooden racquets. It may be that this obsessiveness or mental obstinance for Borg did not always translate that well to business situations where flexibility, an outward focus, and understanding of other people is needed.

It is rather strange to consider that a wonderful, public tennis court in Palm Beach is the former facility for one, just-convicted, high profile murderer and one, accused murderer. Both cases revolved around the death of ex-wives who had been seeking divorce settlements. Both men were successful businessmen, obsessive about money and "keeping score" and loved tennis and the outdoors. Now they spend time in dark prisons. Such bizarre pathology.

Tennis is a great and healthy sport, however, for most and it is always a humbling experience to lose to 14-year olds and to pull a calf muscle when hitting with an 85-year old. To bring such joy to fit, cagey, elder statesmen of the game puts it all in perspective.

Steve Leslie offers:

If there was ever a team sport that lends itself to "Win Ugly" it is hockey. And there were some pretty ugly teams in the old days perhaps no team uglier than the Philadelphia Flyers. The Flyers, aka the" Broad Street Bullies "of 1973-1974 and 1974-1975, were Stanley Cup Champions. Seven players racked up over 100 penalty minutes during that Cup-winning season, and one (Dave "The Hammer" Schultz) sat in the box for 348 minutes--the equivalent of almost six whole games. Interestingly enough, many players on the Flyers claimed in later years that it was the bullying tactics of the Saint Louis Blues that forced them to load the roster with brawn.

There were the New Jersey Devils of the mid 90's who developed a crushing defense that stifled opponents attacks between the blue lines thus limiting scoring. So many teams adopted the Devils method of defense that hockey had to modify its rules to encourage more scoring.

The Charlestown Chiefs with Paul Newman and the Hanson Brothers from Slapshot. Actually there is no Chiefs team in reality this one is just a movie but if you saw it you would get the point.

But Pro Basketball, in a sport that supposedly does not lend itself to rough play, there was one team that personified the "Win Ugly" style of play. That was of course the "Bad Boys" Detroit Pistons of 1989-1990. Although they were viewed as thugs, they also had a beautiful combination of skill, team play and muscle. And they could change their style of play to fit the moment and the opponent. In Fact, they brutalized the Jordan led Chicago Bulls and it was only after the team was effectively dismantled did the Bulls start to win championships.

I think the message here is that they understood the importance of team chemistry adapting to the situation at hand and working together to achieve a common goal. Their vision was to reach the promised land of champion and win over perhaps more individually talented teams, such as the Lakers, Celtics, Trail Blazers, and "Da Bulls."

Rich Bubb remarks:

Victor wrote:

"Keep a notebook handy at all times to jot your thoughts on your opponent down on. Gilbert does this during the game also, and I would suggest that this would be an excellent thing for specs to do. But your good ideas will come to you at all times. Keep a little pad and notebook with you at all times. It will have the further advantage of convincing those you have contact with that you are man of respect."

And just coincidentally, I found this portable notebook in the Cincinnati airport during layover on the way to Glastonbury, CT last Sunday.

And of all the available versions, I picked up this one: because there were no pre-ruled lines to write between. And it's a lot easier to lug around than the wire bound notebook I use as my Portable Brain (aka: To Do List). I also found a few interesting quotes from pages of above webpages:

"The pocket book is making a comeback, in the unlikely-sounding shape of the Moleskine. It is small and elegant, with gently radiused corners so it can slip easily into a pocket. The Moleskine is a Filofax for minimalists, a notebook for trainspotters. - Financial Times"
"My sketch-book shows that I try to catch things in the act."
- Vincent Van Gogh

10-March-2006
A New Department, A New Chair

Rodger Bastien, from Michigan, is currently Vice President at a large investment firm. As a baseball player he gained All America recognition in 1978 and was drafted by Rangers from MSU Michigan in 1979. He has kindly agreed to share his expertise with us by chairing our newest department, Sport and the Markets.

Sport and the Markets is a discussion forum on the correlations between the two disciplines, with the best posts each month being eligible for our \$1000 letters prize. Material is provided free by us and our readers, and all contributions are welcome.

To read Rodger's latest post, A Response to the Beauty of Baseball, the Sport and the Markets link can be found under the Departments list on the main page (eyes left and down).

10-March-2006
Victor Niederhoffer On Interattraction and Stigmergy in Groups and Markets

One of the commonest observations that one can make of group behavior is that , be it the herding behavior of companies or investors, the nest building or cleaning of social insects or a defense/hunting mechanism, it is much greater than the sum of the individual or the uncoordinated actions of the members of the group.

The term interattraction has been used by French authors like Darchen to explain the tendency of the individual members to be attracted to others through chemical or physical modalities. These are the attractions that lead to collective/group behavior. The term stigmergy has been used by Rabaud to describe the biological heritage in a species that leads to feedback actions between the individual and the group. These actions include interaction that leads to the building of pillars and arches in insects and muleteer track networks in human societies where actions trigger subsequent actions that lead to a self organized whole without apparent central coordination.

I believe that these concepts motivate many useful hypotheses about the markets, and next are some preliminary thoughts in that direction.

Let us start out with a very simple and specific market attraction. Consider the individual behavior of nine sector  ETFs. Are there any feedback loops between them that might be predictive of connections between, or the actions of, the ones that are performing the best and the worst in separate periods?

To attack this, Mr. Michael "Dude" Pomada ranked the nine ETFs each week from the lowest to the highest and looked at the performance of the groups in each ranked position for the following week. He found that during the last three years, the groups that ranked the worst tend to go up 0.33% greater than the average in the following week.

Several questions emerge. Does the particular ordering of ETFs in any period have a predictive significance for the market? Are there particular magnitudes of performance within the ranks that are predictive? Is the spread between the nine groups (its density) important? Finally, how does the duration of which each group has been there affect the answers?

These might seem like fruitless questions to some who have not read the paper, A Basis for Spatial and Social Patterns in Ant Species; Dynamics and Mechanisms of Aggregation by the French authors Depickere, Fresneau and Deneubourg, but all these variables; numbers in the cluster already, duration of time spent, and to a lesser extent densities, contribute to an amplifying influence on the aggregation process in the Common Black Niger Ant.

The article that sparked my interest in interaction was Societies of Spiders Compared to Insects by Darchan. The article talks about the higher forms of tolerance and democracy in spider societies and wonders why such societies, with a typically French touch, have not taken over the world. It criticizes the standard typologies of social insects a'la Wilson for neglecting the importance of interattraction.

An ant cannot live alone, and is always associated with colleagues. "Interattraction is the compulsory characteristic with which all individuals have to comply." What follows from this is that social insect societies contain individuals of all ages at all times living together. This creates certain standards for equilibrium, and this is what creates the caste like nature of these societies, and also what presents a closed and aggressive situation to any other society nearby, even a conspecific one.

The key observable aspect of interattraction according to the Darchens is the accomplishment of collective tasks that individuals working separately would be unable to perform. "Fortune and misfortune of social life: the group takes possession of the individual's potentials, increases them, exalts them, makes even new ones appear... but its members lose their freedom and cannot exist without the group." This limits the value of studying the individual in society.

How would this apply to stocks? It would open up the whole potential of looking at market moves in terms of the individual components of the move. It would motivate studies of, not only the extent of the issues which are setting new highs and moving away from the old extremes, but the composition by industry, age and risk factor, of the individual companies that create the move. The ants are able to clean and construct their nest, engage in agriculture and create castes for bringing up young. Analogously, it would seem helpful to think about the structure and stability of market moves, how they vary between tech and sage-like old faithfuls, how often the components gyrate, what communication signals are necessary to cement the move and how the ipo's are fairing in characterizing the collective strength that is a market.

The Darchens points out that individual bees do not create enough heat or ventilation to keep a hive going but collectively they can keep the temperature of the hive at its ideal level. The movements of individual companies, and especially their prospects for dividend and earnings growth, in and of themselves, would seem to be aimless and ineffectual in setting the base for the kind of markets that are properly ventilated and heated. However, collectively the proper mix of rises and falls, booms and busts, can create great things, including the 10.5 million percent return per century that the Triumphal Trio has so finely documented.

The Darchens believe that everything spiders do, if French, are superior to things the ants and bees do, including their interattraction. They point out that no spider lives in isolation, but all are interattracted, and that somehow they are interattracted without the belligerence and hierarchies of the ant and bee insects. "Spiders recognize their own species but show no restriction." They are extremely tolerant, but beyond a certain size of society they split up and form two new spider societies.

The main stigmetic qualities of spiders are; care of young, nest building, cleaning and hunting. Communication is key, and the main forms of communication are scents, vibrations of the web, and the pheromone hydrocarbons that Wilson has popularized. One wonders whether there are some sorts of market societies, be they industries, or companies on certain exchanges, that are much more tolerant of entry and exit than others. Does the constant adding and deleting of the S&P 500 keep it healthy, and are the vibrations up and down within certain societies of companies, and the way they are communicated by the media, such as the bearish financial columnists and the boyya wild commentators with the mediocre track records, a concomitant of healthy or unhealthy webs?

At a more general level, one would like to know what is the key to a healthy society of companies? How can it be fostered and detected, and most importantly, how can it be predicted? Finally, what tests are appropriate to determine whether this is a fruitful line of inquiry?

For a possible expansion of this, look at the work of Buckminster Fuller on Synergetics.

