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31-March-2006
Problems in Probability and Markets by Victor Niederhoffer

I have recently been inspired to read and consider some problems in probability and logic as an aid to better market thinking and trading. One inspiration was the sultan's dowry problem discussed very well in Fifty Challenging Problems in Probability with Solutions by Frederick Mosteller.

Yes, we worked with the sultan's dowry problem and found many useful applications in looking for lows and highs within groups of stocks, and between markets. But what really inspired this post was my mother. She's very sick but as sick as she was when I was visiting her in the hospital she insisted I tell the attending doctor that the author of the above book I was reading was my thesis adviser at Harvard and that I co-authored an article with him. He talks in the book about the beauty of problem solving, the poetry of finding the solution, the delight that comes from it, the new paths that are generated, the remedies to errors in the way we see things, the simple paths to understanding and an appreciation of the ability to reason by the problem solvers.

A nice discussion of how to solve problems which includes

• Studying the question carefully
• Being confident
• Finding clues from the context
• Relaxing
• Waiting
• Not accepting limitations
• Using previous problems solved
• Altering the problem
• Asking questions of those more knowledgeable

is found in How to Solve Problems by James Fixx which is referenced in game theory material found on M.I.T.'s website.

The above points are all helpful, but somehow the thrill of success that comes from solving these problems seems deficient. One problem is that the solutions to the market problems are always changing. Another problem is that many people already apply their insights into solving market problems and the market reflects these solutions in its current state. Worse yet, the market functions as a ballot box where those who are best at solving the problem reflect their views by backing their thinking with trades that bring the market to the correct level given their knowledge.

Problems of the kind posed in the hard parts of aptitude tests, even the challenging probability problems of Mosteller, usually have definite and best solutions and single answers. The market always has a large number of solutions, and they depend upon many uncertain and changing events in the future. As Doc Castaldo here puts it, " The problem is that the solutions are like a game where you have to take account of the solutions of all the other people playing the problem-solving game and also how the flow of new problem solvers is going to change the parameters of the problem."

I have found in my own experience, with some 55 years of problem solving (my father designed the first aptitude tests for police recruits at the academy) and 40 years of association with the best problem solvers, that the best problem solvers are often the worst money makers. As I say this, I am challenged as to how to prove this and what I attribute this to. It's easier to answer the latter. The main reason is that those who are best at solving problems don't answer the right questions.

All these thoughts came together when a problem-solving spec, Mr. Michael Cook, posed the following puzzle:

Two men meet on a street. They haven't seen each other for many years. They talk about various things, and then after some time one of them says: "Since you're a professor of mathematics, I'd like to give you a problem to solve. You know, today's a very special day for me: All three of my sons celebrate their birthday this very day! So, can you tell me how old each of them is?"
"Sure," answers the mathematician, "but you'll have to tell me something about them."
"OK, I'll give you some hints," replies the father of the three sons, "The product of the ages of my sons is 36."
That's fine," says the mathematician, "but I'll need more than just this."
"The sum of their ages is equal to the number of windows in that building," says the father pointing at a structure next to them.
The mathematician thinks for some time and replies, "Still, I need an additional hint to solve your puzzle."
"My oldest son has blue eyes," says the other man.
"Oh, this is sufficient!" exclaims the mathematician, and he gives the father the correct answer: the ages of his three sons.

All the mathematical specs that had the problem thrown at them immediately got the answer. Most of them can answer the question just from the last two words, "blue eyes," because they're used to solving problems like this and they've had this particular one and the 50 other standards thrown at them again and again on math teams and other competitions.

OK, the solution to the problem is contained in the Fixx reference above. But when I originally saw the problem I thought it wasteful for specs because the solution depends to me on semantics. First, one has to believe that oldest means higher than any of the others; ties are not allowed. Second, one has to add the thought that when someone tells you that the sum of the ages is equal to the number of windows in that building that you take the trouble to count the windows, and note it down, and then actually try to solve the problem and find that you're close but you have to differentiate between two possibilities.

Yes, that's it. This problem really is very helpful to specs, but not because you have to throw out the blue eyes. Because you have to always keep a pencil and paper handy with you. And you have to learn to count as a normal habit to test everything thrown at you in the spec arena. If that is your habit, when someone tells you something about the number of windows, you are trained to jot it down. And the rest follows by simple calculation and is left as an exercise for the reader or an improvement in the habits of specs who wish to deflate ballyhoo in what they are told about the market, individual stocks and the relations between.

Professor Pennington illuminates the localization/delocalization argument:

The Chair is asking "Why are good problem solvers not necessarily good traders?"

In many areas there is an important tension between localization and delocalization. Here are some examples:

1. In our interactions with other people, there is a value in maintaining privacy, and one extreme is to keep everything private, never sharing thoughts and feelings about others. But that extreme isn't the best solution -- it's best to let information spread out a bit, or otherwise tensions build to an unbearable level.
2. In physics, when an electron "seeks" its lowest energy state (or "ground" state) orbit around a proton (as in a hydrogen atom), at first glance it thinks it wants to be right there on top of the proton, where the electrostatic potential energy is at its lowest. (In fact, it's minus infinity). But again there's a "tension" associated with its trying to localize itself so much. There's a huge kinetic energy associated with having the electron's wave function's having the sharp kinks that would be need to be non-zero only at one point in space. So the ground state wave function of the hydrogen atom is a compromise between the electron's wanting to be only near the proton to minimize potential energy and wanting to spread itself out to minimize kinetic.
3. In thermodynamics, the goal of a system that interacts with a temperature "bath" (i.e. something that keeps it at a fixed temperature) is to minimize the "free energy," which is not just the energy (U), but U-TS, where (S) is entropy and (T) is temperature. Such a system likes to go to a low energy U, but if it increases U, then it can also increase S. If we blow up a balloon and it then proceeds to minimize U (which doesn't happen!), it will shrivel to take up no volume. But it finds its lowest free energy by increasing U with an accompanying increase in S, finding the smallest U-TS, and that's an inflated balloon.
4. City dwellers can gain on culture by being at the center of the city, but there's also a repulsion between people -- they don't want to live on top of each other -- so the city has suburbs as well as a core.

I don't know firsthand if the Chair is correct about good problem solvers not being good traders, but if so, maybe it's because they're looking for exact solutions and forgetting the role of randomness, entropy, non-zero temperatures, the tension relief from gossip. It's probably a mistake to only trade when you've found a system with 98% winners that trades only on Tuesdays, after bonds have bottomed, with an expansionary Fed, and with no head-and-shoulders topping patterns.

"A great discovery solves a great problem but there is a grain of discovery in the solution of any problem. Your problem may be modest; but if it challenges your curiosity and brings into play your inventive faculties, and if you solve it by your own means, you may experience the tension and enjoy the triumph of discovery."-- George Polya (Author of "How to Solve It")

George Polya (December 13, 1887 - September 7, 1985, in Hungarian Polya Gyorgy) was a mathematician who was born in Budapest and died in Palo Alto, Calif.

Summaries of Polya's problem-solving process: One, Two.

Al continues:

In education they call it "test anxiety", and the kind folks at Western Ontario University have some good advice.

An emotional definition of "risk": Anything that messes with your head and interferes with your decision-making process; that which scares you out of your best positions. The movie version would be "Nightmare on Wall Street." The "F" factor: Is it just a dream? Or are those razor claws real?

GM Nigel Davies offers:

One would have thought that at least in chess, the best problem solvers would be the best players. There is in fact a certain overlap, for example Jonathan Mestel is an outstanding problem solver and an over the board grandmaster as well. But strength in the two disciplines appears to be the exception rather than the rule and I think there are two main reasons for this.

1. The perfection one sees in composed problems, in which ever piece is there for a reason, does not occur in a real game. So when a problemist looks at a 'real' position he is often looking for the wrong kind of idea; he seeks perfection, beauty and precision when what is required is pragmatism.
2. The problemist will be unused to playing against an opponent, someone who is their not only to test his ideas, but even tempt him into believing that a perfect combination may exist whilst in fact he is laying a trap for him.

A cunning player is all the more likely to set such traps if he sees he is playing against a problemist, offering the spectre of an unsound combination and getting him to use time calculating it out. What's even worse is that the man seeking perfection will eventually become so frustrated that he'll start to believe his combination is sound. And that will be the end of the game.

From a Fast-running Actuary:

Perhaps a great example of this is the actuarial profession. To get the "actuarial" designations you must take a series of test, which stress problem solving skills and  have a pass rate below 40%.

All of which the actuaries are expected to study 500-1000 hours for each exam. Further, the latter exams are written exams, graded by volunteer actuaries. The non-paid volunteers often are the actuaries doing exam seminars and writing study guides. Like old lions guarding their "designation" they have double vested interest in keeping the pass rates low and arbitrary. These exams are very time constrained, and quite often the volunteers will simply not grade papers due to "sloppiness". Finally, the Society of Actuaries have completely overhauled the exam program four times since I have been in the business, but kept the same dysfunctional conflict of interest each time. After the first two exams, (of 8 to 20 exams depending on when you took them) you are left with only those who will accept these odds.

Hence, you get problem solvers of first degree upon completion of the exams. However, actuaries are stereotyped in the insurance business as brilliant but impractical people that cannot communicate and cannot function in real life. Much like the computer nerds are.

Some reasons for this:

1. Real life often does not have an answer and, if it does, often the best answer is:
A. The question is just not important enough to waste time on.
B. The answer cannot always be quantified and listed, subjectivity comes into play. For instance, "How much risk is right?" and "What is risk"? The actuarial exam will give you a list of 12 "risks". But they don't include the risk of obsolescence, or uncompetitiveness.
2. Real questions don't have a right or wrong answer. But as Nigel says "perfection" is not obtainable.
3. The answers do not come from a book. You must create your own methods. You must look at what others are not.
4. And finally, and perhaps most important for speculators, in real life the feedback loop is often defective. "Problem solver" situation it is not. Problems solvers, often cannot accept this and would rather ignore it then confront it.

How often have we heard the saying "everybody is a genius in an up market". Day traders, trenders, technical analysis, even star gazers make money when stocks go up. But how many of them bother to analysis if this positive feedback is "alpha", due to their brilliance, or simply luck of the cards. Likewise, how many  brilliant strategies have been abandoned simply due to the down markets the past years.

Problem solvers are usually faced with 3 types of problems involving opportunity cost. The first type is opportunity cost is given. Such as in an exam, chess, football, or basketball. Or is the point in the game, such as speed chess, distance running. Problem solvers do great in these endeavors. They weight the cost, and maximizes the "score".

However, many of life's and the market most fruitful problems are where the opportunity cost is open-ended. The problem solver is left to decide how much effort he wants to give to any one problem. Here is where many world class problem solvers fail to consider what they are giving up. Rather they become obsessed with one problem, "the problem". Such as becoming a "Grand Master", becoming world class marathoner, becoming an actuary, getting a PhD from a top tier university. In pursuing these obsessive problems we all know world class problem solvers who have given up having a "life". It seems that these obsessed problem solvers, cannot cope with the "opportunity cost" problems that life and the markets throw at them. Rather, given a problem they must solve it.

Perhaps the racket and handball players have a more appropriate game. Because for each volley they constantly must weigh the effort to give, without knowing how long the volley and the match will take.

But again many great problem solvers do not have this obsession.

I must confess that I have the "obsessive" tendency to ignore opportunity cost on open-ended opportunity cost problems. Hence, trying to become an actuary and national class marathoner at the same time as being a good husband and Father to my toddler kids. However, this juggling act has taught me not to totally ignore opportunity cost, rather to put some balance even while going over the top in my efforts. Hence, why I believe you see fewer Mothers that are great problem solvers but cannot make practical real life decisions. While I have gotten better with this with experience and age, in this, I have fallen far short of some of the great women that have past through my life.

Yishen Kuik offers:

On a related note is the question of experience versus perspective.

One gets the impression that new breakthroughs are quite often made by fresh minds or outsiders in a field. Gallileo and Copernicus naturally spring to mind, but also Wegener's discovery of continental drift and the fact that many Nobel prize winning work like Crick/Watson have been fresh PhD thesis,

Fresh eyes and an unconventional mind are especially succesful at solving hereto unsolvable problems. Unsolvable problems are by definition those that remain unsolved after many have tried, exhausting the means of well known techniques along the way.

As such only those who try unconventional techniques have a chance at finding a solution, although they risk ridicule by their peers.

What holds back those who cleave to the establishment from trying new methods? Perhaps several reasons can be identified:

1. Humans are social animals and seek comfort in shared opinion.
2. By defying solution by canonical methods, the unsolvable problem points to flaws in the canonical methods, threathing the reputation of men who have spent their life's work upholding it. Thus these men have vested interest to defend the indefensible.
3. Power structures of patronage in every field means that lesser men will bend their opinion to their establishment higher ups. Those who created the canon might have earned their higher up position through their early efforts and now lesser men who depend on them for advancement also move to defend the establishment.
4. Abandoning a lifelong belief in the establishment methods means having to relearn and rethink about the world - a prospect filled with unhappy effort for the intellecutally uncurious. The human instinct is to go into denial and fight the new methods.

To what extent is experience a blinker and inexperience an asset, and how does this affect the market. If the market continually throws up new problems representing new opportunities, why are young people usually assigned to deal with it if experience matters? Do older people simply have too much vested interest in what they have been doing all along to abandon that to explore new pastures?

Is this one of many reasons why trading desks are perpetually manned by young people?

Michael Ott recalls:

When I was a grad student training undergrads I almost always let them solve the 'easy' problems themselves rather than provide a stock answer. I always told them why I did it that way, lest I be accused of laziness. The talk went like this: Most undergrads easily solve about 70% of the initial problems they  face when exposed to a lab for the first time. About a quarter of the time, they get it wrong. But rarely, maybe 1 out of 20 times, does their lack of foreknowledge allow them to come up with a new solution that is better than what is currently available.

This story had two important messages: 1. It's true, and shows that being uneducated but smart can lead to revolutionary changes. 2. If they can follow the math in their head and realize that it adds up to 100%, they can make it in a lab setting.

30-March-2006
The Spread of Disease as Applied to the Markets, by Jim Sogi

The first case study of the spread of disease as applied to the markets is this morning's Class IV Lobagola.

The variables are:
Population size, SIR groups
Ro infection rate, burn rate.

The Ro would accurately be measured by time and sales and transactions at bid or ask. Infections are classified as transactions at ask in rising markets, and the recovered or immune as bid hitters. Infection rate would be the rate of trades at ask / trades at bid.

The main unknown is the population. In the S&P, study of filtered time and sales shows that there are a few fixed groups that can be classified as the population. The locals of 100-300 size and large at 500 and above. The rate of their "infection" and recovery is descriptive of the disease model in the market. There tends to be some persistence at higher rates of infection. This morning was a good example of a rapid infection rate, limited population, and quick burn out, Ebola-like. Some estimate of population is possible by study of prior transactions, giving prior populations of SIR. This morning's infection burned out at the 1819 level. Prior population might be gauged by transactions at this level. Classification and identification of the SIR groups is the key.

Jim elaborates further with a new indicator idea and a market example:

The exact number in the population of infected can simply be determined from prior time and sales by counting prior transactions of that contract at that particular price, in this case at 1317-9 on March 16-22. Number of susceptible is unknown, but the infection rate gives indication of susceptible population density. Volume at price-date-time would be the name of this new indicator and to my knowledge is not available on popular charting programs and is different than volume at price across all dates. Open interest that the senator looks at is counting a similar population.

On a different subject, a tether ball effect has been in play around cash round numba penumbra. 3 Day Mini mean 1309.97. Wind down to pole, bounce off, and wind down like tether ball.

31-March-2006
Always Play Catch, from Steve Ellison

My favorite line from Rodger Bastien's excellent submission was:

"Until he likes the sport enough to play it in his spare time, he's not ready."

This is an excellent principle with much wider application. I read an article by Paul Graham entitled "How to Do What You Love" Here is one excerpt:

The test of whether people love what they do is whether they'd do it even if they weren't paid for it-- even if they had to work at another job to make a living. How many corporate lawyers would do their current work if they had to do it for free, in their spare time, and take day jobs as waiters to support themselves?

Another quote from Graham:

Finding work you love is very difficult. Most people fail. Even if you succeed, it's rare to be free to work on what you want till your thirties or forties. But if you have the destination in sight you'll be more likely to arrive at it. If you know you can love work, you're in the home stretch, and if you know what work you love, you're practically there.

When I find myself searching through data files of futures or stock prices for profitable anomalies while I am on vacation at 2 a.m., using my laptop in the bathroom so as not to disturb my sleeping family in the hotel room, I know I was born to be a spec investor.

29-March-2006
How To Raise a Spec Investor, Part II, by Victor Niederhoffer

Apparently I've hit a responsive chord with my letter to the unborn son about how to become a good spec, and I take the liberty of enclosing my next installment. I intend to make this series of letters an open thing that anyone can contribute to so that it's really good for kids, so please augment and sharpen and guide me.

Let's start at the beginning. You're going to be shaped by books, so you should try to read great ones. The best ones are those that talk about great things, great virtues, in a way that makes you think the author is rolling around with you, pitying as much as exposing, dropping a tear as well as a laugh, sharing a brotherhood with you, the characters, and your neighbors. And there is no one better to start with then Louis L’Amour himself, the man who wrote about a father who wanted his son to be just as good a criminal, as I want you to be a good spec.

Others agree with me here. He's sold more books about 500 million than all other Western writers combined, so he touches the universal hopes and values. As he says, "Every American has a bit of the frontier in him"

A good one to start with is his first, Hondo, a story about a father like me trying to teach a son lessons for life set in Arizona where the Apaches and the settlers fought for survival and a wonderful woman like your mother refused to give up in the face of hardship and danger. Here's how it starts:

An hour passed, and there was no more dust, so he knew he was in trouble. His horse crowded against a dark clump of juniper where he was invisible to any eye not in the immediate vicinity. Dust meant a dust devil or riders, and this had been no dust devil. The dust had vanished and that meant that he had been seen. He studied the terrain with care, a searching study that began in the distance, and worked nearer and nearer, missing no rock, no clump of brush, no upthrust ledge. He saw no further dust. He did not move. Patience at such time was more than a virtue. It was the price of survival. Often the first to move was the first to die. His eye worked along the ridge. To his right there was a shallow saddle, the logical place to cross a ridge to avoid being skylined. Logical but obvious. It was the place an Apache would watch. Hondo Lane could smell trouble and he knew it was coming, for others and for himself.

I know you're going to want to read many of the 100 novels that L’Amour wrote, and that you'll learn and be inspired by them. But before you read it, know that most of your college friends, your professors, and all critics are going to tell you that L’Amour writes summer trash, pageturners, pulp fiction. Part of the reason is that they don’t get the spirit of searching for new boundaries, freedom, adventure, chivalry and individualism that is the code of the West that he writes about. As L’Amour put it "If you write a novel about some woeful, forgotten, ephemeral piece of history that took place East of the Mississippi, you've got historical fiction. But if if it took place West of the Miss, why then it's just a Western. But more important, L’Amour and other great books that are best sellers like those of Jack Schaeffer, or Patrick O'Brian, or Victor Hugo, are about heroes that you might grow into--- heroes who are competent and self confident, self reliant, proactive, and productive. These are just the kind of people that threaten the sense of mediocrity and victimhood that is the spirit of the second handers and levelers that have the world of ideas and education in its grip.( I know that's hard for you to grasp now, but some day it will all become so clear when you read about the destroyers, those who must make everything that is great seem small that are the forces of evil arrayed against L’Amour type heroes like Hondo, or Schaeffer type heroes like Monte Walsh or Shane, or O'Brian type heroes like Aubrey, or Hugo type heroes like Jean Valjean.

Anyway, I've just read Hondo again and so much of it is crucial to the spec spirit - how to survive, how to be ready for and avoid the ambush, never trusting your enemy, always expecting the unexpected, being careful and observant at all times, never giving up, and yes, relying on your friends, especially your dog for help in a pinch that I'm going to memorialize just a few of the main takeaways from it that you might use as a model when you read it and the other great Westerns.

Look before you leap

"He studied the terrain with care, a searching study that began in the far distance, and worked nearer and nearer , missing no rock, no clump of brush, no upthrust ledge."

Before making a trade, look at the environment -- ecological, political and economic. Then examine your counting to see if it is overturned. Finally, beware of the hidden dangers, like the announcement coming in 5 minutes.

Patience is a virtue

Patience at such a time was more than a virtue. It was the price of survival. Often the first to move was the first to die.

The old board game idea of sitting on your hands before you move or trade - schtaaaalllll - as the great German grandmasters liked to advise. How often have you wished you waited an hour or a day to come in to the market, and how much better would you have been if you had. Test it.

As usual, the unusual

To his right there was a shallow saddle, the logical place to cross a ridge to avoid being skylined. Logical but obvious. It was the place an Apache would watch.

Yes, the Level 1 deceptive techniques the market throws at you are one of the most frequent ways to ruination. The angler fish holding out the worm that looks so inviting until you get swallowed when you try to enjoy it. How often does a option sell at an unusually good price right before some completely unexpected (and totally unknown ) catastrophe is about to occur. My goodness, the option volatility in the index in the days leading up to Sept. 11, 2001, was at least 50% higher than the base, and I must admit I succumbed and sold some naked puts when out of the clear blue sky the adversary bid me some fantastic prices. It was certainly nip and tuck then. Don't cross or trade at the obvious place if you wish to survive in desert territory.

The trade begins when it ends

As he fired, he moved getting into a new position in coarse grass. And there he waited.

Sometimes the best opportunities (and, regrettably, the worst dangers) come right after the trade when you've let down your guard and gone out for a snack or taken the liberty of uttering a self-aggrandizing word to your colleagues.

Still waters run deep

Reaching the stream at a bend, Hondo walked into the water on an angle that pointed upstream. When he was knee deep he turned and walked back, downstream and stayed with the stream for half a mile, then emerged and kept to rocks along the stream for some distance further, leaving them finally at a rock ledge. When he left the rock he was again walking upstream. He used every device to hide his trail, changing directions with the skill of an Apache. He lay still, avoiding looking directly at them for fear of attracting their attention.

Yes. Yes. Yes. Don't spread news about your trades to your counterparts or your adversaries, as you might be the victim of a squeeze or worse. It's tough out there, and the people who would do you in are very good at reading careless sign.

Conservation of Energy

Even when he moved there was a quality of difference about him. Always casually, always lazily, and yet with a conservation of movement and a watchfulness that belied his easy manner. She had the feeling that he was a man who lived in continual expectation of trouble.

Whenever anyone watches me play a racquet sport, there are invariably two stages. First, That couldn't be Niederhoffer - he's s so awkward. Then, as the game draws to a close, My goodness, he's not even sweating. All greats at their game make it look easy by moving the bare minimum. The same is true in trading. You put a position on. There's a reason for it. Don't get squeezed out of it by ephemeral factors, especially a stop on the floor, or a move in your favor

Know thyself

He was a man who knew himself, knew his strength and weakness, who had measured himself against the hard land of his living. against the men of that land, and against its wilderness The cobbler should stick to this last. If you're a long term investor, be so and don't day trade. If you can only handle 100% margin on a position, don't switch to futures where you can go with only a 10% margin. If you use Value Line earnings momentum for your stock selections, don't be swayed by a article in a magazine that questions the ability of management.

Only the house can grind

Frightened by what she had done, she stood helpless while he gently took the gun from her hand. "Shouldn't point a gun at anybody when there's an empty chamber under the firing pin. It can be seen mighty plain. `Specially with the light behind it."

This one has multiple meanings and lessons, as do many of the other passages quoted here. The main lesson for me is that you have to go for the jugular when you take the initiative. No half measures. If you're a speculator, you have to speculate and take reasonable gains and losses, not try to get out at the first profit. A variant is that only the house can grind as it has so much lower commissions and transactions costs than you. I want to encourage you to read many of the novels of the other great writers mentioned above.

Yes, I'll take the liberty of giving you a little guide to them and a few others in some of my other letters to you. And if you want to take a break and see what other kids learns from Hondo, especially those in the West of the Apaches that Hondo loved and fought, read this teacher's guide. You're going to be learning a lot from teachers guides like these because the best lessons you learn from books are going to come as you ask the kind of questions that a good teacher would encourage you to ask if just you and she were sitting on a bench together in a park talking about things you both cared about.

I've given this some thought and, inspired by Polonius' advice to Laertes in Hamlet, offer the following.

Yet here, my son! Aboard, aboard, for shame!
The wind sits in the shoulder of your speculative sail,
And you are stay'd for.

Nor any disproportionate position enter into.
Be thou risk aware, but by no means risk averse.*
But do not dull thy edge with ritual hedging,
nor let long periods of time pass away from the market.
Give every strategy thy ear, but few thy capital:
Consider all methodologies, but test them exhaustively.
Neither an exclusive trend follower nor contrarian be:
For the ever-changing cycles seem to save their most
ravenous appetite for those singular in approach.
And nothing dulls criticality and lowers ones guard
like a long string of successes.
This above all -- to thine own self be true;
And it must follow, as the night the day,
Thou canst not then fail in any regard.
Mindful we must remain that markets are,
Albeit a wonder of social interaction and marvelous
Machine for fostering efficiencies, providing incentives
and realizing true freedom,
Only one slice of this wonderful life you are starting.

My blessing season this in thee!

(Hamlet: Act 1, Scene III)

*For a future fund manager, insert the following verse:

Those employees and associates thou hast, their skills and ethics verified,
Grapple them unto thy soul with hoops of steel,
Confidentiality agreements and equitable compensation.

A Father's Prayer, by Russ Sears

```For my kids I plea today.

Put some champions in their way,
Not to give 'em a life of ease,
To find the path that'll please.

Put some queries in their mind,
For the Truth they can find,
Not simply take the party line.

Give 'em wisdom and my love.
To see beyond them and above.

And when my life on earth is gone.
Give 'em my spirit, to carry on.
```

29-March-2006
Officer, There's a Bulldozer in My Bank, from GM Nigel Davies

A curious site greeted me when I tried to visit the bank this morning. The area was cordoned off, a police car was there and a bulldozer was halfway inside it.

It looked as if someone had used it as a battering ram before removing the entire cash-point machine. A latter day Jesse James? Living in Blair's Britain, I figure it was more likely to be a disgruntled borrower. I can just see the guy sitting smugly in the dock as his brief explains how the bank wronged his client with their irresponsible lending. The bulldozer thing was just a letting off of steam.

Whatever happened to debtors prison? And whatever happened to those beautiful old banks with reinforced stone walls, bars on the windows and a heavy wooden door. The tellers weren't pretty young things in mini skirts, they were pale, thin lipped old maids with pony tails and horn rimmed glasses.

It was better like that; money is a serious matter.

29-March-2006
Rivers, by James Sogi

Have you seen the movies of the salmon swimming up the waterfall as the bears wade in and scoop them up with their paws. Some of you have seen them in person. I saw the salmon in the Columbia River gorge but there were no bears, it was a ladder by the dam. The salmon jump and swim upstream determined in what seems like such a hopeless quest. The best of the salmon jump, get swept back, jump again, slowly making headway, and eventually make to a quiet pond upstream to spawn and the cycle is continued. Many salmon don't make it and become feed. The bears are involved in a life and death struggle to put on enough fat for the long wait until they can eat again or they will not survive the winter. The biggest bear fight for the best spot on the river to feed. The market waterfall after Blackhawk's announcement reminded me of the salmon and bears.

I told a river rafting friend of mine that I would rather surf 15' giant waves in the ocean than run a class 4 river. In the big waves I know I will pop to the surface in 20-40 seconds, but in the river, the hydraulic keeps you down where many people drown each year. He told me, always have a good life preserver and a helmet. If you are caught in a hole, don't swim downstream, swim upstream. The water pressure is least near the rock and it is the easiest to escape the vortex.

A few ideas presented from the river to think about for traders caught in the vortex or caught swimming upstream with bears trying to eat them. The 3/21 waterfall seemed similar to today and the action the last few weeks (SP) looks like the rocky riverbed of a class four rapid. Here is the International Scale of River Difficulty.

Class IV. Intense, powerful but predictable rapids requiring precise boat handling in turbulent water. Depending on the character of the river, it may feature large, unavoidable waves and holes or constricted passages demanding fast maneuvers under pressure. A fast, reliable eddy turn may be needed to initiate maneuvers, scout rapids, or rest. Rapids may require "must" moves above dangerous hazards. Scouting may be necessary the first time down. Risk of injury to swimmers is moderate to high, and water conditions may make self-rescue difficult. Group assistance for rescue is often essential but requires practiced skills. A strong Eskimo roll is highly recommended.

Today and the week SP has been like a Class IV rapid with multiple "must" moves. Class V are those 5 sigma plus days. Maybe the market should have a classification system like whitewater running.

Class 5: Expert: Extremely long, obstructed, or very violent rapids which expose a paddler to added risk. Drops may contain** large, unavoidable waves and holes or steep, congested chutes with complex, demanding routes. Rapids may continue for long distances between pools, demanding a high level of fitness. What eddies exist may be small, turbulent, or difficult to reach. At the high end of the scale, several of these factors may be combined. Scouting is recommended but may be difficult. Swims are dangerous, and rescue is often difficult even for experts. A very reliable Eskimo roll, proper equipment, extensive experience, and practiced rescue skills are essential. Because of the large range of difficulty that exists beyond Class IV, Class 5 is an open-ended, multiple-level scale designated by class 5.0, 5.1, 5.2, etc... each of these levels is an order of magnitude more difficult than the last. Example: increasing difficulty from Class 5.0 to Class 5.1 is a similar order of magnitude as increasing from Class IV to Class 5.0.

Rafting is something that I did quite a bit between 12-23 yrs old. Having both the New River and Gauley in my neck of the woods created a golden opportunity to experience the "rivah". These rivers have extensive class IV and V + rapids. The advice given concerning being in a hole seems logical and I have been stuck only 4 to 5 times and my exits have been sideways neither up nor downstream. Part of the classification of rapids is size of the waves. Class V have 5-8 ft waves and the other part is the length of the swim once you are out of the raft. Class V and over is obviously the longer swim and can seem like hours when you are in the water.

The other important part for the "Captain" of the raft is that Class V rapids have very importantly and necessarily spots and objects that "MUST" be avoided versus lower class rapids that they are merely just strong suggestions or spots to be aware of. These Class V events are and can be like 5 Sigma events in the markets once you are in them, but the important part is that a rafter knows of the spots through maps and experience and this is factual (unless you have bad luck being in the middle of a plate tectonic shift or dam bust).

The trader though is only armed with data where he doesn't know what's around the bend only "central tendencies". Of course if you are Cygne Noir and have the great ability to see past central tendencies and predict massive shifts then you are on equal with the rafter knowing what's around the next bend in the rivah. I would rather expose myself Mr. Sogi to the waves, holes, and forces of a river than some of those massive waves you surf, but I grew up on, near, and around rivers and lakes not a beach! I will be surfing this year though on a Lake! My friend in N.C. bought a Supra boat that is built for wakesurfing, now those waves I won't be afraid of!

Duncan Coker responds:

To add to the river discussion, there are other ways to view them in addition to the rafter or kayak's point of view and one of my favorites as a fly fisherman. You throw on the waders,walking in and experiencing the river as a "flow" activity. Flow in several senses of the word, the feel of the current against you as you walk up stream or down, the sound which absorbs all outside noises and outside thoughts, the sites and activities going on in the water. A river is very much alive, from not only the fish and bird life, but the river itself by nature of the water, movement, and directness with which it transports the rain and snow of the mountains to the salt water of the sea.

The world seems different from a river. I think the aspect that captivates most, that romanticizes, that mythologizes rivers, is that of motion. Rivers tell a story of water and the long journey from alpine mountain tops or glaciers from 10,000 years ago, to an ocean a thousand miles away, a journey of both time and distance. So when you are wading and fishing you get to share in this for a while in addition to the leisurely pursuit of an anglers prized rainbow.