The other day here at the shop we tossed around Victor and Laurel's observation that it's "helpful to derive lessons from the social insects in developing insights into why stocks behave as they do," and one thought was to look at the constitution of gainers/losers, either of stocks within a sector, or, up one fractal level, sectors within the broad market. I have no special insight on it, but just to get the juices flowing I notice the remarkable arrangement of tech gainers/losers today, with the sleepy old-skool (might one say, 20th Century) techs (MSFT, INTC) out in front and the recent high-flyers (GOOG, AAPL) bringing up the rear:

```NDX      Change    Last      Open     High     Low
NASDAQ   +7.05    1652.14   1645.73  1657.3  1634.25

1) QCOM UQ   48.48  +.38   +.883     6.13MLN
2) SBUX UQ   35.46  +.54   +.676     2.48MLN
3) MSFT UQ   27.15  +.15   +.644    19.2MLN
4) INTC UQ   19.95  +.20   +.494    30.7MLN
5) YHOO UQ   30.83  +.55   +.439    17.3MLN

LAGGING MOVERS
1) GOOG UQ  333.99    -9.22   -1.31    9.36MLN
2) AAPL UQ   63.21     -.72    -.991  18.4MLN
3) BRCM UQ   44.82     -.75    -.350   7.47MLN
4) JDSU UQ    3.71     -.09    -.199  38.2MLN
5) SIRI UQ    4.8015   -.0885  -.149  19.3MLN```

Prof. Tony Corso conjectured:

There is probably an easier way to capture this pseudo higher moment effect.

When one is looking at the difference between histograms for significance a good way to look at the problem is by looking at the cumulative probability distribution function (cdf) instead. A histogram is just the probability distribution categorized into bins. So by adding the bin counts up and dividing by total n we get the cumulative distribution.

The advantage of this approach is that there are some good non-parametric tests which can test whether the difference between two distributions is significant or not. The tried and true Kolmogorov-Smirnov test looks at the maximum absolute difference between the two cdf's and can even be performed by eye.

The D'Agostino-Pearson test is even more powerful and is based on the squares of the differences between the distributions. The statistic can be checked with the widely available Chi-Square table for significance.

11-March-2006
The Other Guy, by James Sogi

When negotiating, cross-examining, making a deal, sparring, and yes, trading, it's always good to think about the other guy. What do we know about him, what is his motivation, his fear, his methodology, what is his weakness, his strength, what makes him tick, what will make or break the deal, or make or break him, how he reacts to the initial offers, jabs, moves, questions. We've seen the operator who only thinks only of what they themselves want, need, their own fears,  and operate in kind of a bubble. They are often played into comic figures by comedians, but the effect of such behavior in markets is tragic. The masters at their crafts know what the other person is thinking and will do in advance.

A perfect example of thinking about the other guy was Wednesday's false mid day break down in both S&P and Friday's GOOG's false break down. What are guys with orders placed just below the prior low price thinking and why do they put orders there and what will the effect of those orders be? They are thinking if long, "I'll hold the stock, but if it goes down below this point I will sell." That type of order is ephemeral. The other group is the bear order waiting for momentum and want to sell as the price breaks expecting a free fall. Over the past few years we've seen this tactic fail over and over, so for now, that thinking can be considered ephemeral, but as with all cycles, look out for changes. It used to work well before.

What do the 'locals' think? From looking at their orders and how they move their orders, and get filled, it looks as if they try to follow momentum on a daily basis. If the the order flow is up, they tend to pile in that direction. If the order flow is down, they tend to pile in that direction. Many appear to be "locals" in the 100-300 lot range for whom commissions might not play as big a consideration. I've heard that "they" like to follow momentum and order flow, that they often do not stay in long. A similar group, including a large subset of locals, are the "day traders" using similar size. What are they thinking, what is their habit, what are their weaknesses.

Another group is the market makers. They sit on either side of the market with size and jockey back and forth. It's a fast fast game that goes on all day long, and is a battle of the borgs. Programmers jockey their algorithms controlling the API with the spoils to the fastest and most adaptive. It's a fascinating game. Humans are not ruled out, as machines have their limitations and humans have an edge over them, not in speed, but in flexibility to adapt to the fixed rules of machines. That is the machines weakness, they just operate under fixed rules. Plus with only 5 levels of depth shown, their ability to see is limited to 5 levels. They are blind beyond that. This causes much of the price action we see during the day.

10-March-2006
Dept. of Personal Development: Parenting, from Steve Wisdom

I bet you are a good dad. Compound it; you will need it when they are teens.--Kim Zussman

Well, if I were a good parent, I wouldn't need to read books on the subject. QED.

More importantly, everyone believes (s)he is a good parent. It's one of those areas of endeavor where the meaning of "good" is sufficiently murky that you can pick your own metric to judge yourself by. It's like driving: 90%+ of drivers report they're above average. The young buck thinks good driving == agile, quick reactions. The church lady thinks good driving == careful, law abiding. Similarly, an older male thinks he's a good parent because he imparts lots of life lessons, and the young mom thinks good parenting == loving, nurturing.

09-March-2006
Quote of the Day, offered by James Sogi

Oliver Wendell Holmes, Jr., former Associate Justice of the United State Supreme Court, published "The Common Law" in 1881, and this book, given to me by my father when I first started practicing law 27 years ago, has guided my thinking since. Now with emphases on speculation, the wisdom still resonates. He wrote:

The object of this book is to present a general new of the Common Law. To accomplish the task, other tools are needed besides logic. It is something to show that the consistency of a system require a particular result, but it is not all. The life of the law has not been logic: it has been experience. The felt necessities of the time, the prevalent moral and political theories, intuitions of public policy, avowed or unconscious, even the prejudices which judges share with their fellowmen, have had a good deal more to do than the syllogism in determining the rules by which men should be governed. The law embodies the story of a nation's development through many centuries, and it cannot be dealt with as if it contained only the axioms and corollaries of a book of mathematics. In order to know what it is, we must know what it has been, and what it tends to become. We must alternately consult history and existing theories of legislation. But the most difficult labor will be to understand the combination of the two into new products at every stage.

The historical record and its cycles must be amalgamated with the unfolding of current events and indeed is a difficult labor as it is not the algorithms, but experience that provides the key.

When I was in high school the powers in charge took great pride in recounting that Oliver Wendell Holmes had been a student at the Academy. I think the lessons are lessons for ages. Society and markets evolve. Traders and Judges must adapt with those innovations.

Cycles change and so must we.

My lawyer father also gave me Holmes's "The Common Law" when I was in high school. Similarly influenced me to the effect that our system of common law comes from man's experience, not from "a brooding omnipresence in the sky".

I have the impression Holmes is much less influential these days, that very few law students know of him at all other than the standard quotes about shouting fire in a crowded theatre and "three generations of imbeciles are enough" (which has probably made him politically incorrect and hastened his decline).

09-March-2006
Self-Defense with a Walking Stick, from Wasaki

Aside from many good defense tips, many market lessons are laced within.

From the 1901 Pearson's Magazine:

Part 1

Excerpt:

The mode of defense I am about to describe I have called "The Guard by Distance," to distinguish it from "Guards by Resistance". It will be noticed that in this method of defense the man attacked does not attempt to guard a blow by raising his hands to stop it, but simply by changing front from left to right foot -- in other words, by swinging round from his original position, in which his left foot is advanced in front of his right, to a position in which his right foot is in front of his left. By so doing, he avoids being hit himself, with the certainty of being able to hit his adversary.

Part 2

09-March-2006
George Zachar Contributes a Song to the Fixed Income Department

Payroll Friday (to the tune of Manic Monday).

I was just in the middle of a dream.
I was boinking Angelina in
My brand new G5 Gulfstream.

But I must wake up
because the payroll report just came
This is a day
When I so often get maimed.

It's just another payroll Friday.
It never is my day.
Cause it's a whip day.
My "why am I always wrong?" day.

Have to put my orders in
Got to pick my buys and sells.
And if I had tomorrow's Times
I'd still never get a fill.

Cause the market seems to know
Just where I need to execute.
And that damn economist
Won't stop talking on the hoot.

It's just another payroll Friday.
It never is my day.
Cause it's a whip day
My "why am I always wrong?" day.

Of all of the nights
why did Bernanke have to talk last night
with that frown?
Doesn't it matter that the planet's all geared up
and unemployment's down?

He tells me as I'm ready to choke,
"C'mon markets, don't you get the joke?"

Time it goes so slow
when you're getting crushed....

It's just another payroll Friday.
It never is my day.
Cause it's a whip day
My "why am I always wrong?" day.

09-March-2006
Social Insects and Stocks, by Victor Niederhoffer

Social Insects -- ants, wasps, bees, termites and spiders -- are among the most successful and important species on earth in terms of their biomass, diversity, profusion, and useful role for other species. Their main characteristics are the division of labor among reproductive and worker castes, the differential structure of the individuals, adults caring for the young, the mother surviving the offspring. The book "Evolution of Social Insect Colonies," by Ross Crozier and Pekka Pamilo, explores how genetic principles lead to both cooperation and competition in carrying out the group activities and has been very helpful to me in gaining an understanding of social behavior.

One key to understanding the social insects is that they all follow what used to be called altruism, in that certain members of the group who don't reproduce seem to sacrifice themselves for the good of the group . The most common example of this is the drone bees working to provide food for the queen bees without any hope of reproduction. The basic formula that describes this activity is altruism will occur when:

cost/benefit is less than the degree of relatedness.

It doesn't take much imagination to see the many common characteristics of group stock market behavior with that of the social insects. The most striking similarity is how often companies that work hard in the background die or sink into oblivion so that a privileged class above it may succeed. An example of this would be the 95% decline in many of the Internet Indexes over the 2000-2002 period that preceded the spectacular rise of eBay and Google.

The amazing thing about the many groups that contribute to stock market characteristics is that all play a very specialized role, often in isolation from the others, similar to the castes of the bees. Yet the end product is one where no one group, no one expert can expect to show superior performance to another.

Prices are in the main quite rational, and provide a crucial link in signaling the purveyors and users of goods that we get to adjust their quantities and qualities to each other, and provide the capital that is necessary for the continuity and growth of our standards of living.

The degree of relatedness of individuals in a social insect society is measured by the percentage of genes that they hold in common. In almost all species that reproduce with half of the chromosomes coming from the mother, and half from the father, the degree of relatedness of parents to offspring and sibling to sibling is 50%. But because worker bees come from the unfertilized egg of a female, they are related by 75%.

"Remember that all the sperm from each drone is an identical clone. This means that the workers inherit 50% of the queens genes, but 100% of the drones genes. The workers that belong to the same subfamily are related by 75%. They are called supersisters."

The degree of relatedness of stocks would seem to be measured analogously by the correlation between their movements over a reasonable period like a year. For companies in similar industries, presumably the correlation between the price changes would be of the order of 50%, and one could call these siblings; and the correlation would go up to 75% for closely related companies in the same industry like Advanced Micro Devices and Intel. The same way it pays for a drone to die because he can create more identical genes in subsequent generations by providing resources for the queen to reproduce with, it often pays for a smaller company to sacrifice itself for the good of the larger. The fall of Enron could very well be seen as a very beneficial long-run factor for subsequent stock market performance because of the profusion of confidence and clearing of the air that it eventually produced.

At a more general level, the social insects are characterized by what Roger and Bernadette Darchen characterize as Inter-Attraction in Societies. One member of the group cannot live without another. "There are in fact so many physiological interactions, behavior patterns and regulations among social insect groups that there can be no doubt about the integration of the characteristics of the individuals of the group."

It seems helpful to think of companies as being intimately related to each other, with each playing a role in the greater performance and survival of the group -- sometimes competing with the others, sometimes cooperating with the others, especially on big up days when the advance-decline ratio reaches high levels. And it seems helpful to derive lessons from the social insects in developing insights into why stocks behave as they do. This is a very preliminary discussion and I would appreciate your forbearance in the many infelicities and stretches in this preliminary formulation and I solicit your improvements and sharpening of my thoughts here.

From an anonymous contributor:

The quickest implication of your musings on insects and market correlations would be to follow the intellectual path back to John Holland and Edwin Wilson, and make the Spencerian argument that Darwinian evolution and economic change can be modeled with the same formulae (businesses as agents that follow rules in different environments which allow them adapt, thrive, or die, depending on the rules that other agents in the environment are following). From this perspective, buying an index would be betting on the process of natural selection, rather than rooting for individual species.

To take the "economics as a case of natural selection" metaphor a bit further, one could say that while there may be temporary glory in betting on a superb adaptation to a specific conjuncture (luna moth?), sharks and cockroaches are probably the best long-term bet. I leave it to you to expound in your inimitable way on why GOOG is really a cockroach and not a flashy adaptation .

Comparing worker bees or drones with Enron seems like an analogy taken too far. Bee genes have evolved over countless generations to produce sterile workers to further propagation of the genes of parent drones and queens. Drones (like males of multiple other species of spiders, insects, and fish) die after propagating their genes if that's what it takes to improve the chances of survival of the resultant off-springs. It's hard to imagine an equivalent allele in the stock market that evolved to produce Enrons. Neither Enron nor the hyped internet companies were produced by some highly evolved corporate parents to improve their chances of survival. Enron did not improve the chances of it's own genes surviving by dying, in fact it seems like it did the opposite.

Separately, the whole concept of worker bees helping out because they are highly related to anybody in particular seems wrong. The "super sisters" are no different than some enzyme that the queen produces to keep the hive under control. Their genetic composition is irrelevant after they have been produced because they will never propagate. Only the drones and queens who conceived them will reap the rewards or pay the price for the quality of the worker bees they produced. This is different from the evolution of altruism in species where the altruistic individual has a chance to reproduce at some point of their life. In this case the individuals who are successful in propagating their genes through altruism will also have direct descendants who can keep and evolve that trait.

As far as the anonymous comment on the article is concerned, isn't the popular interpretation of the Sage's investment style, his bets on Chinese oil companies, regional furniture marts, and certain behavior of the dollar not withstanding, to bet on the cockroaches? The cockroach is likely to do the same thing tomorrow as yesterday, so a cockroach with a high return on equity is likely to have that return forever and thus can be valued predictably today. Of course if you could bet on a cockroach in the making right before it started evolving and conquered every continent you would be a lot better off. Similarly, you are lot better off betting on the dinosaurs as long as you know that the asteroid will hit AFTER you sell.

If anything resembles an evolving ecosystem in the markets it's the IPOs. The evolving species is the behavior of the investment bankers. Their general willingness to take companies public/the kinds of companies they want to take public/their pricing strategies for the shares are some of the features that are subject to natural selection.

Other participants in the ecosystem are the companies that want to go public, favored clients of various brokerages, and the overall investment public in the after-market. Successful IPOs begat numeruous other IPOs and unsuccessful IPOs result in reduced activity. Actually, the investment bankers "evolve" to become more agressive when things go well. All the other participants evolve as well: they are generally more willing to participate following a single spectacular success or a string of moderate successes.

The overall health of the market determines how discriminating these other participants become in finding similarities between past and future IPOs. In 'difficult' markets only very similar IPOs will benefit from the success of their predecessors, while in 'easy' markets any successful IPO is helpful. Even "altruistic" behavior evolves for the good of the investment bankers.

'First day pop' is the sacrifice that the company going public makes in order to benefit future generations of IPOs. Not flipping all the shares immediately is another altruistic behavior that is necessary for the success of the whole enterprise. Just a little food for thought.

I like to watch ants. They have nests in the bushes and junk and leaves on the side of my house. They have a trail of ants, one ant wide 100's of feet long, and walk in a long line from one end to the other, all day long. They walk over a bridge, over a pond, along a wall, or along the hose. I try to disrupt them by pushing them out of the way, spraying them with poison, or putting stuff in the their way. When ever they are disrupted, they scurry about a bit, reform and continue their line. They will even try swim across water. They seem to know what is going on, and they seem to be able to tell the other ones, "Hey, watch out for the big foot ahead." They seem to talk to each other as they walk past each other to figure out good detours to bypass the hazards. I think they talk with smell communication or their antennae. The ants coming marching one by one, Hurrah, Hurrah.

It reminds me of a point and figure, tick chart of the SP as it clicks up and up tick ,tick, tick, two ticks higher for each 500 trades, tick, tick tick. Or look at the past 100 years or so, or even today, same thing. Click click, tick tick upwards, like a line of ants. Once in awhile they get disrupted, but then regather, and start marching up again. It seems like the traders are talking to each other, "Hey, watch out for the big foot up ahead." The ants, and presumably the traders, have some sort of common purpose, perhaps unknown to each individual. They each certainly seem motivated and take great risks. To tell you the truth, it's probably better to join them rather than try to fight the relentless, mindless onslaught. The ticks come marching one by one, Hurrah!, Hurrah!.

For those who haven't read Surely You're Joking, Feynman's autobiography, his accounts of ant-watching are well worth noting for traders.

Early in his teaching career, Feynman read that ants find their way by smell. An ant foraging for food will travel in more-or-less random patterns, secreting a pheromone and being slightly influenced by the smell left by other ants. A source of food will have more and more ants stumble on it, increasing the density of the chemical trail. At a certain point a critical mass will be reached and all ants will follow the trail and very efficiently clean out the source of food.

Feynman reports that he wondered whether humans could smell the pheromone. He mentioned it to a colleague who thought he was making a joke. So he tried it - he got down on his hands and knees and tried to follow the trail himself. Spent several days setting up experiments with numerous food sources and ants and demonstrated quite convincingly that he could indeed follow the trail laid by a bunch of bugs. You can almost hear his thoughts as the colleague he initially broached the subject with laughed at his ideas. "Of course humans can't smell an ant trail!" "Oh. Have you tested that?"

No experience with this product, so I can't attest to its effectiveness or to the claims, but it does remind one of previous unpleasant experiences.

"The AntPro Strategy:

The AntPro ant control strategy is essentially the warfare strategy described by the 4th century B.C. Chinese general Sun Tzu, in his well known text "The Art of War". The strategy works well with social insects such as ants, because it fully exploits their behavior and biology.