Coming to know anything in well nature is a pleasant activity, noticing the flow is more forceful this month than last, or this fishing run has changed from last year. It is interesting when the practicalities of nature enter your everyday life, like knowing when you can't cross the river downstream, or the when snowfall may block the passes, when the storms might reach the mountain peaks before your descent.

The idea of flow relates to other activities when you are completely engaged and performing well and in time with the environment around you. In a river, fishing, it is leaning in against the waste high current, seeing the slick water next to the fast current, a riffle, where you aim your cast, maybe hearing a quick splash of a rising fish or just the meditative sound of the constant moving water, delivering the fly to the water in an arcing cast, silently it lands in the flow, but is perfectly still on the water for a second before it starts to move downstream. The rest doesn't matter. You have already caught a trophy rainbow, served an ace, made a birdie, sunk a three pointer or taken in the overplus on a nice trade. The end is just the beginning.

28-March-2006
How To Raise a Spec Investor, by Victor Niederhoffer

Dear Son:

I thought it might be good to set down my thoughts as to how to become a good spec before you were born so that they might be memorialized for you and so that I would have a plan to follow. In doing this I am following in the footsteps of Mike Bastian, the hero of Louis Lamour's great book Son of a Wanted Man. Mike is being trained by Ben Curry, his father on how to be an outlaw leader and learns such things as how to survive in a desert, how to throw a gun, how to rob a bank or train or cheat at cards, how to tap a deer on its hindquarters without the dear running away, how to read sign, how to fight, how to pick a lock, and how to choose a friend,

You must learn similar things about specing, and I believe it just as important . I hope I can say to you in a few years like Mike's teacher Roundy said to him.

"You're ready. You can track like an Apache. In the woods you're a ghost, and I doubt if Ben curry himself can throw a gun as fast and accurate as you . You can ride anything that wears hair, what you don't know about cards, dice, roulette, and all the rest of it, nobody knows. You can handle a knife, fight with your fists, and open anything made in the way of safes and locks. And you got a good education so you can handle yourself in any company".

But how to get there, especially if I'm not around for the day to day. Let's start with... (to be continued).

Gary Rogan captures the above in Poetry

```When the day is filled with sorrow
And your screen is flashing red,
Will you live to fight tomorrow

Will you turn out like Mike Bastian,
Knowing how to play the game,
Or like poor St. Sebastian

Will you look like Good Ol' Hetty
Never washing her black dress,
Or end up like John Paul Getty,
After learning to play chess?

Save your pennies, live through sorrows,
You will take the booty home,
You will make it like George S0r0s,
Rich and famous palindrome.

Will the landscape of deception,
Fool you with a tough disguise,
Will you have the risk perception
For returns to realize?

Will you study math and science
To become a better spec,
Or provide SorbOx compliance
For a small cap in Quebec?

Will your brain become a scramble,
And you'll never get the joke
When you go for your last gamble?
Son, the gamblers, they die broke.```

People that know me will understand that I tend to liken an academic approach to chess with one to playing football (that's soccer football) or the violin. I see it as being rather like Beckham measuring wind speed and taking out a pocket calculator just prior to taking a free kick.

However, I do think there is some validity to studying chess systematically, the only problem being in how to do it. I believe that a move by move approach is fundamentally flawed because the possible variations will expand exponentially with each move and pack the mind with stuff that will inhibit thought (cf Lasker). But the number of positional patterns is more limited, and one can learn the kind of things one should be doing in certain types of positions.

This is how the best chess playing academic, Max Euwe, became strong, and a good outline of this method can be seen in his books (plus those of second-handers like myself and Ludek Pachman). Of course he was not half the player that Alekhine was, whose intuitive gifts ran rings around the plodding Euwe MOST of the time. But occasionally Euwe would catch him in one of the set piece scenarios he had studied, and he was then very strong.

Vis a vis the opening, one can manage the first few moves with a set piece scenario such as the London System (1.d4 followed by 2.Nf3, 3.Bf4, 4.c3, 5.e3 etc), the King's Indian Attack (1.Nf3, 2.g3, 3.Bg2) or set up some other such 'safe' position. But the problem is that this is merely the robotic repetition of a few set moves, and that such fix systems can be surrounded and destroyed by an adversary who sees them coming and adapts (cf Lasker - 'what is immobile must suffer violence').

Is there a best way to learn chess? I think the first problem for a lot of smart people who come to the game is in understanding that it is probably much more difficult than their profession every was (the one exception I know of being trading) and limiting their expectations enough to be prepared for gradual progress. Here's an outline I sent originally to another list, which though not universally applicable mentions some of the most useful things that most people never do:

To master chess the most important thing is to get the board out and play. Choose opponents who are fully capable of beating you rather than trying to show off by winning against no-hopers. Use time limits which make the chess moves more important than the clock.

When a game is over try to find out why you won or lost without too much concern over any tarnishing of your armor. Then copy the game score and your conclusions into a notebook, not just as a permanent record but to etch the conclusions into your mind.

Play through Morphy's games at first then those of the other champions, from Steinitz to Kasparov. The five best books to read are 'Lasker's Manual of Chess', 'Capablanca's 'Chess Fundamentals' and then the game collections of Alekhine, Keres and Larsen in which they explain their moves. Study the endgame rather than the opening and practice your powers of visualization with blindfold chess.

Rich Bubb notes:

The Classic Foundation of Wisdom -- Books i.e., The wisdom of sages written, read, learned and relied upon for centuries. The knowledge that stands the test of time, and sometimes difficulties' best solutions are the ones that are already solved centuries ago. Don't reinvent the wheel when you don't have to. Sun Tzu comes to mind.

Don't approach problems with, and/or from, everybody else's perspective. I really cannot remember where I learned this life axiom, but it has served me very well in my day job (engineering).

Learn how to read people. Even the most close-minded person cannot be invisible. Their body can speak, even if their mouths will not.

Know the difference between being Smart and Wise. Smart is knowing to believe only about 1/2 of what you hear, and Wise is knowing which 1/2 to believe. And, the parts ain't labeled.

Acquire learned friends, and learn from them.

Corollary 1: Discount idiots, what they say, what they do, and give them all the rope they need to hang themselves.
Corollary 2: When a friend is going do the (hopefully rare) mistake, tell them, and stop them if necessary. A true friend will thank you later. Someone who does not appreciate your meddling is in Corollary 1.

Respect and honor your friends and loved ones, and don't be afraid of telling them that you do. It's good to hear it once in a while.

Peter Gardiner says:

The most important thing in my life by a margin too large for comparison is being a father. For this one privilege, this honor, this exquisitely painful joy, I will be eternally grateful for life, and in a perpetual - if often distracted -state of awe. What did I trade for this? Nothing. It was bequeathed to me by the billion generations of living things before me, their perambulations and permutations, in all their mingled replications and variations, exactitude and error. For my precious son, what do I wish? So many things, and yet, at very least that he know in every filament of his being that he need never trade for his father's love. It is oxygen. He gets it by showing up, just as I get mine.

Learn to "Take the Hit".

How strongly you remain connected to people, goals and most importantly hope, in the face or frustration, disappointment or injury will determine how successful you will be in your career and your life. Learning to feel and stay connected to people, goals and hope under stress is a matter of maturity. The less mature you are, the less able you are to do it. The more mature you are, the better able you are to do it. Staying centered and keeping your cool is something that you will learn "on the job". The only way to learn it will be to "take the hit" and when you do, bear down and resist allowing disappointment to slide into discouragement, frustration into anger, or injury/hurt into devastation.

This ability is what separates champions from occasional winners in the world of sports. Occasional winners have talent and if it holds out, they might occasionally win a tournament. If, however, they run into a bad stretch, their talent is not sufficient to prevent the wheels from coming off. In other words, they can't take the hit.

Every PGA and LPGA golfer suffers from this except Tiger Woods and Annika Sorenstam. Tiger and Annika are not just winners, they are champions. When they run into some bad holes, they reach inside themselves and instead of coming up empty, as occasional winners do, they discover they have something known as "heart". This causes them to pause, refocus, become determined and then execute. Pressure and adversity cause them to play a different and better game.

Steve Wisdom notes:

With all due respect to Dr. G, whom I like and admire, I've always thought these sorts of remote psychoanalyses very suspect. How do we know Tiger Woods has "heart" and his competitors don't? What is "heart", anyway? Isn't it a circularity: he wins big tourneys; it takes "heart" to win those; therefore he has "heart." Is there any content to the term "heart" beyond "wins big tourneys"? If someone else wins the four majors this year, won't it be proffered that he (rather than Tiger) is the one with "heart", the one who can "reach inside himself"?

Much more interesting would be a prospective study, perhaps of the traits of all 16 year old golfers who are 5-handicappers, with the goal of predicting which wouldn't improve, which would become scratch golfers, and which would win tourneys, as versus retrospective (with the benefit of knowing which player became the best) attribution.

The term "heart" is used/abused often but I hear it most often when it comes to fighting. Of course a champion has "heart" (ability to continue/thrive in the face of difficulty) but it is often applied to those who are losing but not capitulating and continue the good fight and deserve a show of respect. There is a fellow who occasionally likes to fight with the "big boys" as our coach says. He's in over his head and gets pounded on (as we all do but some are better equipped to deal with it and certainly no one picks on him because a man never picks on those who are weaker) but he hangs in there and betters himself. This fellow probably won't get the best of anyone but has "heart" and is to be respected. On the other side, to say someone has "no heart" is to say he's no account, not a man, etc, and is the deepest insult.

29-March-2006

To start, we get fresh bread from the baker and slowly boil chickpeas to make Crostini alla Toscana.

I follow this up with my all time favorite dish. Freshly purchased farmers market artichokes prepared alla romana, where we cut out the choke and the outer leaves and then trim the stem and dice it finely. Then you reinsert the chopped stem into the area vacated by the choke and cook slowly over low heat the artichokes in olive oil and water. If anyone has been to the eternal city where they eat carciofi alla romana by the dozen then he will know the true joy of this dish.

We go on to make homemade egg pasta immediately after returning from Easter service and cut it into a variety of shapes, usually orecchiete to go with the Sardignian pesto we make fresh in a mortar and pestle just before serving.

The star of the show is the baby lamb we purchase from Lobel's meat shop in New York City. We usually go for around a twenty-pounder. We then quarter it and let rest for twenty-four hours in garden rosemary oregano and olive oil. Early on Easter morning we build the fire and let it burn down for a couple hours before we introduce the lamb, which we roast very slowly and take off just prior to serving.

For the contorni, or side dish I'm going to make a croute of asparagus. I take garden onions and slowly carmelize them over very low heat for a long time. Then I place fresh cherry tomatoes and farmers market asparagus over the onion in a flame proof casserole. I then insert whole bulbs of garlic into the casserole (to be eaten by squeezing the cloves out of the head and onto bread with the crostini) and drizzle the whole thing with olive oil and lemon juice/zest. A topping of pecorino romano and breadcrumbs covers the whole mixture, and then into the oven at low heat for an hour and a half or so.

For dessert we make fresh lemon tart with almond pastry and fresh berry gelato. Truly a great Easter meal from the south of Italy. Oh and to complement, a case of Aglianico del Vulture from the volcanic soil of Basilicata.

29-March-2006
Lessons from a Mars Rover, by Jeff Rollert

To some, it might appear that taking the day off to take your son's class to JPL on Fed day would be imprudent. Bond guys know that for much of the day you can sleep, until like the pilot seeing the mountain you suddenly "wake up".

A recent story by the docent on the Mars rover had a possible trading implication. The docent told the story of how one of the rovers recently came to the edge of a crater. The scientists hadn't expected to get their so quickly, and since the rover is way past its life expectancy, they wanted to go down into it. The engineers, after hearing the scientists and making sure they WERE scientists, said no. Much bickering went around until the engineers convinced the scientists to make a mock-up of the crater wall and use the test rover on it. What they found was that the tires gripped well at the bottom, where traction and ease of entry were good, but it had trouble near the top and they became concerned the rover would get to that point, slide backwards, then roll over. Since these were third grade kids, the docent reminded them "On Mars, there's no one to get you back - right-side-up. The final solution was to drive around the canyon rim, taking samples from there. Test, test, test.

Also, the stereoscopic vision of the rover wasn't a help in determining capability. So perhaps asking a single friend what he thinks of a trade can have limited usefulness too. For curing that, thanks Vic.

Memories of bad trades long ago came back to me...many of which I wish I had just "sampled the edge" instead of driving in immediately...not to mention getting in being much easier than getting out.

26-March-2006
Does the First Quarter Predict the Rest of the Year? By Victor Niederhoffer

The following borders on the useful, except for the retrospection, changing cycles and multiple hypotheses that characterize all such studies. However, for the good of our dedicated weekend readers, I put it up immediately, before the Minister of Non-Predictive Studies returns from his weekly weekend tournament outings -- Vic

I queried recently if a good first quarter of the year had any predictive significance for the remainder of the year. The question arose from my observation that this year, first quarter is up 5% to date, and 40% of years have seen 20% or more rises before dividends.

Doc Castaldo has kindly enumerated the data for the first quarter's performance and the subsequent three quarter's performance, (please excuse all those numbers to the right of the decimal). One notes, as he did, that when the first quarter was up the average change over the next three quarters was 9%, whereas when the first quarter was down, the average change over the next three quarters was up a mere 1%.

Using simulation, a difference as large as this is about one in a hundred to have arisen by chance. One notes also that all but one of the bad final nine months of the year were preceded by down first quarters, the one exception being 1987 when a 20% first quarter was followed by a down move of 15% in the last three quarters. One also notes that fourteen, or 25%, of the first quarters were up between 4 and 6%. Such a clustering appears to be non-random, however, more importantly one notes that none of these quarters was followed by a decline the rest of the year, with the average change for the rest of the year being some 11%, with 10 of the last three quarters clustering around a gain of 10%, plus or minus 5%. Again this appears non-random. Despite this, within the 32 first quarters that were up, there does not appear to be a linear association between the first quarter of the years performance and the subsequent three quarters.

One queries whether such results are numerology or a benchmark? One also queries whether such results might be extended to individual stocks? Also, whether classifying independent variables such as the above by clusters of their magnitudes, a la the analysis of the intervals of skips between consecutive notes in my report on musical compositions, (Mozart was much more regular than Scriabin), or conditional on classes of the independent variable, a la my report on the statistical analysis on regression forecasting, might be more appropriate?

One also queries whether the other quarters show similar relations and whether such relations could have been discovered on a prospective basis, rather than by the retrospective approach above? Finally, whether there is a general relationship between predictive patterns based on retrospective seasonal analysis and the subsequent out of sample performance of such relationships, (I posit a 90% reversion to the mean)?

The S&P returns since 1950 (terminating at month end).

We can define a dummy variable to be 1 if the 1st quarter is up and 0 otherwise. A regression with the Q2Q4 return as dependent and the dummy as independent gives the following results, (courtesy of Alex Castaldo):

Summary Output:

Regression Statistics

```Multiple R        0.310541
R Square          0.096436
Standard Error    0.128288
Observations            56```

ANOVA

```                df      SS        MS        F      Significance F
Regression       1   0.094852  0.094852  5.763328    0.019839
Residual        54   0.888727  0.016458
Total           55   0.983579```
```                 Coeffici   Standard   t-Stat     P-value
Intercept        0.014621   0.027351   0.534569   0.595143
Q1 is Positive   0.084269   0.035102   2.400693   0.019839
```

Thanks to Doc, Tex, and Mr. Saur for calculations and/or the approaches alluded to above. One encourages other queries and, with the Minister's permission, other useful answers sparked by the above beginnings.

I have been trying to think about the application of this to individual stocks and the logic that would apply:

1. Public companies try very hard to report an up year in earnings.
2. If a company's earnings for the first quarter are coming in close to even with the prior year, the company will pull in all its reserves, accruals and accounting techniques to report an up first quarter. With normal human optimism, management will likely feel that if it can get through the first quarter reporting up earnings, things may improve as the year progresses (or the unfavorable factors affecting the first quarter may ameliorate), making it possible to report a real up rest of the year.
3. If, even with these, a company cannot report an up first quarter, there will be a tendency to throw in the towel on the year, not only report the honestly down first quarter but throughout the year clean house by take whatever hits to earnings are hidden on its books, thus putting the company in better shape to report subsequent up years.

Thus a company's down first quarter should be a greater than random indication that earnings for the rest of the year may well be pretty bad. Of course it should also be mentioned in connection with this:

1. That it assumes a correlation between company earnings and stock performance.
2. That company first quarter earnings are not reported until a month or so after the end of the quarter, thus assuming that stock performance perhaps to some degree anticipates what will be reported as earnings.
3. That it is pure theorizing, involving no actual counting whatsoever.

To check how sequential quarters relate to each other, first I divided S&P 500 monthly closes into non-overlapping calendar quarters. I then regressed this quarter's return versus the last:

```                 Intercept         Slope
Coefficients    0.020985914      0.063795182
Standard Error  0.005320862      0.067142238
t Stat          3.94408172       0.950149779
P-value         0.000107572      0.343074058```

The slight positive autocorrelation between serial quarter returns was not significant. However quarter returns on average were up about 2%, which was of course in retrospect significant.

It might stand to reason that what happens in any given quarter could have a bearing on the subsequent three quarters. So I sorted the same S&P 500 returns into quarters, ending June, and then the subsequent three quarters. I then checked the return for the following three quarter period, conditioning on whether the June quarter was up or down:

```t-Test: Two-Sample Assuming Equal Variances

QTR RETURN         JUNE DOWN      JUNE UP
Mean              1.014621074    1.096383321
Variance          0.02348825     0.012138242
Observations      22             33

Pooled Variance                  0.016635415
Hypothesized Mean Difference     0
df                               53
t Stat                          -2.303153926
P(T<=t) one-tail                 0.012611876
t Critical one-tail              1.674116237
P(T<=t) two-tail                 0.025223751
t Critical two-tail              2.005745949
```

The three quarters following a down June quarter were significantly lower than the following three quarters when the June quarter was up. The question becomes whether each quarter, not just the first, predicts the following three?

28-March-2006
Benevolence and Thoughts from Faulkner, by Tyler McClellan

It has been a long while since Victor has posted on the general guiding spirit, which directs us in our interactions with each other on this list. The spirit of Franklinian discourse where one assumes that he has much to learn from conversation with those who also wish to prosper. In fact, many of our cherished ideas are shaped by, although often criticized, this benevolent interaction: chief amongst these being a belief in the tremendous positive return to the financing of human creativity and ambition. In many ways the stock market itself is informed by a similar sense of benevolence for all the protestations to the contrary. For what would exist but for the generally positive return to the financing of our fellow humans' ideas?

One is always reminded of the maxim that ideas can and do become tangible wealth. And one does well to think about the great lengths of time in human history when wealth was solely that, a measure of the physical quantities capable of producing output. How much more important now is the human mind in its transformation of input into output, and how much more wealthy is the city of New York than the farms of Iowa. All thoughts for the day about what it means to be a pillar for the construction of a certain edifice. And, I would hope that each of us would be one of those pillars and that the edifice we build collectively through the list would be a testament to the possibility and promise of human beings. Not to wax philosophical, but for the real purpose that this spirit of optimism and respect should hopefully inform all of our contributions.

For this list is a clash of prejudices and prescriptions. Those very prejudices give rise to the diverse hypothesis we seek to nullify through Popperian falsification. But this task is made possible by the realization that it is the hypothesis we reject, not the hypothesizers, and that we have faith in this process for the very real reason that we respect the creativity and autonomy of each list member. I again request the list's patience and post William Faulkner's speech upon acceptance of the Nobel prize. For me it is always necessary to strive after the pillars instead of the wrecking balls.

I feel that this award was not made to me as a man, but to my work--a life's work in the agony and sweat of the human spirit, not for glory and least of all for profit, but to create out of the materials of the human spirit something which did not exist before. So this award is only mine in trust. It will not be difficult to find a dedication for the money part of it commensurate with the purpose and significance of its origin. But I would like to do the same with the acclaim too, by using this moment as a pinnacle from which I might be listened to by the young men and women already dedicated to the same anguish and travail, among whom is already that one who will some day stand where I am standing.

Our tragedy today is a general and universal physical fear so long sustained by now that we can even bear it. There are no longer problems of the spirit. There is only one question: When will I be blown up? Because of this, the young man or woman writing today has forgotten the problems of the human heart in conflict with itself which alone can make good writing because only that is worth writing about, worth the agony and the sweat. He must learn them again. He must teach himself that the basest of all things is to be afraid: and, teaching himself that, forget it forever, leaving no room in his workshop for anything but the old verities and truths of the heart, the universal truths lacking which any story is ephemeral and doomed -- love and honor and pity and pride and compassion and sacrifice. Until he does so, he labors under a curse. He writes not of love but of lust, of defeats in which nobody loses anything of value, and victories without hope and worst of all, without pity or compassion. His griefs grieve on no universal bones, leaving no scars. He writes not of the heart but of the glands.

Until he learns these things, he will write as though he stood among and watched the end of man. I decline to accept the end of man. It is easy enough to say that man is immortal because he will endure: that when the last ding-dong of doom has clanged and faded from the last worthless rock hanging tideless in the last red and dying evening, that even then there will still be one more sound: that of his puny inexhaustible voice, still talking. I refuse to accept this. I believe that man will not merely endure: he will prevail. He is immortal, not because he alone among creatures has an inexhaustible voice, but because he has a soul, a spirit capable of compassion and sacrifice and endurance. The poet's, the writer's, duty is to write about these things. It is his privilege to help man endure by lifting his heart, by reminding him of the courage and honor and hope and pride and compassion and pity and sacrifice which have been the glory of his past. The poet's voice need not merely be the record of man, it can be one of the props, the pillars to help him endure and prevail.

28-March-2006
A Fish Story, by Philip J. McDonnell

The ancient Chinese proverb about teaching a man to fish has long been a motto of the Spec List. So it only seems natural to relate a recent fishing expedition to Cabo San Lucas with possible lessons for trading.

The first impression one receives when arriving at the airport in Mexico is that capitalism is alive and well in Baja California. Vendors and salespeople are lined up to prey upon the tired and unsuspecting passengers. They try various ploys and deceptions to gain the trust of the unwary. Some offer assistance, others pretend to be "official" with some sort of badge, clipboard or other ruse. It is all designed to engage the target in conversation. The conversation rapidly turns to offers of hundreds of dollars in cash and benefits if you are willing to endure a timeshare condo presentation.

At the marine, the forces of capitalism raged as well. As our group of eight strolled the dock, we were inundated with offers. We were looking for a craft that could take our entire party out for a fishing expedition at a reasonable price. We had carefully decided to show up at about 2 pm at the docks. That is when the fishing boats all return. One bit of advice had it that the way to tell if a boat had caught fish was to look at the flags. One fish per flag was the guideline. But that seemed a bit like reading an analyst's research report to find out if a stock is worth buying. One never knows when a little deception might be afoot. Instead we chose the shoe leather approach and actually walked around and interviewed the gringos as they exited their boats. This allowed us to make an intelligent choice subject only to the vagaries of the mistress of the sea.

When the gringos described the size of their catch they would put both hands up to show the length. Then as we watched the hands would get farther and farther apart. One can only suppose that it is some expanding universe effect due to being at sea for a few hours. When a friend would come by to confirm the size his hands would be even bigger. Apparently the effect is contagious. Cognizant of Prof. Leo Goodman's advice that unreliable data should be reduced to a simpler form such as plus or minus we decided to only trust the actual fish count data and ignored any size data.

With the lessons recently learned from the Sultan's Dowry problem our group proceeded to get multiple quotes from the competing boat charters. Prices were VERY negotiable. Essential tools in the process included the ability to convincingly walk away multiple times and to appear uninterested at every new offer. We finally chartered a 42' fishing boat for the following morning at a rather spectacular discount from the original asking.

Our adventure began at dawn. The vessel proceeded at high speed directly out from Cabo San Lucas about 10 miles to the deep waters of the Sea of Cortez at the area where it meets the Pacific Ocean. The entire San Lucas fishing fleet that morning was about 60 boats spread out over about a 15-mile front. All the boats were in constant contact via radio. Each time someone saw a marlin, whale or porpoise there would be excited chatter in Spanish over the air. Although clearly all the local fishermen cooperated in finding the fish there appeared to be unwritten rules as well. The boats all maintained a good spacing of about a quarter mile between each other. When one boat left an area another might take its place. It did not occur to me that there was a very good meta strategy at work here which significantly aided our ability to catch fish.

We slowed the boat and began to troll for marlin and other surface feeders. Our fishing guides kept a sharp lookout and would intermittently break into rapid fire Spanish when they spotted something. As with traders the fishermen were looking for patterns which indicated a higher probability of a profitable effort. They became excited when following a pair of cormorants. The presence of the birds and their low flying behavior indicated a school of small fish in the area. This was confirmed when we spotted very small choppy areas of the sea indicating the schools may have been chased from below. This bird following tactic reminded me of the traders who try to follow putative good traders such as Buffet, Icahn and others. One supposes that the bird following technique works better.

We saw whales on several occasions. One whale treated us to several rather spectacular "blows". Another ostentatiously slapped his tail on the surface some 12 to 15 times. Small groups of porpoises were abundant. Invariably one or more would proceed to buzz our boat apparently for a closer inspection. Again following the porpoises was a common tactic because often they are where the smaller fish are.

For the first few hours we had no bites or marlin sightings. We became rather disappointed. However as we proceeded to turn the boat inward back toward shore the fishing meta strategy became clear. The noise of the collective engines of the boats was concentrated in an arc some 10 miles out from shore. As we proceeded to slowly troll inward to shore we were driving both the smaller fish and the big game fish in toward shore. The result was that they were being compressed into a smaller space and thus easier to find and catch. In effect the fleet was trying to trap the fish population between the line of boats and the shore - and then slowly close the noose. One cannot help but compare the herding behavior of the fish to that of public and even certain institutional investors.

About an hour after we began to drive the fish back to shore we began to spot marlin. At first I couldn't see what our fishing guide was pointing to. Marlin like to come right to the surface and look down on their prey. presumably the underwater surface acts like a mirror when viewed from Brewster's angle and below. The mirror effect serves to camouflage and confuse the prey allowing the advantage of surprise to the marlin. When the marlin is at the surface its dorsal fin is visible out of the water just like the classic image of a shark. However the marlin fin is jet black and curved like a boomerang or a sickle blade. Once we learned the technique even the gringos became proficient at spotting marlin.

As we continued trolling in toward shore the marlin sightings became more numerous. They seemed to appear in groups of about 3 or 4 individuals. Just as a trader likes to get his position in before a big move in the market the strategy with marlin was to position the boat ahead of them, going in the same direction and slow down so as to let the marlin run onto the slow moving bait presented off our stern. Our guides would augment this with live bait manually cast right into the path of the hunting marlin. The big fish could be seen to go directly for the offered bait. As with so many fish stories the fish proved a bit smarter than we were. On several occasions the marlin stole the bait right off the hook. One time the marlin actually was hooked but managed to free himself. Generally after we were in a group of marlin for more than two minutes or if one got snagged they all would dive for deeper water causing us to lose track of them. Each time we moved on until we saw more fins.

Eventually after several exciting hours of catch and unintended release we were approaching shore and the end of our educational but unproductive expedition. We had nada (nothing) - or so we thought.

On the dock we met another group returning from a close to shore trip with a good catch for the day. They had yellowtail tuna and many Sierra. It turned out that they were staying in the same condo complex where we were and we got their number. That afternoon at the pool my friend said the previous occupants of his condo had left a full closet of liquor, far more than he could drink during his stay there. He offered me some. My trader instincts immediately took over. I proposed that we swap the other fishermen some of our surfeit of liquid refreshments in exchange for their overplus of fresh fish.

Our proposal was immediately accepted by our new fishing friends. That night we enjoyed the freshest hamachi (yellowtail) ever, served sushi style. It was complimented with gourmet cooked Sierra. My friend with the overflowing liquor cabinet has a day job as exec at a high gourmet food chain and restaurant operation in Silicon Valley. His skills served us well that night. The whole experience calls to mind the Chinese proverb. Even if one isn't a good fisherman, a good trader can always get fresh fish.

27-March-2006
Thoughts on Piece Relationships, by GM Nigel Davies

One of the more difficult aspects of chess is knowing which pieces to exchange and which to keep on the board. Surprisingly there are very few books which deal explicitly with this subject, one of the few being Znosko-Borovsky's 'How to Play the Chess Endings'.

Strong players are usually aware that certain combinations of pieces work better together (two bishops are normally superior to bishop and knight, rook and bishop are usually better than rook and knight, queen and knight are stronger than queen and bishop). But the problem doesn't stop there.

The real difficulty arises when there are exceptions to the rules, or when one has to assess a complex network of these relationships within a given position. I think that the ability to unravel this network is an important aspect of mastery.

It also seems that the same kind of model might exist in personal relationships or company mergers. Say, for example, you meet someone who on the surface has very similar interests to yourself, but dig deeper and you find the hidden clause of incompatibility. Or two companies might appear to be a perfect fit for a merger, but when push comes to shove you discover issues (software incompatibility or company culture for example) which make the whole thing very difficult. On the other hand a more successful match might be achieved in spite of no apparent compatibility.

This explains why Grandmasters are often reticent in assessing a position, they are trying to look below the surface. Getting to the heart of a position can be a difficult matter for the strongest players, but their weaker brethren will voice an opinion all too quickly.

26-March-2006
Steve Leslie on Ivan Lendl

I have been having a very lively discussion with the Grandmaster on styles that chess masters exhibit. He brought to my attention that the top players tend to be technical experts in the game. They have a complete command of position and analysis and use this to their advantage.

I began to think of an analogy in sports that may be descriptive and helpful especially to traders and turtles. In men's tennis, perhaps one person who completely personified the trait of specialization was Ivan Lendl. Lendl is not usually a name that flows off the tongue as one of the great tennis players of all time, those comments are usually reserved for others. The casual tennis fan will cite Borg, Connors, Sampras or McEnroe, but curiously Lendl is not mentioned in this group. This may be due to the fact that he was a very quiet and methodical man. He certainly did not have the Aryan looks of Becker or the celebrity verve of Agassi, and he hailed from a soviet bloc country. Yet, upon further reflection he certainly deserves mention as one of the truly great champions.

Ivan Lendl was in all likelihood the most relentless ground stroke tennis champion of all time. He relied on heavy topspin and consistency from the baseline to help him achieve his purpose. He rarely approached the net -- he did not need to. He wore out his opponents by playing to his strengths, grinding them down and thus forcing them into errors. He was criticized for not varying his style of play but was rigid in his adherence to his methods and of the coaching of Tony Roche. Perhaps this had to do with him growing up in Czechoslovakia through the 1960s.

He was also in marvelous physical condition. He won three times at the French Open, where matches can last up to five hours. Absolutely a formidable force during the 1980s. Take a look at some of his accomplishments.

He was ranked No. 1 in the world for 270 weeks, including 157 straight from September 9, 1985, through September 12, 1988, just three weeks short of Jimmy Connors' all-time record. Lendl is the holder of 94 career singles titles, including his 1980 feat of winning three tournaments in successive weeks on three different surfaces.

Lendl captured 8 career singles titles in Grand Slam events and reached an astounding 19 Slam singles finals. He reached 8 consecutive US Open finals (1982-89), winning three, 1985, '86, '87. Lendl also won twice at the Australian Open, 1989 and 1990, and three times at the French Open, 1984, 1986, and 1987. Arguably his most memorable victory occurred in the 1984 French Open Final. Down two sets to love, and trailing 4-2 in the fourth, Lendl won the title over John McEnroe in an epic battle.

In 1982 he won 15 of 23 singles tournaments entered, compiling a record of 107-9, which included a 44-match streak. In 1985 Lendl captured 11 singles crowns in 17 tournament appearances, and in 1989 Lendl won 10 titles out of 17. He finished 4 years (1985, '86, '87, '89) as the top ranked player in the world. He was named the Most Improved Player on the men's tour in 1981 and its Player of the Year in 1985, '86, and '87.