```"Hold out baits to entice the enemy"
"All warfare is based on deception"
"Attack him where he is unprepared"
"Appear where you are not expected"```

Thus the skillful leader subdues his enemies without any fighting. When you consider the damage done by certain ant species, you quickly realize comparing ant control to warfare isn't much of a stretch. For example the Imported Fire ant currently infests over 300 million acres from Florida to California, and is responsible for death and injury to humans, domestic animals and wildlife. It provides a good example for how the AntPro strategy works."

Pardon this hasty dispatch from the field but the topic seems quite relevant given recent discussions on interaction and entomology. These are notes I collected while reading about self organizing systems some time ago after reading one of Chair's posts along similar lines. Quotes came from the links below.

Self organization is the study of how complex systems evolve from initial conditions. How do ants form a line? What causes herding? How do the various bids and asks coalesce into price? Farmer is modeling multi-agent systems in the markets along these lines. As far as I know, that is the state of the art.

"Self-organization is a basically a process of evolution where the effect of the environment is minimal, i.e. where the development of new, complex structures takes place primarily in and through the system itself. Self-organization is normally triggered by internal variation processes, which are usually called "fluctuations" or "noise" [mutations]."

"The increase in organization can be measured more objective as a decrease of statistical entropy. This is again equivalent to an increase in redundancy, information or constraint: after the self-organization process there is less ambiguity about which state the system is in. A self-organizing system which also decreases its thermodynamical entropy must necessarily (because of the second law of thermodynamics) export such entropy to its surroundings, as noted by von Foerster and Prigogine. Prigogine called systems which continuously export entropy in order to maintain their organization dissipative structures."

"The essence of self-orgainzation is that system structure often appears without explicit pressure of involvement from outside the system. The organization can evolve in either time or space, maintain a stable form or show transient phenomena."

"If a system is not at equilibrium, then it is dynamic, meaning it is undergoing continuous change of some sort. One of the most basic kinds of change for self organizing systems is to import usable energy from the environment and export entropy back to it. The idea of ``exporting entropy'' is a technical way of saying that the system is not violating the second law of thermodynamics because it can be seen as a larger system-environment unit."

08-March-2006
Real Estate Anecdotes, from Roger Arnold

So far this year, in my personal business, I have taken about 100 complete loan applications. Of those about 50 have been returned with supporting documents and checks to order appraisals. Of those about 30 have withdrawn their applications. This is something I have never experienced before. Once an application has been submitted and underwritten withdrawal is a very rare event.

About half were refinances and the other half purchases. Refis withdrew because of rising rates and purchases because of fear of overpaying for a home and / or an inability to sell an existing residence at a desired price. All were equally scattered among my biggest markets, Florida, DC metro area, San Fran, Houston / Dallas, Portland Oregon and New York / New Jersey. Average loan amount was about \$450,000. This appears to be a continuation and acceleration of the downward compression in values / sales that began in the 2 million plus market about 18 months ago.

The market up to about \$250,000 in price is still very strong with many 100% loan programs still available. That market appears to be benefiting from the top down compression and actually strengthening as a result. Home sales are brisk in that range as many higher end buyers are selling their \$500,000 plus homes and downsizing or renting; i.e. realizing profits and awaiting the fall out.