In Summary, Lendl understood who he was, what he was, implemented his game plan, and did not veer off course. We can all learn a lesson from this champion.

Jiri Lendl, the father of the tennis start, was a Czech Junior Chess Champion. Interesting how prowess in games often runs in families, despite the fact that totally different attributes would SEEM to be required. At least according to popular wisdom. I understand that Ivan himself is also not a bad player.

Dr.Alfonso Sammassimo "Il dentista" offers:

I couldn't help but comment on my favorite tennis player of all time, and the subject of many a late night heated debate with friends and fellow players.

The record speaks for itself, but those who watched him over his career might better appreciate that although his game appeared mechanical (the media tabbed him the IceMan), his strategy adapted beautifully to each opponent. I remember taking my seat with anticipation (at what was then 'Flinders Park') for the 1989 Australian Open final between Lendl vs Mecir. It had the ingredients of an exciting match between two in-form and very different opponents. But in just over an hour Lendl destroyed Mecir 6-4 6-2 6-0 in what most spectators claimed to be the most boring final ever. Lendl apologised to the crowd in his acceptance speech, explaining that he and Tony had decided the best approach against Mecir was to hit the majority of shots straight and deep, providing Mecir with very few of the angles he needed to deliver his own sublime magic. For me, it was a brilliant example of planning and execution to defeat a wily and talented opponent.

I molded my game on Ivan because I knew at junior level that while I wasn't as talented as the other players, I worked harder and was smarter. It got me as far as my talent and injury riddled body could take me. I trade now the same way I played tennis. Adapt your strategy for each new opponent, and execute coldly.

Steve Leslie's critique of Ivan Lendl and his mentioning of Lendl as one of the game's greats is one of the best assessments of a professional's professionalism that I have found on Daily Speculations. Debating Lendl's Game Persona in comparison to McEnroe, Connor, and later on Becker, reminds me of arguments over what speculative approaches are best suited to the markets. Lendl was a highly structured and systematic player -- his best surfaces were clay and hard courts, which are often best approached through consistent tactics. The more aggressive, high risk styles of the other three are often better rewarded on grass. Lendl never won on the grass of Wimbledon, but Connors, McEnroe, and Becker won 8 times cumulatively

27-March-2006
A Few Abnormal Things, by Kim Zussman

The mean and stdev were calculated for 14146 daily returns of SP500 since 1950 to check for normality. These values were used to generate random daily returns from a normal distribution with same mean and stdev. Comparing the worst 20 daily returns for the real series and the normally-distributed simulation:

```t-Test: Two-Sample Assuming Equal Variances

daily ret SP500        Sim
Mean    -0.0617       -0.0286
Variance 0.001293822 1.62355E-06
Observations 20 20
Pooled Variance 0.000647723
Hypothesized Mean Difference 0
df 38
t Stat -4.113703144
P(T<=t) one-tail 0.000100616
t Critical one-tail 1.685954461
P(T<=t) two-tail 0.000201232
t Critical two-tail 2.024394147```

i.e., significantly greater mean decline in 20 worst actual SP500 days as opposed to 20 worst in the normally distributed simulation. The same exercise was done for the 20 best returns of both series, and again the actual returns were significantly higher (t=8).

Taking the 10 best and 10 worst daily returns of the SP500 series, here is a list of how many standard deviations from the mean they were (negatives are declines):

```10.18 -22.90
6.41   -9.26
6.05   -7.68
5.97   -7.61
5.72   -7.57
5.70   -7.47
5.62   -7.41
5.61   -6.84
5.51   -6.52
5.33   -6.02```

The drops were more severe than the gains, and yes that 22 is in Oct 1987.

So what if daily returns are not normally distributed, especially if both top and bottom tails are heavy? Besides influencing choice of statistical tests, there is the question of ruin-especially for those high enough on the food chain to leverage their IQ's.

To check this, located the greatest rolling 20-day declines for each of the 14 non-overlapping 1000 day periods for the last 55 years in SP500. The table below lists the year at the end of each 1000 day period, and the % drop for the single greatest 20 day decline in each period:

```2006 -19.65
2002 -16.88
1998 -8.01
1994 -13.73
1990 -29.56
1986 -7.35
1982 -12.98
1978 -14.69
1974 -13.90
1970 -13.76
1966 -8.67
1962 -15.47
1958 -9.31
1954 -7.76
```

24-March-2006
Vic recently made mention of the the S&P Managed Futures Index, which has been "bouncing around like a yoyo...always amazing in its battle to overcome the layers of vig."

For interested readers, here is a snippet of data reflecting the past 25 days or so, with daily percentage changes updated to 3/21/2006.

```DATE     	TFI   	   PCT
2/14/2006 	1052.64    0.7
2/15/2006	1043.72   -0.9
2/16/2006	1046.59    0.3
2/17/2006	1041.38   -0.5
2/20/2006	1041.38    0.0
2/21/2006	1051.92    1.0
2/22/2006	1058.11    0.6
2/23/2006	1056.43   -0.2
2/24/2006	1063.80    0.7
2/27/2006	1069.01    0.5
2/28/2006	1060.21   -0.8
3/01/2006	1065.61    0.5
3/02/2006	1064.19   -0.1
3/03/2006	1062.96   -0.1
3/06/2006	1065.98    0.3
3/07/2006	1064.95   -0.1
3/08/2006	1051.64   -1.3
3/09/2006	1056.35    0.4
3/10/2006	1073.08    1.6
3/13/2006	1077.25    0.4
3/14/2006	1054.55   -2.1
3/15/2006	1063.03    0.8
3/16/2006	1048.37   -1.4
3/17/2006	1058.79    1.0
3/20/2006	1062.47    0.3
3/21/2006	1070.80    0.8
```

26-March-2006
The Importance of a Good Grip, a Question from Fred Crossman

The incomparable golf teacher, Harvey Penick, placed great importance on grip, but told his students, "The player to beware of is the one with the bad grip and the bad swing." Perhaps Vic has some anecdotal advice or a story about the squash or tennis grip? Or, can a trader succeed with a bad position at the right time?

23-March-2006
A Washington Post editorial today sparked a lively commentary and debate about income inequality in the United States. For more on the topic, follow this link to our Letters Department.

23-March-2006
The placement of trading stops continues to be a topic of immense interest and discussion among our viewers. To read what fellow speculators are thinking, click this link to our Letters page.

24-March-2006
The Importance of Little Things, by Victor Niederhoffer

It's the little questions that you ask about the market that help make you a better speculative investor. At least that's the spirit that animates the day to day activities in my shop as we bounce around and test about 100 such queries and hypotheses during the day. I find the best questions I come up with come out of the day and fray and I thought I'd share a few that came up in the office on March 22nd that my colleagues and I are trying to answer.

How does the first quarter affect the whole year? Yes, if you look at the daily vol's, it's consistent with a 10% a year move. But, but, but there are so many big changes in the market. Here are some of the big ones above 20%:

Big changes in the market
Percent change Percent change
Yearwhole yearfirst quarter
1950228
1954458
1956265
1958385
19612311
19672012
1974-30-3
19753125
198026-5
1985265
1988318
1989276
19912613
1995349
1996205
1997313
19982713
1999205
2002-230
200326-4

That's 4 in the 50's and 60's, 2 in the 70's, 4 in the 80's, 6 in the 90's, and 2 so far in the naughties. Are not these 40% of all years or so that have percentage changes above 20% completely inconsistent with say a daily standard deviation of 3/4% with a standard deviation of the deviation per day of 1/2%?

The market's up 3% so far in 2006. What's the best prediction for the year based thereon? What is the correlation between the market in the first quarter of the year and the last three quarters of the year? Is the correlation more significant than the spurious January Barometer that has been wrong so frequently in the past? Is there any reason to think that the correlation has changed. Are their too many runs in the back to back big yearly changes, like the run of 5 in the 1990's to be consistent with independence in the ensemble of daily percentage changes? Hint: the probability of 5 or more successes in a row in a binomial experiment with a success ratio of 1/3 and 50 tosses is .01.

We will have to leave the 100 other questions that arose as an exercise for the reader. Here's a brief list.

Given the announcement of a company being added to the S&P 500, what is its average performance from the close of the day before announcement and the opening the next day? Given that it opens up more than 8% the next day, does this change the relation? A certain holding in acertain stock inspired by the holdings of a former wife inspires this question.

As noted by Mr. Andrew Ravano below, every day brings another big merger announcements in Europe (Aviva-Prudential, Bayer Schering, BNP Paribas-Banca Nazionale et al.). Are such announcements responsible in part for the 6 year high in the DAX breaking thru the round number of 6,000 recently? Does the effect carry over to the U.S. markets as Trimtabs suggests, and is the relation due to a signaling or a liquidity effect?

What is the effect of relative weakness or strength of the NASDAQ on the subsequent performance of itself and the other averages as it's divergence from the other averages has increased substantially during recent days?

Have the inter-market relations between bonds and stocks and crude, stocks and the dollar changed dramatically lately and what does it portend?

What is the effect of an earnings warning on individual stocks during the Sarbanes Oxley era and is that old effect where the masses blindly sell the market when the one or two companies that have suffered misfortunes give a warning still an ideal time to buy?

The ten worst performing companies in the NASDAQ 100 headed into the close of the the first quarter are Amazon -24%, Sirius -23%, Expedia -22%, XM Satellite -22%, Intel -21%, Yahoo   -19%, Google -18%, Whole Foods -16%, Apple -16% and Patterson -15%. Will there be window dressing at the end of the quarter and does this provide an opportunity? (Why does the quote from Grandpa Martin Niederhoffer to Brooklyn College quote Lou Irons in his letter demanding that Artie Niederhoffer carry, kick or throw the ball on every play come into mind in conjunction with the answer to this question?)

Inquiring and naive minds at this and adjacent desks wish to know.

Martin Lindkvist notes:

With cash data on the S&P500 from Yahoo (1950 until 2005), I found that the correlation coefficient between Q1 and rest of year (Q2-Q4) was 0.14 (r2 was 0.02) with a t of 1.0 (unsignificant).

I did not check the correlation between January and total year (the Jan. barometer) but instead the correlation between Jan. and the rest of the year (Feb-Dec). I found this to be 0.32 (r2 was 0.10) with a t of 2.5(significant).

24-March-2006
Book Review: Martin Lindkvist reviews "Letters From a Self-Made Merchant To His Son", by George Lorimar

I remembered when Lack mentioned the title a while back that I should read "Letters from a Self-Made Merchant to His Son". Said and done, ordered it, and the sequel, "Old Gorgon Graham - more letters from a self made merchant to his son" through abebooks. This was in mid Jan, and they only arrived yesterday, but considering that they only cost me \$4 in total and were the original from 1903 and 1904, it's OK anyway.

And what a treat! First of all, they are very very funny. Second, they give a lot of pointers about business life and life in general worth reading. Of course, most of it is just common sense, nevertheless, its often in things concerning common sense that one slips up so I think that they have a practical value too. To me, they seem like a good addition or alternative to many "succeed in business"-- books. And why not give a set to your own son when he is just about to go to college?

Here are some tidbits:

"There is one excuse for every mistake, but only one. When a fellow makes the same mistake twice he's got to throw up both hands and own up to carelessness or cussedness. Of course, I knew that you would make a fool out of yourself pretty often when I sent you to college, and I haven't been disappointed. But I expected you to narrow down the number of combinations possible by making a different sort of fool of yourself every time."

"A dirty shirt may hide a pure heart but it seldom covers a clean skin. If you look as if you had slept in your clothes, most men will jump to the conclusion that you have, and you will never get to know them well enough to explain that your head is so full of noble thoughts that you haven't time to bother with the dandruff on your shoulders."

"I simply mention Lem in passing as an example of the fact that when you're through sizing up the other fellow, it's a good thing to step back from yourself and see how you look. Then add fifty per cent. to your estimate of your neighbor for virtues that you can't see, and deduct fifty per cent. from yourself for faults that you've missed in your inventory, and you'll have a pretty accurate result."

"A lot of young men start off in business with an idea that they must arm themselves with the same sort of weapons that their competitors carry. There's nothing in it. Fighting the devil with fire is all foolishness, because that't the one weapon with which he's more expert than any one else. I usually find that it's pretty good policy to oppose suspicion with candor, foxiness with openness, indifference with earnestness. When you deal squarely with a crooked man you scare him to death, because he thinks you're springing some new and extra-deep game on him."

"The boy who does does anything just because the other fellow do it is apt to scratch a poor man's back all his life. He's the chap that's buying wheat at ninety-seven cents the day before the market breaks."

Heartily recommended.

24-March-2006
A Quick Yen Q&A

A homebrewed yen-carry trade (involving no logistics save a futures trading account, perhaps at a discount broker) is to simply sell yen futures. Crude math, per the BBG clipping below: the dollarwise price of yen for future delivery rises about 1.15% per 3 months, i.e. 1 point (JYU6 minus JYM6) on an 86 base, roughly the 4.5%/year you mention.

If the dollar doesn't cheapen (i.e., the yen doesn't strengthen) from its spot level then you make the 4.5%. Bear in mind, a forward/future FX price is exactly the same as a yield-differential between the two currencies, by arbitrage.

There's a bushel-basket of academic research on whether yield-differentials are a good predictor of future FX shifts. Do they over- or under- predict? Perhaps Doc(s) can summarize better, but I believe the academics generally concur with Ken.

```J A P A N E S E   Y E N
Chicago Mercantile Exchange
Last     Change
1) JYY  spot   85.13     +.33
2) JYM6 Jun06  86.11     +.34
3) JYU6 Sep06  87.12     +.29```

24-March-2006
A Study of Full Moons and S&P 500, by Vince Fulco

Recently, we received numerous market comments suggesting anomalous behavior in the SPX during the full moon period of the lunar cycle. Both strongly positive and negative returns net of SPX performance were claimed. Putting some data under the magnifying glass, we looked at a subset of the SPX from 1980 thru early 2006 for the periods when a full moon occurred. Specifically, we constructed 1 and 3 day periods consisting of the SPX behavior on full moon day (close to close) and the 3 day window created by the trade day before the full moon, the trade day of and the trade day after.

The summary figures indicate nothing noteworthy in the SPX during the full moon’s occurrence. Z-scores for the 1 day and 3 day windows were 1.268 and .736 respectively. Mean returns (%) were .16 for 1 day windows and .17 for 3 day windows. Standard deviations were 1.02 and 1.73 for the same period. These are in line with all non-overlapping SPX periods.

```		      SPX- All Periods          SPX- Full Moon Period
One Day Window            One Day Window
Percent Change (%)        Percent Change (%)

Min.               -22.90%                   -3.10%
Median               0.00%                    0.10%
Mean                0.04%                    0.16%
Max.                8.70%                    5.60%
NA's                  0                        0
Non-NA's              6606                      222
S.D.                1.04%                    1.02%

SPX- All Periods          SPX- Full Moon Period
Three Day Window          Three Day Window
Percent Change (%)        Percent Change (%)

Min.               -12.60%                   -6.70%
Median               0.20%                    0.20%
Mean                0.11%                    0.17%
Max.                8.00%                    5.10%
NA's                  0                        0
Non-NA's              2202                      222
S.D.                1.76%                    1.73%

Z Score- One Day Window
1.268

Z Score- Three Day Window
0.736```

24-March-2006
Book Review: James Sogi on "Introduction to Statistics"

For specs wishing to get started in Statistics and R, a perfect book I wish I had when I first started learning is Introduction to Statistics Through Resampling Methods and R/S-Plus, by Phillip Good, a professor at UCLA.

The book is written at the high school or introductory college level and should be accessible for all. I plan to give it to my college age son to read for a starter. What is different about the book is it relies on computational methods, Monte Carlo particularly, rather than calculus for statistical tests and numbers but gives a basic understanding of the processes underlying statistics, probability and modeling. Good gives the R codes as he goes along for each concept and teaches R at the same time in very digestible portions. It's the perfect introduction for market analysts and now there is no excuse for any of you not familiar with counting methods. This is the ultimate starter and is highly recommended reading for all. Many of the questions Victor poses, such as Little Things, might appropriately be addressed with such techniques.

24-March-2006
Income Gaps, by Kurt Specht

As the saying goes, "everything is relative". My question is, should we be more concerned about the income/wealth gap between low, middle and upper classes, or the relative well-being and general improvement in wealth of the low and middle classes? I contend we should not be so focused on the gaps, unless those gaps grow to enormous extremes, and that the low and middle classes will not become unhinged or significantly dissatisfied if they perceive their standards of living are continuing to improve (albeit perhaps slowly).

For numbers to put on the table, I refer to two informative posts by Don Boudreaux in Cafe Hayek, "A 1975 Sears Catalog" and "Working for Sears Goods". .

Prof. Gordon Haave says:

I contend that it is not the "gap" at all that matters, but rather the mobility i.e. the ability for those who start out on the lower rungs to improve themselves. This is why, despite a more narrow income gap in France, there is much more class warfare... If you are born poor, and you don't get the best schooling and place at the top of the exams they have at the end of high school, you basically have no chance of ever being in the top rungs of society.

In the US, anyone who works hard has a shot at the top. My concern is that at the same time we are pulling the rug out from under the middle class, the government is getting ever larger and it is more and more difficult to be an entrepreneur.

Since Einstein's physics of relativity "it is all relative" has entered the popular vocabulary. But is it all relative? And for most people since the word "everything" includes the notion of truth, it suggests that truth itself is relative.

Here is a key point: philosophically, Einstein believed that there is existence and truth independent from the human mind. He called it the "objective reality." However, he also acknowledged that a human's perception of the world and reality depends on (is relative to) our emotional, intellectual and instrumental capabilities. His entire body of work is based on this very philosophy.

I believe there is existence and truth independent from the human mind and that truth includes the economy and the markets; each one of us are a very small part of it. I find those who're harmonized with this knowledge reap way the best of it.

23-March-2006
Forward and Back, by Victor Niederhoffer

One of the commonest themes in the market and life is the forward and back, jump and slide behavior needed to gain a goal. The average stock during the day reminds one of the proverbial frog caught at the bottom of a well jumping 2 feet forward every 30 seconds and then sliding back 1 1/2 feet. How long will it take the frog to get to the top of a 1,300 foot well? The problem is a bit more difficult if it's random after each jump whether it moves up or down, especially if there's an absorption barrier of some kind after it hits the bottom of the well, and also if the amount gained or lost on each jump varies as a function of how high or how much vertical movement up has been gained in the last several jumps. Yet, this problem is relatively close to what we see in the market as the S&P tried to surmount 1,300 and as the Dow tried to surmount 11,000.

First there were all the jumps right up to the top where the market frog just hit it intraday and then slipped back. Next there were all the articles in the media talking about how long it had been for the frog in previous tries to go past or stay at the top in previous times caught at the bottom. Then there were the slips where the futures went past the level but the index failed and now falls back below the top, back and forth as the index goes first above 1,300 after 5 years as of 7 days ago, stays above for 5 days, and then falls below, and then climbs back thru the top at 1305.04 as of the March 22 close.

Such behavior backing and filling, forward and back is like a Latin Dance or a tug of war or the thrust and pull of flight or the moves in individual stocks. Fortunately, we learn how to deal with such frog type games as kids with such games as Chutes & Ladders or checkers; especially Russian checkers, where the pieces appropriately can jump forward and back at will. I propose that a frog index be made of the movements of individual stocks. Consider starting with how long it takes the stock to advance each 15% on its way to a 2 bagger, before a 10% fall the other way. Or consider the hyper-geometric distribution of the number of jumps up that the random frog above would make before slipping back if such jumps were really random or best yet some extensions of a jump and slide problem of your own.

The hundred days and daughters problem...

An interesting aspect of the solution is that if you have 100 daughters to judge from as a spouse and you wait and pass on 37 of the daughters and then pick the dowry that is bigger than the previous high, you have a startlingly high probability of 37% of picking the one daughter with the highest dowry of all. For those not eligible to choose from 100 eligibles in the romance market, they might find choosing with similar judiciousness in the dowries provided by the daily closes that the sultaness of markets proffers.

A lamentable absence...

It has now been 5 weeks since the last Heard on the Street Column by Abelson appeared. At first they referred to him as being out and now for the last two weeks, they have referred to his status as "on leave." It seems cruel and unreasonable that after 40 years, the paper would send him out to pasture without a fond goodbye, so one must regretfully suspect that the late 70 something, chronically perpetually bearish author is sick. We send him our condolences and will refrain from making fun of him until we are apprised of his health or otherwise.

A Nockian Analysis...

Like night follows the day, a million articles are now appearing saying that the Bush ownership society has failed because "the benchmark for American equities is down 2.8% since Bush took office five years and two months ago. That's the worst performance during the same stage of any two term administration in the past half century except that of Richard Nixon." A current example is the recent Bloomberg article, "Stock Performance Undercuts Bush's Vision of Ownership Society" By Brendan Murray.

Talk about the use of propaganda with card stacking here to pick just the worst starting and ending dates, as stocks flirt with a 5 year and all time high. And yet the professors at Yale, Harvard, and MIT, are already in ecstasy about the problems of the economy and the card stacking of the stock market performance of other two term administrations during the past half century, and the failure of his privatization of Social Security plan. And yet, such a reading of the tea leaves amidst the great prosperity of the last 5 years should create a nice back and forth between the parties during the next 29 months leading up to the 2008 elections. Whenever the market gets too high, the out party will be trying their highest to keep it low, forming a bandwagon behind such forthcoming books as "The Great Risk Shift" by Jacob Hacker (their own man) and attributing the decline to the failed policies of Karl Rove (or the shooting accident of Dick Cheney) and whenever it gets too low, the incumbents can be expected to hold the line on keeping the economy strong by refusing to take away the main thing that has sparked our growth the last 5 years; the reduction in capital gains rates, the increase in international trade and immigration, and the increased pace of technological improvement and reduced cost of search fostered by the Internet. Such back and forth would have amused Albert Jay Nock, who noted in Memoirs of a Superfluous Man that the most important job in the United States is Secretary of the Interior (a position even more important today than when Nock wrote the memoris in 1943, since the job of managing one-third of the country's land includes the supervision of an operating brothel). And such observer from the grandstand might take comfort in the knowledge that the push and pull, back and forth of such ideas and political salvoes, the natural equilibrium between the two forces, the overriding desire within the grand scheme of each faction to never veer too greatly from their main activity of plucking the geese with the least amount of hissing, should be very good for keeping vols in the teens.

Steve Ellison says:

The Secretary of the Interior? The governor of my state was just nominated for this vital position. It's a small state in which personal contact still makes a difference, so I had about a 5-minute conversation with the governor during the 2002 campaign in which he said that what he was most proud of was actively working to make the state friendly to new business creation. Jobs would always be lost due to recessions or other changes, but a high rate of new business creation would more than offset the losses.

Anybody who has plugged an AC power adapter into the wall has transformed a back-and-forth motion in to a constant source of energy. Similar principles are used to capture tide and wave energy. What do all of these methods have in common? They use the fact that the motion has a fixed point with respect to which it predictably changes direction. Doesn't sound like the motion patterns of stocks. Yet there is hope: the self-winding watch provides an example of something that's moved up and down in a totally unpredictable fashion yet manages to do something useful and completely repetitive with that motion.

23-March-2006
The Myth of a Small Trader, from Rod Fitzsimmons Frey

Myths are wonderful because they are so universal. Here's a myth I've taken as my inspiration as I learn to trade and confront the Buffet Tigers and the Abelson Tigers. This myth tells me why this list is such a delight: it's filled with Anansis, who are optimistic, hopeful, and brave. It's my retelling, with some small details I originally heard altered to fit my own life.

A long time ago, before saying "a long time ago" put people to sleep, all stories belonged to Tiger. Tiger owned the stories, and the stories were named after Tiger. The stories were about the hunt; and death; and the futility and harm that would befall you if you tried to take a part in one of the stories. Anansi was the smallest of the jungle creatures. He was so small that he had to tiptoe from corner to corner on the tips of all eight feet. Anansi was very small, and Anansi knew how to be afraid. But Anansi was brave.

One night, Tiger was telling a Tiger story that was particularly fearsome. Monkey screamed in terror from the tree top, and even the normally rude Hyena just stared into the fire. As the story finished, everyone was quiet, and nobody heard Anansi tiptoe up to Tiger.

"Tiger", he said, "I want a favor from you".

The whole jungle fell instantly silent, for nobody spoke to Tiger unless they were begging for their lives.

"I want you to give me all the stories."

Silence gave way to a shocked chattering. No-one could believe Anansi could be so brazen. Everyone wondered what horrible fate awaited him.

A minute passed. Then Tiger said "Yes. I will give you the stories."

The confused, outraged, jubilant cacophony that erupted was interrupted by Tiger's roar. "BUT! You must do me two favors first. Two from the weak is fair trade for one from the strong."

"First, you must bring me a full hive of live honey bees and lay it at my feet. I would love my own private stash. And second, you must bring me Snake, since I would like to tickle his belly with my claws. He never comes near me."

And the jungle was filled with the sound of delighted hooting and sadistic laughter at Lion's joke. Of course Anansi would die a terrible death trying to retrieve the hive, since even one sting would kill him. And Snake wouldn't even bother to chew when Anansi came close to his lair.

But Anansi just tiptoed away and made his journey directly to the Queen Bee's hive. Under the hive, he began to weep. "Why are you crying?" asked the Queen Bee. "I've counted forty three tears, and you've only been here seventeen seconds." "Queen Bee," said Anansi, "I am to lose a bet with Tiger. For he said I could never count the bees that lived in a hive, and now I see all the activity, and I know he is right."

Queen Bee, who had no love for Tiger and his taste for honey, told Anansi, "There is one way. We will all fly out, then as we fly back in you can count. Then Tiger will lose his bet." So all the bees flew out, and flew back in, and Anansi counted in a loud joyous voice. And when the last bee flew in, he corked the hive and took it to Tiger.

"Here it is," said Anansi. "Is that good enough, or do you still want Snake?" Tiger almost decided to eat Anansi right there -- for virtue and honor never featured in Tiger's stories -- but all the eyes of the animals were staring in shock at the hive, Anansi, and Tiger. "Of course I want Snake!"

So Anansi went to the river to find Snake. "Anansi!" said Snake, who smelled him long before Anansi could see him. "Why are you here? With a sword? A sword?? Put it down before I eat you so I do not scratch my mouth".

"Ah, I should have known I could not tiptoe quietly enough," said Anansi. "But being eaten is better than losing my bet with Tiger!"

"What bet?" asked Snake. "I said you were the longest creature in the jungle, but he said you weren't even as long as a bamboo tree," replied Anansi. "I was going to try to measure, but now you will eat me."

"OF COURSE I am longer than a bamboo tree! Cut one down and we'll compare. Then I'll eat you." And Anansi cut down a long, straight Bamboo and laid it beside Snake. Snake stretched, and stretched, but he couldn't make himself longer than the tree. "You're so close!" cried Anansi. "Here, I'll tie one end and you will be able to reach!" And Snake stretched further and further, until he just passed the length of the tree. And Anansi tied his mouth shut, tight to the other end.

When Anansi delivered the gagged Snake to Tiger, the forest shook with excitement and life. Tiger gave Anansi the stories, and slunk off on tiptoe, for with the stories Anansi was the powerful one. And the first story he told was about the croaking meow of the Tiger.

23-March-2006
Europe's M&A Craze, by Andrea Ravano

Merger and acquisitions are pumping prices in Euroland at levels unseen since the 2001/02 bear market. There is hardly a day when a deal is not announced, rumored or closed. In the past couple of weeks we have seen Aviva bidding Prudential, Enel of Italy trying to buy Suez of France (fat chance!), Merck AG bidding for Schering AG, Bayer outbidding Merck AG on Schering; then as of today Alcatel and Lucent have confirmed their merger talks, sending Alcatel up 3.5% on yesterday's close.

Other rumors are playing games of hide-and-seek with speculators and investors alike. I will not speculate on gossip just to avoid other specs running into unwanted trouble, but I assure you there are more steaks on the grill to be cooked. I might be a little naive, but I cannot understand why nobody, or very few, if any, merged or bid when the market was at a 10-year low back in the 2001/02 period.

One reason is, of course, that balance sheets look a bit better now than then. Take the case of Vivendi, which had so much debt that analysts talked about Chapter 11. In 2002, the stock reached an all-time low of approximately 8 euros. But, following hard restructuring and a fire sale of unnecessary assets, the company is now as clean as it could be; two corporate raiders have bought significant stakes in the company and their price target (whatever a price target is) is now 32 euro.

My feeling is that there are more than numbers to the problem. I think that the financial arena is more subject to the mood of investor's than we would like. How come the corporate raiders didn't enter the market before the company was restructured when the shares of Vivendi were trading around 10 euros? I must confess I have very little familiarity with extracting data, but one doesn't need to be a statistician to observe that major M&A activity has grown to record levels just as the market in Europe was reaching record levels, only 30% off the historical "Bubble" high of 2001.

23-March-2006
Trading Systems vs. Execution, by James Sogi

I had an interesting discussion in Berkeley with an erudite spec about trading systems versus execution. Say you have a system with significant distribution and 60% win ratio. Can you improve it through execution? System traders says no, you must trade the system or in fact you are introducing a new system via the execution that has not been properly analyzed. In every trade there is the systematic probability and a random component. I say that good execution can improve the system.

Assume that the statistics show that discretionary execution increases the success rate over the win ratio expected from the system. Within a probability of success within the system time frame, there will exist a random component in which negotiation skills can improve the results due the random component. Assume execution is discretionary.

My other argument in favor of discretion is that the original entry on the system changes as soon as the next tick, and the probability has either increased or decreased, and changes at each tick. How can the system trader resolve the historical evolution in real time except by either discretionary execution or by constantly updating the analysis in real time, which reduces to discretion ultimately by forcing system choice on the fly. A purely system trader becomes a follower of fixed systems with the inherent danger. What think other specs?

Tom Larsen says:

Gee, if I had known specs were talking about this subject across the bay from me in Berkeley, I would have run right over--maybe next time. You hypothesize discretionary execution that "improves the success rate within the system time frame", and I'm wondering if the statistics you mention show that the discretionary execution improves ALL systems or just yours. Not to be flip, but if his discretion can improve all systems, why is this broker still a broker? And, if the discretionary execution only improves your system's results, isn't that a curious result that needs to be investigated further? What is it about the execution that is helping your system?

Another issue regarding discretion is--how much discretion? Are you saying unlimited discretion? When I was an institutional broker, traders would give me all kinds of discretion, but sometimes I had to "know my customer" to know what I should do. If someone gave me a limit with 25c discretion, it might mean "try not to use it" or it might mean I better use it because this guy doesn't like to wait i.e., is time a factor? Also, obviously size is a factor.

James Sogi responds:

Excellent points. First, the bottom line profit or return rate is the ultimate test, not the winning ratio. Another excellent point was that the joint probabilities of two winning systems, an execution and systematic trade system, both with positive expectation on a binomial basis will beat both standing alone. This is the best answer to the question. The challenge to quantify the discretionary system is a difficult but pertinent criticism. Execution should be systematized for various conditions as well as the larger trade parameters. The probability distribution is merely an expectation distribution or past historical description. As the trade unfolds, one can't separate what might have been from what actually happens except by equity curve in real life except though the decisions on the firing line. Thank you for the erudite, enlightening and challenging responses from the system traders.

23-March-2006
Intermarket Relationships, by Steve Ellison

I couldn't help noticing that, as the 10-year bond plunged after 9:00 Chicago time today, the euro, yen, and pound declined with it. Here is an update of my earlier study of the correlation of daily changes in the bond and euro, using data since October 19, 2005.

```SUMMARY OUTPUT

Regression Statistics
Multiple R            0.156
R Square              0.024
Standard Error        0.005
Observations            105

ANOVA
df          SS           MS         F    Significance F
Regression                1      7.05E-05  7.05E-05    2.58          0.11
Residual                103        0.0028  2.74E-05
Total                   104        0.0029

Coefficients Standard Error t Stat P-value
Intercept          7.22E-05       0.00051     0.14    0.89
10-Year Note           0.32          0.20     1.60    0.11

```

23-March-2006
Movies: A Review of "Being There," from Steve Leslie

Upon recent reflection I was reminded of a very unique movie with screenplay by Jerzy Kozinski and based upon his novel.