Nationally and regionally however the US is still in the denial phase with just the beginning signs of anger / blame becoming evident.

As the process accelerates in the US recognition and anger / blame should next be evident in the predominant "bubble" markets in the US; i.e. on the east coast form north to south: Boston, New York, New Jersey, DC Metro, and Florida; on the west coast from south to north: Phoenix / Tucson, San Fran, Vegas and finally Portland Oregon. Everything in between should be fine.

On a global basis these three stages should be felt first in Australia / New Zealand, UK, Canada and finally the US. Australia / New Zealand have been in mild consolidation for 2 years. They think they are now rebounding; but it is probably a very short and mild bounce up that will reverse again within the next few months. The UK is in a similar situation to them. Canada is just now beginning to show signs of weakness. The bubble there is concentrated in the Vancouver / west coast area.

The last three global real estate cycles saw appreciation and subsequent consolidations being the greatest in Australia, UK, Canada, and the US in that order, both to the upside and the downside. Many things are different now though since the last bottom in the early 90's; i.e. MBS market growth, adoption of inflation targeting, freedom of global funds flow, etc. I don't know how this is going to play out this time but I am very worried about it.

8-March-2006
Another Kind of Sell-Off, from Sushil Kedia

18:30 Tuesday: the Hindu pilgrimage city of Varanasi was rocked by serial blasts beginning at a key Hindu Temple. Many are dead. This comes in the wake of strong protests to the recent US Presidential visit from Islamic extremist groups and a charged up environment already.

11:45 Wednesday: market starts selling off on re-open after the sun-outage break after attempting a test of the opening high seen at 10:00.

Questions arise, because at 14:40 Tuesday  the Nifty futures had started trading at nearly 30 points discount to the underlying, providing a well counted signal of a rapid fire sell-off to come at the next day's opening; since it has always done so in the last few years ever since futures trading became the vehicle of speculation here.

How does the market prepare in advance for a coming emotional jerk?

How does one judge going forward into this sell-off? I think the emotion is now exhausted and it may be time to take the cane out in a few days again.  Prices it seems have a better reflexive capability than individual participants in knowing much in advance.

07-Mar-2006
A Happy Day, by Victor Niederhoffer

Though it is not necessary for me to regale you with the predictive significance of a day like Monday, because I am of that order of practitioners who test everything before sharing, it is but reasonable that I should by way of thanks share with you the reason and the rarity of what happened today.

Happy times and happy ages were those which the ancients termed the golden age, not because gold so prized in this our iron age was to be obtained in that fortunate period without toil but because those who then lived were ignorant of those two words "mine" and "thine." In that blessed age, all things were in common. To provide their ordinary sustenance, no other labor was necessary than to raise their hands and take it from the sturdy oaks, which stood liberally inviting them to taste their sweet and relishing fruit. In the clefts of rocks and in hollow trees the industrious and provident bees formed their commonwealths, offering to every hand without interest the fertile produce of their most delicious toil. Then did the simple and beauteous young shepherdesses trip from dale to dale and from hill to hill with no more clothing than was necessary to cover what modesty has always required to be concealed. But now, in these detestable ages of ours, no damsel is secure though she were hidden and enclosed in another labyrinth like that of Crete. For even there through some cranny or through the air by the zeal of evil importunity, the amorous pestilence finds entrance, and they are often wrecked in spite of all seclusion.

I was reminded of these golden days recounted in Chapter 11 of Don Quixote by the moves in bonds, more than half a point down; the Goldman Sachs Futures Index, down 2%; and the S&P, down more than 5 points. Guess what? It has only happened eight times since 1996, the last time being April 13, 2003.

I used to call these days healthy days since they knock all the excesses out of weak bulls. But just as the Don felt an obligation to tell the history of knight-errantry to the kind goatherds who had entertained him and fed him cheese and wine, I feel an obligation to tell you what the predictive significance of the eight occasions of this patterns have been on the days following their occurrences on 10/8/1998, 5/6/1999, 9/2/1999, 9/17/2001, 9/18/2001, 1/27/2003, 8/13/2003 and 4/13/2003.

On average, it was bearish for bonds for the next two days, then quite bullish. It was bullish for stocks, and neutral for the commodities for the next two days, but then bearish.

Regrettably, the golden age of moves like this is no longer upon us, and it is unsafe to assume that the kind of happy resolutions that happened in the golden days have not been usurped by these more perilous and informative times.

Read Excerpt from Dr. Brett Steenbarger's forthcoming book

February 2006 Letter and Contribution Awards

Daily Speculations is a benevolent forum to encourage good thinking about the market. Material is provided free by us and our readers. Because incentives work, and to augment the mutual benefits of participating in the forum, we offer awards each month for top contributions or letters to the editor. Some highlights among the many augmenting posts in February:

1. The discussion on cycles in late February was one of the best ever on Daily Spec. Special recognition and thanks to Phil McDonnell, Bruno Ombreux, Jim Sogi, Tom Ryan and John Bollinger for their elucidating comments.
2. Jim Sogi gets deeper and deeper, while helping us and others stay afloat. We thank him for his posts on binary modeling and rogue waves, which elicited a comment from an erudite new contributor, marine research expert Michel Olagnon.
3. Tom Ryan, known to Daily Spec readers for practical and scholarly insights on geology and trees, startled us with a thought-provoking post relating Shakespeare's playwriting to speculation. (Feb. 3)
4. Alex Castaldo consistently enlightens readers with essays that present the results of his intense study and thought with great clarity and wit. We recommend his latest, “Fibonacci’s immortal contribution to Finance” (Feb. 12).
5. The Letters to the Editor section drew a highly interesting comment (Feb. 21) on the racial element in the opposition in Europe to the acquisition of Arcelor by Mittal of India. The author requested anonymity.
6. Shane James’s letter on destructive memes (Feb. 16) offered a highly entertaining inside view of medium-term currency forecasting at investment banks.

We award \$500 to Jim Sogi and Michel Olagnon, and \$250 to the others mentioned. Read the winning posts.  -- Victor Niederhoffer and Laurel Kenner

06-Mar-2006
The Latest Pronouncement from Omaha, by Laurel Kenner

What would Sunday be without a column from Abelson or an annual letter from the Sage of Omaha?

Biology Catches Up. Most revealing are the s#xual allusions sprinkled in the report. The old lion continues to snuffle around the pride, snarling at the young lions who have excluded him from female companionship. After boasting of his latest acquisition (closed in just one week after a glance at the financials) he archly invites entrepreneurs to call him and pitch their businesses for sale.

I'll be waiting like a hopeful teenage girl by the phone.

The invitation makes it even more painful to read, later in the letter, that Berkshire took an aggregate loss of \$404 million unwinding the derivatives book the Sage acquired with the purchase of General Re. Did the traditional quick glance at the financials fail to enlighten? Not exactly:

Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I waited several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were particularly worrisome because their potential to explode could not be measured.

Is he is pleading feeblemindedness? Confusion? Naivete? Lucky the Sage has total control of his board.

A bit of preaching about the dangers of derivatives for the rest of us, and then he closes with another s#xual allusion:

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, "My wife ran away with my best friend, and I sure miss him a lot.

Warren's own wife died in 2004. (They hadn't lived together since 1977.)

A Sage's-Eye View of the Economy. The Sage is still bearish on stocks, and his letter introduces a fresh reason: an unchanging pie of returns that is increasingly being diminished by the ever-growing friction of the marketplace. He tells a little fable about wealthy families (the Gotrocks) and their advisers (the Helpers) that assumes that if only the same families would hold onto the same stocks and be happy, never trading in for new stocks, then all would be harmonious and happy.

A record portion of the earnings that would go in their entirety to owners -- if they all just stayed in their rocking chairs -- is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses -- and large fixed fees to boot -- when the Helpers are dumb or unlucky (or occasionally crooked.)

We don't disagree that overtrading is a good way to the poorhouse, and we are well aware of the pandemic. And yet.

By the Sage's math, stocks grew at a compounded 5.3% from 1899-2000, excluding dividends. His conclusion:

To achieve an equal rate of [5.3%] in the 21st century, the Dow will have to rise by Dec. 31, 2099 to -- brace yourself -- precisely 2,011,011.23. But I'm willing to settle for 2,000,000; six years into this century, the Dow has gained not at all.

You tell me -- gee-whiz-golly-shucks? Or logical argument? The Dow grew from 66 to 11,497 in the 20th century. We are always hearing that things will be different, but nobody has convinced me yet. And it's not just because I'm a cock-eyed optimist, although I do tend to whistle the happy tune.

Drs. Niederhoffer and Castaldo surveyed the literature and wrote a definitive essay for "Active Trader" magazine in April 2004 on the subject of stock market returns. An uncut version of the article appears on this Web site.

The docs had a somewhat higher estimate for long-term stock market returns -- 6.3% vs. the Sage's 5.3%. But their main point is worth repeating high and low:

The best working hypothesis is that stock returns have nothing to do with reported dividend growth and payouts, but have everything to do with the requirements of entrepreneurs for risk capital, the return they can make on investments, and the requirements of investors who invest at risk. The best working hypothesis for the next 100 years is that investors will achieve what they require a priori for their risky investments.

What is there about the "old man" syndrome we all know so well, where the old man devotes 99% of his active thinking and desires to having romance with younger women, that is so prevalent among Value Investors? Note that Ben Graham nowadays might well have been locked up for his proclivities in this area as he often goosed friends' wives on elevators and was serial in California in his old age. And hardly a speech goes by where the Sage doesn't talk about his romantic allusions.

Laurel Kenner points out precisely why I think J.P. Morgan Sr. would have viewed Warren Buffett as an "aw, shucks" version of August Belmont. He would have admired Buffett's abilities as a promoter and been permanently wary of taking him at his word. Belmont's investors made money, but they had a hard time making withdrawals.

The story of Merlin and Nimue also records all the highlights of "old man" syndrome. This is an ancient thing indeed.

1. An old Merlin, late in his life, falls for the young Nimue.
2. Nimue implores Merlin to part with his magic in exchange for promises of love.
3. Despite his wisdom, which tells him he is doomed, Merlin is unable to resist his lust, and allows Nimue to seduce him.
4. Niume uses the magic learnt from Merlin to later entomb him in stone.