"Being There" 1979 is a very difficult movie to characterize. Is it a political movie and thus an indictment against our political system. Is it a comedy that magically meanders from light to dark . Or is it just a movie with the intent to entertain. In the end the viewer is left with many many thoughts to pause and consider.

"Being There" was Peter Sellers' triumphant final film. It is a stately, beautifully acted satire with a premise that's funny but fragile. Chance, the hero of Jerzy Kosinski's novel and now his screenplay, is a slow-witted imbecile with a quiet childlike voice who has spent all his adult life in seclusion, working as a gardener and watching television as his sole source of entertainment.

Chance, who is played with brilliant understatement by Peter Sellers, is immediately mistaken for Chauncey Gardiner, an aristocratic businessman (because he wears his former benefactor's elegant hand-me-down suits) and witty raconteur (because he laughs at other people's jokes). He is admired for his fluent knowledge of Russian; this comes from nodding knowingly at a Soviet diplomat at a party. Chance also advices the President, and appears on something like "The Tonight Show." He is depicted as an economist noting the changing of the seasons means that all is well in the garden, and everyone mistakes this as a metaphor for the economy.

In the final scene we notice Mr. Gardiner walking away from the camera an onto the surface of a pond. He continues without sinking once again puzzling the audience as to who is the real Chauncey Gardiner.

The other fine actors in "Being There" -- Melvyn Douglas as a poignantly ailing rich man, Shirley MacLaine as his s#xy, sprightly wife, Jack Warden as a suspicious President and Richard Dysart as the sick man's quietly watchful doctor -- conspire to accept Chance as a plausible figure, and thereby keep the story in motion. There is superb ensemble playing in "Being There," particularly in scenes that bring Mr. Sellers and Mr. Douglas together. The timing is often so perfect that the film, at its very wittiest, strips conversation down to its barest maneuvers and stratagems.

It is well worth the visit to the local Blockbuster to seek this timeless classic or to Netflix.

22-March-2006
George Zachar on No Good News...

All popular discourse on society and economics follows the maxim NO GOOD NEWS.

If stocks are rising, that means the rich are getting richer relative to the poor, so that's bad.

If stocks are falling, it means the economy is at risk, and that's bad.

If interest rates are rising, it will slow the economy, and that's bad.

If interest rates are falling, it means investors anticipate a slowing economy, and that's bad.

If a city's population is growing, it means more stress on the environment, higher housing costs, and a greater strain on public services, which means higher taxes.

If a city's population is falling, it means those left behind must fund the city's infrastructure, which means higher taxes.

If a free market economy is growing, by definition the most productive citizens' wealth grows faster than that of others. Naturally, inequality is always touted as a "grave and worsening social problem" at this point in the cycle.

If the economy is shrinking, of course, the argument is that redistributive policies are "needed more than ever" to help those "at the bottom" during "this crisis".

One can make the case that passing vogues in political discourse are a coincident/lagging economic indicator.

22-March-2006
The Creativity of The Market, by Victor Niederhoffer

Inspired by such thoughts as "a good soup is more creative than a bad article" and "creativeness often consists of merely turning up what is already there", did you know that right and left shoes were thought up only a century ago? This line of thought leads to an inspiring article on creativity from the VirtualSalt website.

I have been looking at recent market movements for the sheer joy of wonderment, and the stern, hard task of earning a profit.