Again, the great wizard and prophet, couldn't resist Niniane's beauty and Merlin followed her everywhere. She again promised her love to him, in return for Merlin to teach her everything about magic. Before she had lured Merlin to his death, the great wizard had built her hidden domain and palace near the Lake. With his magic he hid her home, so that anyone who went by, would only see a lake instead of her home.

When Niniane decided to return home, Merlin decided to accompany her, hoping to seduce the Lady of the Lake. Though, Merlin knew that his end was near, he could not control his passion or lust for Niniane. On their journey, Merlin and Niniane met King Ban, his wife Helen (Elaine) and the infant Lancelot, who was then named Galahad. Merlin told her that this baby would grow up to become the greatest knight in the world.

By the time they reached her home, Niniane decided to get rid of Merlin, enticing the sorcerer to teach her his magic, which she would use to trap the wizard. When they entered the forest of Broceliande, Niniane was tired of Merlin's company. She used the magic she learned from him, and entomb the sorcerer in rock. The Vulgate Merlin says that imprisoned Merlin in castle made of air, which only she free him.

In the Vulgate Merlin, Gawain learned of Merlin's fate and entombment, while in Suite de Merlin, it was Pellinor, who discovered the news of Merlin. Whichever knight it was, he returned to Arthur with the news.

It seems the successful old man momentarily capturing the young beautiful lady is an illusion created by each mirroring their emotions onto the other. The visually stimulated man looks at s#x as a performance. Her acceptance of his advances as validation of his masculine, virile performance. While the young lady looks at s#x as an emotional attachment, and his interest as validation that her ideas are valid. The illusion generally can only withstand minimal pressure, unless one party is willing to fall into delusion.

After reading Mr. Buffet's annual letter of why the dollar must fall, I see him projecting his beliefs onto all investors. If all US investors simply tried to capture/conquer foreign "value" perhaps he is right. Yet, it seems to me, that most US investors in foreign markets are investing in "growth" or trying and succeeding in creating wealth. A concept as foreign to him as women's ways are to men.

Steve Leslie adds 10 Reasons Why People Don't Sell Stocks

06-March-2006
Riz Din on Questions on Markets and Wives

In Letters to the Editor, Steve Leslie asks a host of interesting open questions. Thinking of relationships as non-linear may bring us to closer to the answers. For example:

• Some growth is good for the economy, but when economic data is much stronger than expected, there is greater risk if inflation and higher interest rates, which may be perceived to be damaging to stocks.
• When oil prices rise, stocks generally perform badly; but if oil prices keep going up, the oil sector capitalisation grows and weighting becomes greater, and so the correlation moves from negative to positive.
• Raising taxes generally increases revenue but it also depresses economic activity, and these offsetting effects will depend on what is being taxed and the level of taxes (see the Laffer curve effect).

This reminds me very much of self-correcting mechanisms in nature. It is also why I have tempered my excessive predictions on the markets, the economy and on wider society. In a world of linear relationships it is easy to predict the demise of an economy (demographic projections), the collapse of markets (talk of the end of the cult of equity as pension funds shift away from equity to debt), or the continual worsening of society, the end of oil as a resource, or the destruction of the earth through environmental neglect. In most cases I believe the self-correcting mechanism, which often involves the substitution effect, steers us away from the extremes. I am a moderate optimist on all fronts.

P.S. - 'Why do stocks seemingly and magically drop 30 percent in one day but take nine months to climb 30 percent?' If this observation is statistically observable in the wider market, it may help to explain the equity risk premium. Maybe the 'price' of the 10% annual returns of the markets is a skewed risk distribution; suggesting short-term investors are the grist for the mill. I believe this kind of skewed return also helps to explain the risk of investing in the foreign exchange carry trade. Free lunches are few and far between.

05-March-2006
Thoughts While Pruning, by Allen Gillespie

```Pruning is a necessary chore,
for a garden not to be a bore.
Dead and overlaying wood must go,
if new buds are to grow.
Now AT&T is saying bring an old love to me,
17.5% higher.
```

05-Mar-2006
Some Challenging Market Problems, by Victor Niederhoffer

One of the best ways to generate tactics for dealing with market moves is to look at some of the seemingly endless creative constellations of price changes that the market throws at you and treat them as if they were brainteasers on one of those simple mathematical challenges that Martin Gardner specialized in at the Scientific American or that the devious aptitude testing service mastermind that my friend Adam Robinson likes to call "Pam" loves to throw at you near the end of a test, or that Google might ask you in your employment questionnaire to see if you really dig search. In all candor, many questions arising from recent moves are beyond my own ability to solve, and I solicit guidance as to the answers so that I can sleep better at night and strive to climb up the stairs from semi-minor conference investment play and financial woes suffered in 1997 in connection with the meltdown in Thailand and related moves in U.S. stocks and derivatives.

Quantify the Cluster. The S&P has been particularly stable lately. The last two digits of the daily high have been:

99,92,94,92,99,94,96,96,94,92,93,84

The last two digits of the lows have been:

84,84,84,80,92,87,87,86,83,86,82,73.

How could this clustering best be quantified?

Ranges. Eleven of the last 11 highs have been within 4 points of the mean of 96; 11 of the last 11 lows have been with 5 points of the mean of 87. Has it ever happened before? What comes next?

If you get that one, Dr. Kim Zussman poses a related teaser. The highest close of the last 12 days is 1294. The lowest close of the last 12 days is 1282. That's a ratio of high to low of 1.01. It's the lowest in six years. What does it portend? Given that you knew in advance that the recent period would show such a narrow range, what would be the best trading strategy to adopt? For example, buy 4 points below the previous close or current open, and sell 4 points above? More important, now that the market mistress has set us up for these narrow-range days, what does she like to do in the future to preclude fast-buck artists and fixed-system followers -- and, dare I say it -- reversalists galore from depositing too much, nay, any overplus in their accounts?

Generalize these findings to other markets. Feel free to use these recent opens, highs, lows and closes in your answers:

```S P H 6   - -   S & P   5 0 0   F U T U R E
3/3/06 TO: 2/13/06
DATE  |OPEN     HIGH     LOW      CLOSE
F  3/ 3|1284.70  1299.00  1284.50  1286.40
T  3/ 2|1287.20  1292.50  1284.40  1291.60
W  3/ 1|1284.20  1293.50  1283.50  1291.90
T  2/28|1291.00  1291.80  1280.00  1282.40
M  2/27|1293.30  1299.60  1292.10  1294.00
|
F  2/24|1290.50  1294.20  1287.10  1293.00
T  2/23|1291.90  1295.90  1286.70  1290.20
W  2/22|1287.30  1296.00  1286.30  1292.20
T  2/21|1291.30  1294.00  1283.00  1285.20
M  2/20|
|
F  2/17|1291.20  1291.80  1286.20  1288.90
T  2/16|1283.70  1292.80  1282.30  1291.70
W  2/15|1277.20  1283.70  1273.00  1282.20
T  2/14|1265.70  1281.30  1263.10  1278.30
M  2/13|1267.10  1269.00  1260.80  1265.70```
Source: Bloomberg

Variations. The total variation relative to the ultimate variation has been enormous. In the good old days of the 1980s, the bond market often moved up and down 3 points during the day about five times before closing unchanged. At the end of the day, several operatives from the Palindrome's garage would check in with each other. "My goodness, what a day, that was the wildest roller-coaster ride in America." The answer would always be, " Tell that to George, he came in at 3 after playing some tennis and asked why things were so quiet."

Friday, March 3's move in the S&P brought back those days. Stocks opened down 7 at 1285, stayed relatively unchanged until 11:30 a.m., rose 13 points to 1299 by 2 p.m., then moved down 13 points to the 4:15 p.m. close at 1286, down 6 on the day. On a two-point box point-and-figure chart, it might have looked like this:

```1298                   x
1296                   x    x
1294                   x    x
1292    x              x    x
1290    x   x          x    x
1288    x   x  x       x    x
1286    x      x            x
```

Twenty moves of 2 points or more in one direction to cover just 6 points of total move. OK, what better method can you come up with to measure the intraday volatility in a market relative to its total algebraic change? What does such a day with great choppiness indicate for the future? How could it have been predicted in advance so you could have sold at the high and bought at the low a few times or more?

Googledrang. On Feb. 1, Google opened at 389, down some 43 points from its January month-end close of 433 on earnings woes. Since that time it has been buffeted by fear upon fear and the slightest bad buzz -- for example, a report by the Treasurer that the company cannot expect to grow 100% a year indefinitely -- has been enough to bring back those evil memories and recapitulate an immediate double-digit decline. Everyone's afraid to hold overnight, especially if they're day traders and their ultimate backer, be it family or broker, tightens the reins.

Within that context, there have been some nice moves and opportunities for profits. For example, the opens on the last four Thursdays -- up 2, up 2, up 3, unch, up 17,. What other indications of sturm und drang can you find? And are there any days that are particularly prone to overreaction? Could these days have been found in advance? Generalize the findings to other stocks?

Meetings. Many company chieftains speak at big meetings scheduled many weeks in advance. For example, Google executives put on a very well-received show at their annual analysts' day meeting of March 2, and the stock often jumped 5 points a minute as key executives hit upon felicitous or ugly choices of phrases. I got turned off by the "You all have been asking some very good questions and I'm just happy to say that we've been following the founder's message of "Do No Evil," very well during the last two years" -- the type of language that the master negotiator (he who parlayed a \$1 million preferred stock investment into a 5% interest in the company, CEO Eric Schmit, humbly threw out to the hoi polloi. You see, I remember all too well a friend of mine who had an ingenious answer for analysts who asked how he could say the company's condition was so great when he was selling his holdings in it. He would retort, "I'm doing it for you all so that I can provide the float and liquidity for institutional purchase that you all said was necessary for it to become an institutional favorite."

I find, however, that what turns me on and off about presentations at analysts' meetings has nothing to do with what's going to drive the stock. Let's start at at the beginning. What is the performance of companies in the days before, the day of, and the days following analysts' days? Same for annual meetings and other meetings, especially those before analysts' societies and brokerage conferences. Does it depend on the moves of the stock in the period before the current one and on the corresponding moves in the most vividly remembered previous such meeting? What are the key words and messages that are communicated at these meetings that might signal some useful decisions?

```G O O G     U S
DATE  |OPEN     HIGH     LOW      CLOSE
F  3/ 3|384.30   387.24   375.76   378.18
T  3/ 2|364.28   381.10   362.20   376.45
W  3/ 1|368.56   369.45   361.30   364.80
T  2/28|393.20   397.54   338.51   362.62
M  2/27|381.27   391.70   380.28   390.375
|
F  2/24|377.30   380.07   373.49   377.40
T  2/23|365.61   381.24   365.39   378.07
W  2/22|367.15   368.95   363.86   365.49
T  2/21|366.44   373.54   365.11   366.59
M  2/20|
|
F  2/17|369.86   372.14   363.62   368.75
T  2/16|345.67   367.00   344.49   366.46
W  2/15|341.27   346.00   337.83   342.38
T  2/14|345.33   351.69   342.40   343.32
M  2/13|346.64   350.60   341.89   345.70
F  2/10|361.95   364.50   353.14   362.61
T  2/ 9|371.20   374.40   356.11   358.77
W  2/ 8|368.48   370.69   354.67   369.08
T  2/ 7|382.99   383.70   363.345  367.92
M  2/ 6|385.31   389.90   379.56   385.10
|
F  2/ 3|393.62   393.90   372.57   381.555
T  2/ 2|403.82   406.50   395.98   396.04
W  2/ 1|389.03   402.00   387.52   401.78
T  1/31|430.57   439.60   423.973  432.66
M  1/30|429.23   433.28   425.00   426.82
|
F  1/27|435.00   438.22   428.98   433.49
T  1/26|439.54   439.99   423.56   434.265
W  1/25|451.26   454.23   429.22   433.00
T  1/24|436.03   444.95   434.48   443.03
M  1/23|407.38   428.39   405.73   427.50
```

Extra credit. Most fixed-income prices such as U.S. bonds and German bunds are at yearly lows, while stocks are near yearly highs. What does this signify? The German DAX 30 Index moved from below to above the English FTSE-100 on Thursday, Feb. 23, a event which has occurred only three times in the last 20 years. On Friday, the pair were back to their old positions with the FTSE at 5859 and the DAX at 5721.

Do crossovers like this have any predictive significance? What other significant crossovers have been of particular importance from a descriptive or predictive standpoint?

Looking at SPY daily, the recent several day condition is both narrow/flat in terms of closes, and also near a (possibly important) round number 130. In fact, the highs of this period twice perforated 130 from below, the first time this has happened since 2001.

Since 1/03, marked days when SPY high came from below to perforate rounds of 90,100,110,120 if this was also a 20-day high. I noticed that these dates (listed below) also marked beginnings of moves which were variable, so the question is whether the range of closes (MIN/MAX) around these round perforations contains any forecasting power. Here are the dates of the high/round perforations:

```2/27/2006
11/2/2005
5/23/2005
2/4/2005
12/3/2004
8/25/2004
12/26/2003
8/18/2003
6/6/2003
4/7/2003```

So on each of these dates, I checked the MIN/MAX of 9 daily closes centered on that date. Then checked SPY 20d return starting the day after the 9d period ended (thus visible ex-ante). Here is the data (not including recent period):

```MIN/  nxt
MAX  20d ret
0.966 1.030
0.968 1.015
0.975 1.065
0.978 1.010
0.979 1.012
0.982 1.034
0.983 1.003
0.984 1.008
0.987 1.002```

As expected by eyeball, the next 20d return was inversely correlated with MIN/MAX:

```Slope
Coefficients    -1.065525905
Standard Error    0.960331393
t Stat    -1.109539804
P-value    0.303854213```

...though the correlation was not statistically significant.

It seems there is a slight tendency, when rounds are first perforated by highs and the local range of closes is wide, for subsequent returns to be higher than if the range of closes is low.

Alston Mabry offers:

The total variation relative to the ultimate variation has been enormous...Okay, what better method can you come up with to measure the intra day volatility in a market relative to its total algebraic change?

It's not a bad horse, so I'll ride it again: "minimal path" or "MP". ("Minimal" because there would also be a "maximal path" and "average path".) Take the lesser total in points of two possible paths through the S&P:

```Close > Open > High > Low > Close
or
Close > Open > Low > High > Close```

Just add up the points and ignore the signs. That is, an up move of 4 points and a down move of 3 points is a total move of 7 points.

I think MP does a nice job of capturing intraday volatility. Here's a recent 10-day stretch, showing the MP, net point move, and net log % move for each day for the S&P (index, from Yahoo):

```3-Mar-06    24.35    -1.91   -0.15%
2-Mar-06    13.96    -2.10   -0.16%
1-Mar-06    11.7    +10.58   +0.82%
28-Feb-06   17.46   -13.46   -1.05%
27-Feb-06   11.59    +4.69   +0.36%
24-Feb-06   11.34    +1.64   +0.13%
23-Feb-06   12.52    -4.88   -0.38%
22-Feb-06   12.64    +9.64   +0.75%
21-Feb-06   16.97    -4.21   -0.33%
17-Feb-06    8.66    -2.14   -0.17%```

There can be stretches of fairly stable values, interrupted by substantial moves up or down. However, I cannot prove that this is other than random. Also, many of the tricks that one can perform with MP can also be performed with the more usual volatility measured as the SD of log % moves. Still, one might be able to add an extra indicator light or two to the dashboard.

06-March-2006
Mark Goulston on Achiever's Disease

I have seen many "powerful" clients who suffer from this malady of actually believing that they are an exception to the rule. They weren't psychopathic and had "narcissistic" features, but weren't dyed in the wool narcissists. I saw many of them as having a combination of obsessive compulsive disorder and bipolar disorder.

The obsessive compulsive aspects mitigated against the bipolar aspects which kept most of these people from going way over the edge. It's something I called OCB (obsessive compulsive bipolar) a.k.a. achiever's disease. I wrote about it for Fast Company magazine.

This Week's Commentary from Dick Sears

03-March-2006
A Sun-Baked Spec Looks Ahead to Next Friday

```Employment Friday
Children awaken to the
Screams of the father

Employment Friday
Zen koan -- What is the sound of

Employment Friday
Really? It touched that?

Employment Friday
Long short short long no matter
Burning Ben Franklins```

03-March-2006
Footwork, by James Sogi

Footwork is critical to effective fighting and sparring and many other sports. One important aspect of footwork is going backwards. There are numerous techniques, shuffle back (right and left) cross step back, and back step. It takes practice and uses different muscles to avoid falling on your butt. The back step is used to gain space, change timing, rhythm, distance and defense. The specific technique to focus on tonight is hitting while back stepping.

Probably the best example is the Ali vs. Frazier fight, the "Thrilla' in Manilla" where Smokin' Joe keeps charging in, head down, swinging. Ali is back stepping around the ring, leading Frazier, and as Ali back steps, he shoots off punches that catch Frazier coming in. When Ali can sense Frazier is stung, he reverses forward and flurries with a combination. Ali is always just a step away. Our coach always told us to change up the rhythm. Don't step, punch step, punch mechanically, like Frazier. Soon the charging bear gets exhausted, and the back stepper can move in for the knockout, and has scored points all during the defensive phase. This type of tactic can work when entering a position and when you don't quite get the bottom tick like some traders I know.

Having been taught by a lot of good coaches over the years, there has not been a single one that has not said that footwork is more important than anything else. Lay the foundation and the basket will make its self. It is impossible to shoot, if you are off balance and balance is gained by correct footwork. How can MJ or Dirk Nowitzki make those fall away jump shots? Mostly because they are balanced when they take off. Obviously the footwork will come with practice, to create muscles memory it takes 17,000 repetitions on average. Now, have a guess what Dirks personal coach had him do over and over again; without even shooting, just jumping in to the position. Lay the foundation and the success will come, it might be tedious but ultimately worth it. I cannot think of any sport or any part of life that that doesn't apply to.

Few combinations of Head Coach/QB have been as successful as the Bill Walsh/Joe Montana (hate to admit it as a die hard Raiders fan). "Bill Walsh rarely spoke of Joe Montana's arm; it was Montana's footwork he loved, footwork that made his arm so accurate." Seth Wickersham, ESPN

Barry Gitarts mentions:

I used to take lessons from a martial arts expert who created his own style. He often said the problem with most point fighters is they move back and forth in a linear fashion and that one could have an edge by moving in a circle around the opponent.

03-March-2006
A Zen Moment on Bloomberg News, Noticed by George Zachar

Consecutive headlines from NI ECO on Bloomberg:

8:49 All the Letters Spell S-L-O-W-D-O-W-N: Caroline Baum
8:48 *LEHMAN RAISES FED FUNDS FORECAST TO 5.5 PERCENT FROM 5 PERCENT

03-March-2006
Ducks vs. Gulls, by GM Nigel Davies

During the last couple of years I've had much opportunity to watch the feeding practices of ducks and gulls, which share the same habitat at the local park. Under normal circumstances the gulls are more than a match for the ducks, being highly aggressive when bread is thrown and able to intercept it in flight. But this morning, with freezing conditions, there was a change in the normal status quo. The ducks became much more aggressive.

It reminded me of the situation of chess players in Hungary before the Berlin Wall came down. Although there weren't 'professionals' as such (the authorities wanted to avoid this kind of nomenclature), most of the Hungarian players only went into work to collect their salaries, spending the rest of the time 'relaxing' (OK, they were 'supposed' to be studying chess in order to crush Westerners, but very few saw a pressing need for such squishing).

Of course, things are very different today and relaxation is a thing of the past. Many play in tournaments designed to provide title norm opportunities to Westerners, these 'businesses' having offshoots such as female 'tour guides' (with the optimal pay off being to marry some naive Western chess anorak and get the hell out of Budapest). Others have become 'coaches' and still others have left 'professional chess' altogether. But they learned to be competitive with the gulls when the chips were down.

03-March-2006
A Perspicacious Spec Waxes Poetic, A Continuing Feature

WIRE: Madonna eyes Israel house to await Messiah...
```Chosen people face
G-d! Choose someone else!```

02-March-2006
Thoughts Inspired by an Unsatisfactory Day, by Victor Niederhoffer

I have traded continuously for some 10,000 consecutive days, but never had a single fully satisfactory one. Yesterday was no exception. Among other things I did not get out of all the positions I wanted to at the close, I allocated much too much of my capital to a certain search engine stock powered by executives too smart by half, and I suffered from faintheartedness the previous day when I should have taken out the cane but instead merely used a walker.

As punishment, at the end of the day I bought "The National Enquirer," Clocker Lawton's
"Handicap Selections," and "The Gold Sheet." Lawton has been clocking for some 60 years, and I used his sheet regularly when I bet on races in the 1950s. Strangely, he has not aged, and still maintains a staff of clockers and other researchers in New York who are "salaried employees and [those] other from him [from] whom he buys services." His selections are sold at most leading newsstands near OTB parlors, although I was disappointed to note that they do not seem to be available at the gate of the track the way they were in my youth. The key to his selections is the early morning workouts that the ponies take, and his crack team of operatives who can tell how fast the ponies are and how hard they're trying despite the efforts of the boys to disguise their true strength.

It reminds me of a certain gold broker who handled the Hunt's trades and had a tendency to come up the elevator to the fifth floor of  4 World Trade and buy thousands of contracts of gold after lunch. Counterparts of Clocker Lawton on the floor paid early warning sentries hundreds of dollars to signal ahead when the broker pressed the button to go up so they could buy in advance. Why take the risk of having a position open for a hour or two, when you could just have exposure for the one-minute ride up to the fifth floor before front-running? The idea of finding out when executives are holding their annual meetings, directors' meetings, or meetings before analysts' societies, and monitoring the flow of pizzas and coffees ordered by the operatives at the federal agencies, would seem to be a variation of the Clocker's techniques.

On my sheet for Wednesday, March 1, the Clocker has successfully handicapped eight top winners in 11 races and nine winners, eight on top, at the Meadowlands the previous Sunday: doubles, exactas, a pick-3, a trifecta gold, a most preferred play, a cut losses maneuver, and Preferred Play Vince the Man won and paid 5.60.

It would be good if market commentators were to post their records, even if not as good as the Clocker's, and also if they had a cut-loss maneuver and various parlays.

As for the "Gold Sheet," the level of analysis was so far superior to anything I've seen in markets there's no comparison. The sheet starts out with a lengthy article on the psychology of conference tournaments that could be a model for psychological investigations of incentives in markets. Of course the coaches want to get on a winning note for the big one, but they do not want to show too much of their good stuff. The author concluded, "The teams most likely to try the hardest are members of major conferences who find themselves on the proverbial bubble for the NCAA tournament and teams from mid-major conferences who know that the only way for them to make the NCAA field is by going the distance in their conference affair." If only there were a way for analysts to tell when companies were going to devote all their efforts to winning for their stockholders with such fine distinctions.

I would recommend that some major brokerage hire the "Gold Sheet" analysts for an analysis of motivation and sharp testable conclusions that would give its customers a unique edge. The hoop ratings and point spread records for all basketball teams contained in the "Gold Sheet" is so far advanced over anything I've seen in the market that I want to throw in the towel on my own research efforts and just hire them to do a comparable thing for markets and retire to Acapulco. Such things as average points scored away and at home, for and against, the home court value, the current power rating (a combo of some kind), the percentage that they beat the point spread, the straight up record at home and away, the record of beating the point spread when they were favorite and dog, all broken down by home and away. There is much further quantitative analysis, much of it is too small for me to read, but I can say it's so far in excess of anything I've ever seen vis-a-vis individual stock analysis that there's no comparison. The qualitative analysis they give of each game includes teams to beat, top contenders for each day and each game in the future and this is very similar to what one sees on the street.

After being inspired by the extent and quality of research in these two related fields, one's displeasure with oneself is somewhat allayed and one is much more ready to join the fray the next day.

Your note reminded me of what Teddy Roosevelt wrote about the man in the arena. They -- both Roosevelt and the man in the arena -- never had a satisfactory day either.

I understand why you, as someone trading every day, find valuation methods suspect. Most of them are. They rely on an unproven and unprovable correlations based on past events. They do not measure the heat of the present moment, (The reason that I am not a fan of Money Ball is that the statistics can tell you how to win the regular season games but they do not measure heart. That is why, under Billy Beane, the Oakland A's have consistently failed in the post season.) But, those of us in the Kindleberger seats are not entirely spectators. Like Clocker Lawton we enjoy studying the morning workouts, and our old-fashioned calculations of value work better than chance. We do have our own capital at risk. We are not playing with some institution's money, but we are not at the plate or on the mound, either. At best, we are in the dugout watching like the bench coach and making the occasional remark about the tendencies of the next hitter or pitcher.

In the end the race remains in the hands of the jockeys just the way the market remains in the hands of the traders. Enjoy day 10,001 as best you can.

Perfection is an ideal to aspire to; once you make it the standard to live by, you're doomed to be dissatisfied, if not downright unhappy.

I did house calls on a dying iconic composer some years ago who felt miserable beyond the fact he was dying. I asked him what that was about and he replied:

"I've been successful in the eyes of the world for more than 40 years, but there have only been five times when the music in my head matched the music I composed and played. Knowing it was possible caused me to try to do it every day, and every day other than those five occasions come up short."

I told him he had blown it (in our relationship he appreciated my direct/bluntness vs. the many sycophants he had.) To know utter perfection at his level five times in a lifetime was something almost no one experienced. He had foolishly treated an ideal as his standard for daily living and he should stop it already.

On another note, we experts don't always practice what we preach. For instance , I suffer from a similar malady, where when I accomplish something, it doesn't make me happy (because I too chase the elusive carrot of: "I could have always done better"), but when don't accomplish something, it makes me miserable. I have however used this distorted mind set to deal better with mistakes or disappointment, by saying to myself: "Hey, even if it went perfectly, you still wouldn't be happy. So just let it go." It sometimes works.

Dr. Kim Zussman notes:

Isn't the discrepancy because people want to represent trading/investing/speculating as loftier than gambling?

In Bodie Merton finance text, the chapter on futures explains their use for hedging (especially agricultural commodities). It goes on to describe financial futures speculating, and adds that critics claim it has no social value (to borrow a phrase from old anti-skinflick cases). The book counters with the oft heard arguments that speculation improves price accuracy and provides liquidity.

Besides futures contracts, what are some other products that have no social value?

1. Tennis rackets
2. Skis
3. Contraceptives
4. Fiction (which includes non-fiction)
5. Dogs and cats
6. Las Vegas
7. California
8. Alimony futures

Extending these ideas to business, no company I have worked for has ever said that it would be OK to ease up a bit this quarter. However, organizational culture and structure may unintentionally provide motivations to employees to let up at times. For example, Oracle has a very expensive product that may require a long period of intense persuasion to make a sale. The sales force has incentives based on Oracle's fiscal year. Thus the sales reps work around the clock as fiscal year end approaches to close deals and beat their quotas. It may not take any additional prompting for "the boys" in the sales force to decide that the weeks after fiscal year end are a time to attend to neglected families, relax, and begin working on new sales prospects that will take months to close. Oracle often shocks Wall Street with poor first quarter earnings.

Just as champions can become complacent, a long period of success may sap an organization's motivation. For example, Nike has attempted to replace Phil Knight three times. The board and Knight himself believe the company needs change to stop rapidly rising costs and rethink the company's growth strategy. Yet when recently fired CEO William Perez began making changes, the employees rebelled and said that the proposed changes were not compatible with the company culture. Knight is unable to resist stepping back in when one of his successors is not doing something the way he would have done it. After Nike's decades of success, it may take a catastrophic event to shake the employees out of their complacency (a former CEO of a company I am familiar with who is often mocked on this lists' website had a similar thankless task)

Reminds me of my naive first days as a clerk in the silver pit back in 1983 when one my more worldly colleagues would curiously categorize a tiny sliver of the floor population as either a former "elevator kid", who had previously plied his trade hanging out in the lobby pending some guy's arrival, or a member of a more established and decidedly more flush genus, known as a "bathroom guy."

Regarding the latter, there was an infamous Comex board meeting back in January 1980 during which the ruling powers decided on a "liquidation only" rule to thwart the Hunts' silver play. According to legend, it seemed that as the discussions began to take an apparent and obviously consequential direction there was an unusual number of people in the room who seemingly took turns excusing themselves to use the men's room. The way I understood it, either there was a fat tail of impatient bladders not ordinarily found in a normal urological distribution, or there was a series of surreptitious phone calls to Rouse Woodstock and the other after-hours bullion desks around at the time.

All made by those cagily if suddenly bearish.

Joe Gelman comments on Clocker Lawton:

Clocker Lawton is, as you may have suspected, long gone. His twin sons took up the mantle quite a few years ago, and I believe only one actually hoisted binoculars daily after a time. This information is itself almost a decade old, and for all we know, the Clockers' selections may be the output of dual Pentiums (possibly AMD's, value players that they are) cranking away at 5 terabytes of past performance data. Or maybe not.

02-March-2006
A BBQ Tell, from Alston Mabry

I was driving down route 21 towards Austin, and it was about lunch time. I was wondering where I should stop. There was a place that had a sign up for "deli sandwiches", but my experience with little country stores and "deli" sandwiches has never been very positive - soggy wonderbread, tasteless "cheese", etc. Then I saw it: the Texas state trooper cruiser pulled in at Bullseye Bar-B-Q in Caldwell. You gotta figure that a state trooper, who covers a big area with a lot of lunch possibilities, would know where to eat. So I pulled in to Bullseye, too. Smokey was having the ribs, and that sounded good to me. It was a wise decision.

01-March-2006
Poisons and Markets, by Victor Niederhoffer

The book "The Elements of Murder: A History of Poison" is the kind of book that tries to relate all aspects of history and criminology to poison. It promises to show the inside details of poison and the history of civilization, the fall of Rome, and the British Empire, the inside details of the deaths of every famous person you know including Mozart, Handel, and Beethoven, King Charles, Napoleon, and all the Roman Emperors. It fails miserably in each of these attempts, as each seems so far fetched that even the author doesn't seem to believe in the extension that apparently some misguided editor advised him to make.

What the book does contain is a discussion of the prevalence, the isotopes that cause death, the main murders committed, and the antidotes for the three elements that are most commonly used as poisons: mercury, arsenic, and thallium. Also, there is some commentary on other harmful elements such as lead, nickel, beryllium, fluoride, and selenium thrown in as a roundup. But, there are no principles discussed and you end up with a hodge-podge of random facts.

The best chapter by far is the "Poisonous Elements of Alchemy". Chemistry started with alchemy's quest for the three unobtainable goals: a philosopher's stone that could change base metals into gold, the elixir of life that could eliminate death, and the Alkahest, the universal solvent. The main elements used by the alchemists were poisons, mercury, and arsenic, and it is likely that constant use of these elements by such famous alchemists as Boyle, Newton, and Brandt (the discoverer of phosphorus) contributed to their death or madness. One of the interesting aspects of alchemists is that often they were gifted scientists, well respected in their fields, and the luster from their true contributions led to the unjust acceptance and waste of time involved in alchemic pursuits.

One of the pleasant things about poisons is that they are used less and less as a method of crime because chemists and labs have developed techniques that can detect even the most minute concentrations of most poisons. The correspondence between the alchemists and the chartists, and the chronics in our own field and the physical and financial poisons they administer is quite clear to me. There's also a direct correspondence between prominent hedge fundists, and investment savants and writers who espouse the alchemical methods in our field and thereby give it undue luster. Regrettably, while chemistry has replaced alchemy in the field of substances, and great labs and techniques exist for identifying the poisons in the real world of biology and physical science, no such improvement in knowledge and techniques, appears in our field. Even more regrettable, there are no experts that regularly testify as to the likely path, time, and modality of administration of poisons in our own field the way it is commonly practiced in the court room or the criminal investigation.

If I had to identify the main poisons in the financial field, I could do no better than the list that I identify as causing me nightmares at the beginning of Prac. Spec. There is the canard that growth is bad, that earnings woes are the key to market declines, that any trace of optimism is bad for stocks, than any uncertainty or gilding of the lily by companies is bad, and the whole host of technical things about moving averages and new highs and lows, and stochastics being predictive of future market movements. The worst, immediate, deadly poison similar to arsenic's effects would seem to me, to be the drastic, double-digit decline that often occurs when a company announces an earnings shortfall. The worst, long lasting effect similar to mercury is the malaise that accompanies fears about the economy slowing down, or the brake that the Fed will mistakenly put on the economy if employment is too strong. Fortunately, there are some market poisons that are expelled from the system quickly like antimony. I would hope that the message, that it's good to wait for stocks to fall to a level where you can buy companies for less than cash on hand, the cigar butt kind of investing espoused and practiced so unsuccessfully by Graham, and now espoused by the Sage, would be considered in that category.

PS. The best thing about reading the poison book was that it elicited some great insights on poisons in markets by my colleagues on the list and I will attempt to distill their insights in the near future. Please pardon the somewhat didactic and unfinished approach here as I am have many strings pulling at me these days.

More Poisons, from Peter Gardiner

1. That there is a 'philosophers' stone' which can transmute the dross of one's confusion and uncertainty into gold in one's pocket.
2. That the assiduous cultivation of arcane, technical, abstruse, and generally unpronounceable knowledge will provide the means of eliminating uncertainty in markets, and if not, at least impressing your betters.
3. That the happy or unhappy coincidence of one particular datum or item of news with some imagined or perceived market event is therefore proof of a causal relation between them.
4. That competence in some other field will somehow, as if by the magic of one's will or the superior powers of one's analysis and synthesis, be immediately, profitably, and predictably relevant to making money in the markets.
5. That there is a 'priesthood' into which one must be inducted in order to learn the 'secrets' of making money.
6. That profitability in trading varies directly with the product of brain power and time spent in its application.
7. That 'randomness' doesn't really mean that at all if you are 'really good'.
8. That the field of speculation can be mastered as long as one is willing to put in the time and effort, or has at least has the right professional or personal associations.
9. That one can learn how to trade by preaching to others, rather than quietly observing what the hell actually seems to be going on.

One of the "big lies" that poisons our financial discourse is that Americans don't save, and that by a chain of inevitabilities, we're economically doomed.

A new Fed study, above, titled "Recent Changes in U.S. Family Finances: Evidence from the 2001 and 2004 Survey of Consumer Finances", offers the following antidotes:

```                 1995     2004
% of families
who saved        55.2%    56.1%

net worth of all families in
thousands of 2004 \$

1995     2004
median           \$70.8   \$93.1
mean            \$260.8  \$448.2```

To make any translation to the Fed Family Finances data from the National Income Accounts means the journalist also has to understand the difference between Net Income (if positive it is savings) and New Worth, on a mark-to-market basis, which takes into account relative value changes in asset and liability values as well as net income increments.

Not likely!

Peter Earle offers:

With respect to drawing parallels between poisons and market-derived death, I note the following general categories of deadly ingestants:

1. Corrosives - mercury falls into this category, as do acids, alkalis, and the "salts"; disability and death via these come by severe burning and inflammation of exposed tissues in the mouth, throat, and gastrointestinal tract.

2. Irritants - arsenic is the prime mover in this category, which includes lead, copper, zinc, and other metallic compounds; injury and expiration here arrive via burning, nausea, vomiting, and at times rupture/burning of organs.

3. Neurotics/psychoactants - strychnine, opium derivatives, and the like fall into this category; seizure, convulsions, and general neurological/central nervous system shut-down occurs from ingesting these in excessive quantities.

...traveling, variously, in solid, liquid, and gas states.

I'd add, as a natural philosopher at work and with an eye extended toward market applications, that these are good qualitative groups into which poisons might be divided. However, that knowing as we do of allergies and "reactions" - from hives and rashes to vomiting and, tragically, sometimes death - that an effective definition, or categorization, of poison is far from simple. Indeed, "aquagenous urticaria" describes a rare but documented condition in which individuals experience toxicological effects from ingesting or coming in contact with water, plain old H2O. One man's sustenance - volatility harvesting, catching bounces, trend following, or what you have you - is another's discomfort or demise.

Other poison topics for exploration, where markets are concerned, may include:

1. Treatment of poison - in particular, by means of other poisons.
2. Developing immunity by means of ingesting poisons in small amounts, over time.
3. Poisons in nature (venoms, bacteria/viruses) versus man-made poisons (mercury powders, dioxin, et al).
4. Stages in "a" poisoning: ingestion; immediate, acute reactions; target organ/system exposure; longer-term (i.e., 5/10 minute) action; fully exposed state. Perhaps long term effects, if death is not indicated: carcinogenic, "flashback", etc.

James Sogi contributes:

Hate, greed and fear poison the mind and lead to physical manifestations. Compassion, and its manifestation in Hawaii, as the spirit of Aloha, are the universal solvent and antidote. This is not the airline version of aloha with which you may be familiar. Though briefly stated here, the truth of the foregoing is profound, and is not limited to its attendant social benefits, but to the workings of one's own well being.

These poisons can spread on social scale into memes and infect cultures, businesses and families. These poisons can contaminate your trading room, and your living room, and wreak havoc on the bottom line. The universal solvent does not seem like it is critical to trading, but as an antidote to the poison, it can help the bottom line.

Poisons, have their means of insinuating themselves. In processed foods, in radio, TV, magazines, in schools, poisons are spread and build up in the system. It can creep in slowly, and paralyze the trader.

Chemists now are working on the electro magnetic communication between molecules, and the competition between various chemicals for reaction with others. Though not life, they exhibit remarkable lifelike properties. For example, Carbon monoxide beats oxygen to the blood platelets. Viruses that Dr. Dorn mentioned, sneak into healthy beings, weaken the host, and turn the victims into pod victims (even though Dr. Zachar points out that core inflation is steady and Americans DO save.)

01-March-2006
A Slice of Life and the Pizza Indicator, by Henry Gifford

I once started a file where I saved various definitions of "inflation" I saw reported in my (rare) newspaper and magazine reading. It soon grew to encompass so many different definitions that the exercise seemed pointless, and I abandoned it.

I was attempting to count how many times "inflation" was used in the narrow sense I use it, which is to describe a lowering of the value of money, which I learned when I was 4 years old (1964) and spent evenings with my siblings helping my father separate silver dimes and quarters from the others. My mother reports that at the time (or a few years earlier) my father predicted that inflation would effect every aspect of life, especially people's attitudes toward savings and their long vs. short term attitudes toward everything. Perhaps he meant this to include attitudes toward health too. Anyhow, my mother said she disagreed with nothing he said, since despite being college educated she had never heard the word "inflation."

The mention of the changing supply/demand ratio for hip replacements, and the resulting change in price, makes it clear that price changes alone cannot be used to measure the changing value of money. Nor does a particular standard of living remain standard as such things continue to be invented. The resulting confusion seems to be used to the advantage of the political class.

My favorite way to measure inflation is by the price of a slice of pizza, because it takes into account many factors such as real estate, taxes, increased efficiency of supply distribution and shipping, decreased influence of the mafia, wages, energy, etc. The man who sold me pizza for 25 cents a slice in the 1960's is still there, but doesn't remember the exact years he changed his prices. Any accurate data anyone could provide would be appreciated.

Steve Wisdom responds:

Yes, all true. But pizza is non-scalable (labor-intensive) and inflexible, a recipe for above-normal "inflation." The methodology of baking pizzas is about the same as 1, 2, 3 generations ago. And a NYC pizzeria can't move to avoid the NYC tax/regulatory climate, America's worst, since its customers are walk-ins.

Longtime DailySpec readers will recall my post a while back comparing the relative price change in beer (scalable) and theatre-tickets (labor-intensive) since the time of Shakespeare. The relative cost of beer has gone way down.

According to the Cleveland Fed's "Inflation Central" page, 25 cents in 1960 was equal to \$1.62 in 2005. Until recently, a slice of pizza and a subway ride traded at rough parity. The last bump in real estate costs broke that, with slices now running in the \$2.50 to \$2.75 area, while a ride on the D out to Coney Island costs \$2.00.

R#fco Notes: Victor's Statements on R#fco; Media Coverage; News Story Correction Tally; Letters From Readers

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