1. "How did they know?" The DAX and every other market yesterday out of the clear blue sky fell to the hot place near the end of the day, and then miraculously bad Microsoft news came out after the close and the market fell a fast 1% at the open, with Nasdaq down even more, only to come back like Odysseus after visiting the dark recesses. What an appropriate punishment for those who knew in advance.
2. Lobogola. The moves in soybeans up from 5.70 in November to 6.40 today are a perfect example of the Lobogolan tendency (see The Education of a Speculator) for elephants to migrate back on the same path that they traveled. It happens much too often for chance. Why and how to profit from same?
3. The investable managed futures index. It's been bouncing around like a yoyo recently, always amazing in its battle to overcome the layers of vig. Here are some dates of terrible recent declines and marvelous rises.
``` Date        Terrible Decline	 Wonderful Rise
3-16-06	    -1%
3-14-06	    -2%
3-10-06				       1%
3-08-06	    -1%
2-10-06	    -1%
2-21-06				       1%
12-30-05	    -3%
12-14-05	    -3%
12-09-05				       1%
12-08-05	    -1%
12-01-05				       2%
11-30-05	    -2%```
What are the moves in markets that cause these big declines and rises and what do they tell us about what the big managed futures people are trading? And does this have any more than curiosity value? Same for commitments of trader's reports.
4. A break through the round. The S&P Index yesterday closed at 1297 after being below 1300 for 5 years and above 1300 for 4 days. What do such breaks on the downside mean? And is the symmetrical move on the upside of equal predictive significance? And, does it vary by market?
5. Contrary motion. Intel was awfully strong yesterday in the morning rising 3% to \$20.30 while the Nasdaq at the time was down 1%, only to fall back to the earth below at the close. Does such relative strength within the early hours predict anything during the current day or the next one? And does it depend upon the denouement?
6. Mythology. As I come up with these heroic market moves, I am struck that I seem to have a Norse or Greek myth in mind for each of them. What are the lessons that mythology teaches us for market moves? Do mythologists make as good a market persona as mathematicians or musicians?

I nominate a famous mythological character for insight into lessons for traders.

1. - Pride/overconfidence
2. - Inexperience
3. - Attitude (fearful or fatalistic)
5. - Inappropriate timeframes/markets
6. - Distractions (health, family issues)

It seems to me that the most common theme in investing is the search for the holy grail. The idea that there is an object (or investing methodology) that will solve all problems. One of my toughest jobs as a consultant is convining people that the holy grail of investing doesn't exist.

21-March-2006
A New Review by Dennis Vako of A History of Interest Rates, by Homer and Sylla, can be found at Daily Speculations Reviews: Books and Theatre

21-March-2006
Quality versus Growth, by Victor Niederhoffer

The market mistress is a femme fatale who is endlessly creative in luring investors to part with their chips, dignity and financial life. One of her latest dodges is always to show herself in the company of very ugly competitors so that she looks good in comparison. Take the case of all the investors in stocks who have made 5% a year over the past 5 years, an abysmal return by most standards including those relating to random selection of the average mid-cap stock which has gone up some 50% in the last 5 years. In comparison, the S&P 400 Midcap index has gone from 517 to 738 during this period.

According to a recent article by Bloomberg columnist Chet Currier, "More Fund Managers Use Bond Logic to Pick Stocks", one fund group wearing this style is the Davis Select Advisers, who "overseeing" some \$60B these days, sported a 5% a year return annually over the last 5 years versus a 2.4% a year benchmark they are compared to. So enamoring was their performance that they were recently awarded the \$3.6 billion Clipper Fund. They describe their style as quality investing in blue chips not selling at premium P/E's "in a time of few obvious bargains." According to a Bloomberg story they said, "Our purchases in 2005, including WalMart stores and Microsoft, reflect our desire to trade up in quality." Might I ask on a prospective basis when they might note a time when there are obvious bargains around so that I could wear that look also and trade up also.

To add a bandwagon effect to this style, the sage of Nebraska is quoted. "Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication".

And yet, investors are paid for accepting risk, according to the books I have read, the courses I have taken, the articles I have absorbed, and the tests that I have run. A standard formula is that their extra returns for this acceptance of risk are equal to beta x the stocks risk premium on a market portfolio. Such a relation is derived in all corporate finance texts including one of my favorites Corporate Finance Theory  by Aswath Damodaran. A typical empirical documentation of the relation is the annual return of 17.6% for small stocks over a 66 year period versus 12.4% for all stocks. Damodoran summarizes such studies, "There is clear evidence here of a positive relationship between the variance in returns and the average returns on investment classes".

What's particularly mischievous about the current styles that show that investors to their advantage wearing quality and low variance stocks is that they set investors up to use such fashions at just the time when the climate is most likely to favor the opposite style. You see, empirical studies also show that after a period of 5 years when the overall market is flat or down, that's exactly when the returns in the future from buying the high variance, low quality stocks are best. Such could easily be documented by calculations based on the data that appear in the Triumphal Trio's book Triumph of the Optimists and doubtless one of my operatives or a reader will perform a hand study, to provide a foundation for those who don't wish to always be behind the form.

I can not leave this subject without alluding to a related fashion, this time not from the Midwest, but from the mountainous areas. The idea here is that because investors lost so much money by being long and absorbing risk in 2000-2002 that the thing they should prudently wear in the future is chronic bear apparel or fund of funds apparel to diversify away their risk.

The great English detective Horace Rumpole liked to end his cases and apprehensions of the criminal with the lament "Why does it always have to be romance?" I feel a similar craving "Why in the words of Robert Bacon does the public always lose so much more money than they have a right to lose?"

S&P Equal-weighted Index (not including dividends; quarterly rebalancing):

Feb 28, 2001: 1225.74
Mar 20, 2006: 1761.04

Total return: 43.7%
Annualized: 7.5%

In an old IBM motivational book called "On Leadership", midst a collection of great photographs and quotes, there was a shot of Vince Lombardi standing in front of a chalk board covered with X's and O's. From the look on his face -- and just all those teeth -- you knew he was making a point that some bunch of lugheads better be paying attention to. And below it was a quote from the man himself:

You must know.
You must know that you know.
And you must make it abundantly clear to others that you know.

21-March-2006
In Too Deep, by Craig Maccagno

I had a long and reminiscent conversation today with a good friend that used to accompany this novice motorcycle racer to the track on almost every occasion. It spurred some old and valuable lessons to mind and I thought perhaps there might be one worth sharing. I will begin with a bit of background for those unfamiliar.

When racing, the art of braking is one of the most important aspects to improving your lap times, on most tracks you must average roughly one mph faster around the track to lower your lap time by one second. The most opportune place to do that is through the turns, so you attempt to adjust the bike speed to get around the turns one mph faster, then keep that advantage on the straights. You will be unable to go down the straights faster if you cannot get out of the turns faster. Many are taught that one of the best methods for learning brake control is to think of it more as a reverse throttle, instead of twisting it you pull or press it to begin deceleration, but where and how you let off the brakes is actually more important since that sets your cornering speed. I believe Keith Code said it best -- "the product of braking is to set the speed of the bike correctly for that place on the track so that no further changes are necessary and your attention will be free to focus on riding the turn", go in too fast and you will need to do more braking when you should be turning, too slow and you will have to increase your speed while turning, both very inefficient when every second counts.

So when you are racing you establish reference points for where you should start braking and where you should be finished braking. These reference points are called brake markers and are typically small paint lines on the edge of the track, or any fixed item that is readily visible. It could be something as simple as an asphalt patch, etc. Okay enough background on braking.

For this rider, the lesson came in turn one at Willow Springs Raceway. This was several years ago and at the time the bike was a 600 Honda Hurricane. Turn one was a hard left that came at the end of a half mile straight in which you were at top speed (if memory serves, for that bike it was roughly 135-140 mph). There were three paint lines evenly spaced near the end of the straight to serve as brake markers, this rider had a penchant to begin braking at marker two and release at an asphalt seam that was nicely visible. I had been running fairly consistent (though not terribly great) lap times and then on the 'lesson lap' a momentary loss of focus at 140 and I had missed my number two brake marker and realized it while passing the last brake marker. I was in too deep, with no time to think, heart in throat with fear, and adrenaline pumping, there was nothing to do but brake hard and fast and push the bike over with everything I had, to attempt to still make the turn without sliding the bike and myself into the infield. The end result was being forced to brake later than comfortable, as well as release early and lean the bike beyond everything I was used to. This was a major screw up and now I was going to pay, this was going to hurt. Much to my amazement the bike took everything in stride (what a trusty steed indeed!) and we came out of that turn faster than ever before, carried that speed into turn two and pushed that one beyond the norm as well.

Needless to say that was the best day ever at the track, the rest of the day was spent whittling down lap times now that my limitation barriers had been crushed and learning that times when we believe we may be pushing ourselves to our limits, that may not be the case at all. This was indeed a valuable lesson, one that was remembered many years later and helped this lowly trader navigate a miserable trade in which he once again found himself in too deep, huge loss, bigger position than ever and facing disaster. There was nothing to be done but get a little bit bigger and start moving some contracts in and out to save my hide, the day in question and the next few to follow were spent moving smaller positions in and out while leaving a larger than wanted position on, fighting not to blow up the whole damn account, and miraculously enough, as I scaled in and out, the market came back to my starting point. Where I promptly puked up the entire position and it continued on it's merry way to what would have been a wonderful profit for this trader, but in all honesty I wasn't terribly upset since the value of that lesson was immediate.

In terms of trading, I can not stop asking myself what is so magical about the point were I would have taken the position that, often when a position goes against me and then returns to its start point, it then continues to move upwards in the hoped direction, (although this might be since I invariably take my positions at the wrong point). Instead I wonder if the same line of thought would not be valid for any chosen point of reference. In that case perhaps the precondition that would allow the price to also continue its path beyond that specific point of reference, after having come from the other direction, would be if the point of reference was followed by many participants. This might include recent highs or lows.

21-March-2006
A Stop Loss is a Sure Loss, from Sushil Kedia

I learnt this from one of the shrewdest and clearly one of the most successful traders to have ever happened in Mumbai whenever I ask him how he chooses his stops. Now, that's one snazzy phrase that also describes the ethos reflected often times on the list and is emphasized in various ways by the Chair too.

One wonders, if risk has to be controlled at all points of time, and if Losses are not going to be accepted while they are tolerable enough, and if there is no guarantee for each trade to result into profits, how would it all add up together?

What are the appropriate things to study and what are the specific skills and counting frameworks to be acquired such that it may lead to a style of trading that does not incorporate any stop losses (of any kind), yet is able to control risk in pre-defined ways?

Is a time-stop also a type of stop loss? In other words, if I predict that my purchase now will yield a profit by tomorrow's close, the fact that I am specifying an exit in one day would stop further losses (or gains).

Martin Lindkvist replies:

Sure it is. Stop losses with regards to adverse excursion (as Sweeney would call it when prices go the wrong way - I would just call it my usual type of entry) have an inbuilt assumption: that prices going in that specific direction means that the odds favour a continuation of that adverse excursion. In short, a positive serial correlation. If there is a negative serial correlation it would mean that we in fact have a bigger expectancy if we instead stay with the position (all this lays aside any overleverage which might force us to abandon the trade). That is, the reason for the trade strengthens during this adverse excursion.

The time stop, while not assuming that there is either positive or negative serial correlation, neither makes any other assumption of either strengthening or weakening reasons for the trade as the trade goes on after initiation. In a sense, the best stop is to continuously monitor the trade and the expectancy as different factors affect it: other markets, how the price has moved, etc, etc.

In that we all choose a time to exit the market, we all have stop losses (or perhaps position stops as the rest of you also might have profits when you exit), it just does not have to be solely about price or time.

21-March-2006
Kevin Eilan comments on Ben Bernanke's Speech Before the Economic Club of New York, March 20, 2006

...With the benefit of hindsight, we now recognize that an important change occurred in the U.S. economy (and, indeed, in other major industrial economies as well) sometime in the mid-1980s. Since that time, the volatilities of both real GDP growth and inflation have declined significantly, a phenomenon that economists have dubbed the "Great Moderation." I have argued elsewhere that improved monetary policies, which stabilized inflation and better anchored inflation expectations, are an important reason for this positive development; no doubt, structural changes in the economy such as deregulation, improved inventory control methods, and better risk-sharing in financial markets also contributed...

The Chairman provides in his speech a number of theories for the lowered term premium and decline in macroeconomic volatility. Unfortunately, not one hypothesis relating to the significant and historical slashing of capital gains and income taxes post 1982, and the possible ensuing effect on long term real growth and investment (which would ultimately help to lower inflationary expectations). Not a word.

His first hypothesis? Better "management" by the fed. With all due respect: what a joke.

I suggest that anyone remotely interested in interest rates/the curve pour themselves a cup of strong coffee, and plough through the text of Fed chair Bernanke's speech. Its an accessible overview of current conventional wisdom on the yield curve and bond price fundamentals.

Things that struck me::

Conspicuous by its absence, Bernanke did not mention, let alone tout, his desire to set a formal target for inflation. He made it a point, high up in his speech, to remind the Street "price stability is a symmetric objective: It is important to avoid inflation that is too low as well as inflation that is too high." (He no doubt already has received quite a collection of toy helicopters.)

In keeping with his past practice, Bernanke reads a lot into derivatives prices:

...the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook..

20-March-2006
Vinh Tu Wins DailySpec Award for Best Post on Origin of Species

On Feb. 15, the Chair sought contributions from Daily Speculations readers on how Darwin's insights in The Origin of Species might be applied in classifying, quantifying, predicting and asking good questions. To augment the discussion, an anonymous donor agreed to disseminate \$1,000 to the contributor who reduced our ignorance in this field the most. As with Darwin's tangled bank, there were many very fit entrants who vied for supremacy, to the benefit of all of us. The President of the Old Speculator's Association spoke from the exalted heights of his Tennessean Olympus. Steven Ellison wowed us. Prof. Gorden Haave and Steven Leslie spoke with gravitas. As for the surfing speculator, Jim Sogi, who has probably gathered in more Daily Spec prizes than anyone to go with his other trophies -- we can only say that his case has given "You can't win 'em all" new meaning. In this crowded field, we have chosen to award the \$1,000 to Vinh Tu for combining insights from Darwin and Dawkins to propose an ecology of market memes.

The discussion certainly has not ended and may bring further rewards both in insights and financial benefits both from this site and in life.

20-March-2006
Socks, Stocks and Bundles of Trouble, by Victor Niederhoffer

A most poignant and instructive probability problem is to find the number of odd socks that are created when you start losing single socks from a pair. It turns out that despite normal intuitions, as you lose socks, you seem to create odd unmatched pairs to an inordinate extent. This is an example of a Murphy's law phenomenon that leads us all with drawers full of unmatched socks, baskets of unmatched stocks, non matching shirts and ties, old friends who no longer fit the bill for today and related phenomena..

A typical formulation of the problem is this. Suppose you start with 10 pairs of matching socks of different colors - and then you lose 6 individual socks. What are the chances of ending up with just 4 matching pairs versus seven matching pairs? The answer is that you are 100 times as likely to end up with the worst case scenario of 4 matching pairs as the best case scenario of seven matching pairs. In a discussion of this problem Henk Tijms concludes in Understanding Probability that "When things go wrong they really go wrong." An excellent discussion of this problem with a general solution is contained in Odd Socks: A Combinatoric Example of Murphy's Law

The gist is that if you have 20 socks, 10 different pairs, after you lose the first sock, the chances that the second sock lost will break up yet another pair is 18/19 versus only 1 in 19 that the second sock will kindly be from the original pair first broken up. Now after the second sock was drawn there are 18 socks left. Sixteen of them will unkindly lead to a third pair broken up versus only 2 leading to a match with one of the original pairs. After the third sock is drawn, there are 17 socks left. Fourteen of them will unkindly lead to a fourth set broken up versus 3 that lead to a match, etc..

If you lose 6 socks the exact probability of having them each break up a pair is (10 C6/ 20 C6) all times 2 to the sixth, which come to 0.37. This is the same probability as picking six socks from the 20 without once coming up with a pair. A discussion of this and an exact formula for the probability of picking 0, 1, 2, ... 3 pairs leaving you with 4 pairs, 5 pairs, 6 pairs, 7 pairs is contained in the highly poignant odd socks paper referenced above.

Now, is not this the same phenomenon we witness so often in our market activities. We start with a basket of stocks that each have a reason for being in our portfolio and fit in nicely with our requirements. Then an event occurs and leaves us without a good reason for holding the stock. We lose a match. Now another event or reason for holding a stock goes astray. Again we are left with the likelihood that the stocks and reason don't match. Ultimately the only thing we are left with is a drawer full of stocks that have no rhyme or reason in our portfolio and that are just remaining there because of inertia.

Is not the same thing true with respect to many other phenomena like the friends we are left with, or the names in our rolodex? So often the reasons for their being there in the first place are gone with the wind, and when we look at what's remaining we have a motley collection of old codgers, bags, and misfits, that have no possible value for the current.

What other phenomena come to mind in markets and life that leave us all out of kilter because of a probability chain regrettably related to the odd sock problem?

I have one for you. Jack Welch had a policy of throwing away his "mismatched socks" every year. It was 10% of the GE workforce. It was the policy of the company to eliminate the bottom 10% of the achievers in the company who just did not fit. Those who were not producing at the level expected. They were replaced by others in a never ending search to find the ones who were a proper fit for the company, who brought a new energy and a fresh agenda.

This was discussed in detail in Good to Great by Jim Collins. Collins said that the first thing that companies that went from good to great did was get the right people on the bus.

Over the weekend, I rented and viewed the DVD release of The Smartest Guys in the Room -- previously I have read the book underlying that 'documentary', and the '24 Days' chronicles of the fall of Enron. The original sources of the power trader tapes are also on line, and they make for chilling listening. Edgar retains the Raptor and LJM filings for those interested in doing more detailed research.

The DVD has a video segment from an internal Enron corporate communication piece video of Kenneth Lay extolling the virtues resulting from the Enron peer review system, the 'benefit' of chopping off the bottom 15% each year (throwing out the odd socks), and the asserted benefits of hiring for change-agents with 'ideas' regardless of the merit or maturity of the analysis brought in..

[Skilling: vice McKinsey comes to mind as Exhibit A; this practice permanently wedged open a vein into the heart of Enron through which a steady stream of amoral gamer MBAs flooded in, and which dulled any potential residual sensitivity in the Executive Suite or at the Board level, and to like 'gamesmanship' with V and E, and AA].

The video then cuts to a floor trader who points out that he clearly understood that he had been incentivized to 'step off the throat' of his co-workers, to profit maximize and to retain his perks as well as his employment. The gleeful gaming and 'rape' of California's ISO in the power trading induced rolling blackouts resulted in part from that 'win at any cost/take no prisoners' approach. We know how Enron turns out of course.

It is my opinion that it is fair to state that GE under Welch demonstrated an extraordinary 'ability' to present smooth earnings and growth. But, query: is managing for 'no unmatched' socks the cause, an effect, or simply a spuriously 'found' correlation? Perhaps GE provided an accurate presentation of its financial data, maybe cleaning out the drawer worked, or maybe, it just is an example of a well-played match of good old Wall Street oriented book-cooking 'gamesmanship' in the tenor of the times..

Gary Rogan notes:

The unmatched socks problem has an interesting parallel in the ability of DNA in the living organisms to resist damage. The DNA consists of two strands that are a mirror image of each other, with each "letter" of the genetic code only allowed to be "mirrored" by another specific letter. Roughly 100,000 times a day a human cell is attacked by "free radicals" and damaged. There are special repair anti-oxidant proteins that will detect un-matched genetic letters and repair the damage. It's only because the probability of both sides of the "mirror" being damaged at the same time in a fashion that "makes sense" to the repair mechanism is astronomically small that we survive for any length of time at all, as the number of pairs is on the order of 10 million and each attack usually damages one letter (imagine 10 million pairs of socks and the chances of a matched pair being lost vs. a couple of unrelated socks). When both letters are damaged in a consistent fashion, cancer or a genetic mutation (if s#x cells are involved) may result.

This problem is also related to how useful mutations are developed and passed on the next generation. Due to the vanishingly low probabilities of both the mother and father having exactly the same mutation, it is suspected that viruses affecting large populations play a role in introducing this mutation to both. In some ways, the "socks problem" is the flip side of the parallel system reliability discussed in this forum last week.

Prof. Gordon Haave mentions:

The solution to the mismatched socks problem is to only buy the same kind of socks. (I buy black Gold Toe socks. All other brands of sock are inferior!)

The question is, do fund managers approach the problem in the same manner? That is, do they just stick with stocks of a certain character trait? There seems to be an increasing trend in that direction i.e. the magic formula from The little book that beats the market.

I am very familiar with one well-known value manager. They started with a screen from which their portfolio managers pick stocks from. Over time, they started refining that screen with an eye for using it as a low-input formula they can invest directly off of. Since they went live putting people in the screen, it has outperformed their portfolio managers by about 5% per year. The question remains however, over time, will only having one sock in the drawer be catastrophic, in the rare event that another color of sock is needed that is.

As I prepare to relocate to Reno, Nevada, I find that I have a house full of unmatched socks, so to speak. Winnie the Pooh toys for children who are now teenagers, books I read once and have no interest in ever reading again, and artif

acts of hobbies I took up but lost interest in. Once in a great while, a match turns up. My son took up hockey, and I still had my ancient gear from high school in the closet.

I have found trying to maintain a portfolio of stocks with Value Line timeliness rank 1 a similar challenge. Since only 1/17 of the stocks ranked have a timeliness ranking of 1 at any given time, a stock that loses this designation is not likely to get it back soon (actually the rankings have enough autocorrelation that the chance of a quick return is probably more like 1/4). Thus if I try to reduce commission expenses by ignoring some rank changes, after a few months I may find myself with a portfolio of unmatched stocks..

Grandmaster Nigel considers:

It seems to me that the sock problem is a strong argument against diversification, the motley crew of leftovers being a natural result of making the original picks on superficial grounds. Could diversification be another meme, a way of having the public confused by many offerings when a simple index tracker would see them make much better returns? Surely the correct strategy for buying socks is to find a single optimal color and design and buy only this kind of sock. The advantages are manifold:

• No odd socks
• Savings, through understanding the correct price of your chosen sock
• Greater efficiency vis a vis a saving of time and knowing what to buy and to wear

There is a similar situation re chess openings in that most people should stick to a limited repertoire in which they are specialists rather than flit from one line to another. The only caveat is that in order to fend off boredom it is good to change every few years.

Incidentally it seems that both Einstein and con-man extraordinaire, Death Valley Scotty might have come to similar conclusions on this, Einstein going for the no-sock option whilst DVS had multiple sets of the same clothes.

Yishen Kuik mentions:

Pairs of socks immediately bring to mind paired trades, matched not by colour but by historical co integration.

If gremlins who steal socks are substituted for forces in the market that give rise to ever changing cycles, breaking new relationships and restoring old ones, might there be a lesson here?

If one has paired trades [A1,A2], [B1,B2], etc ... is the article telling us that we should also want to make sure that if we break up the pairs and form new odd pairs [A1,B2], [C1,B1] that they also have a co integrated relationship? Applying this to the risk arbitrage world, if we keep our pairs of acquirer/acquiree within related industries, say oil, even if the deal falls through between A and B, and between C and D, we will not be terribly punished because the acquisitive temperament in the industry is high and perhaps A might try to acquire D instead and likewise for C and B.

20-March-2006
The Google Factor, from Prof. Ross Miller

While some are resorting to numerology to divine the future of Google, it is worth noting that key players in the mutual fund industry (including Fidelity and American Century) loaded up on Google several months ago. My own quick and dirty statistical analysis of one of the largest of these funds indicates that their Google holdings have been so great that Google is more significant in explaining the fund's pattern of returns that the entire NASDAQ 100 is. This is even more impressive when one considers that Google itself is a fair-sized chunk of the NASDAQ 100. The Google factor continued through last week to exert a major pull on certain funds -- enough o turn what would otherwise be an up day for them into a down day.

1Q2006 is the first quarter since Google arrived on the scene where Google is down big-time from where it started the quarter, and still with two weeks left to go. It has only had one down quarter before, 1Q2005, and that decline was modest. Mutual fund managers may be loathe to exhibit large chunks of Google in their quarterly reports. While the efficient market hypothesis indicates that window dressing is already "baked into the pie," there is also a lot of academic evidence that end-of-quarter anomalies are real. While I am certain that Google is keeping announcements of nifty new things in its silo to spring on the market over the next two weeks, the question is whether those goodies will be enough to offset the tide of fund managers taking to the lifeboats.

20-March-2006
May No New Things Arrive, from Steve Ellison

In O'Brian's The Wine-Dark Sea, Stephen Maturin in Peru gives a gratuity to a local who has helped him find his way, and the local bids him goodbye with a parting blessing, "May no new thing arise." Maturin replies, "May no new thing arise". Jack Aubrey tells Maturin that he would like to see no new things arise in the Navy or in music. In Jane Austen's 'Emma', the title character's father, Mr. Woodhouse, dislikes news of any change. A deep-seated aversion to change appears to be a quite common human characteristic.

Carl Jung once said that all change is experienced by the ego as death. Think about what happens to people who refuse to change.

The history of technology shows that technological change is exponential. So we won't experience 100 years of progress in the 21st century-it will be more like 20,000 years of progress. Bring on the New Things -- they are so much of what makes life rich, wondrous, complex, challenging, rewarding, maddening, joyous and never boring. It's always something, and I wouldn't want it any other way.

19-March-2006
A new collection of Haiku, "A Tribute to Purim," can be found in Market Haiku.

19-March-2006
How to be Rich in Business, Markets and Life, by Victor Niederhoffer

I'm sure that many of us recall the anecdotes about J Paul Getty, the world's richest man in the 1950s. He made his workers pay for their own telephone calls with a pay phone at his home, and would choose to wait half an hour at the roller-skating rink with his date if it meant that he could get them in for half price.

Many of us have learned things from him, like how you should always be a contrarian if you wish to succeed in business, and how you should read Henty to get a great introduction to English and American history. Getty makes the Sage of Nebraska look like a spend thrift and was a technical genius in the spirit of Howard Hughes. Having invented new methods of finding, extracting and drilling oil, (one time a well was stranded, as the drilling team was unable to fish out a drill bit that had gotten stuck in it. Getty went out and bought a six foot marble shaft from the local cemetery, had one end cut to taper and threw it down the drill site. The heavy slab slammed the bit out of the way and the technique is now called the Paul Getty Special!)

Getty made money hand over fist in wildcatting, hotels, stock market trading, real estate, and every aspect of the integrated oil field industries, and therefore can command our respect and has much to teach us.

At six dollars retail price, his 1965 paperback How To be Rich is about the best buy that anyone can make for improving their abilities in business and life. The flavor of the book is best captured for me in the following paragraph:

All my sons chose to enter the family business. Each was allowed to start right at the bottom of the ladder. My sons served their apprenticeship by serving customers in filling stations ... they sold gasoline and lubricating oil, filled batteries, changed tires, and did their share of cleaning grease racks and sweeping the premises where they worked. Despite this, innumerable casual acquaintances have blandly asked me to do them a favor and give their sons or unemployed relations executive level positions in firms I control. They never seem to understand why I turn them down and they almost always become highly indignant about it.

The best section of the book is about habits that successful business people should have. They should be optimistic and cheerful, relaxed and patient, thrifty, and pause to review their reasoning before making decisions.

Executives would do well to periodically make an inventory of the things they do in connection with their own work that are useful and productive habits, write them down on a piece of paper, and eliminate all those that remain.

A key point is what Getty refers to as the imp of the impossible. Never undertake the impossible, but also never accept a no on what is possible.

Another chapter in the book is on millionaire mentality. That mentality is to be imaginative and farsighted, while at the same time taking care of the little things that add to to the bottom line. A nice technique of Getty's here was to instruct his book keeper to shortchange by five dollars each of the key managers in any of his businesses who needed to pay more attention to cost-cutting. After doing this you can expect to have each of the managers in your office to upbraid you within an hour of the pay check. Then Getty would say to them:

I've been going over the company's books. I've found several examples of what I consider unnecessary expenditures which could cost the company's stockholders many tens of thousands of dollars. Apparently you paid little or no attention to them, and made no effort to reduce the expenses or correct the situation, yet when your own pay check was involved you were here in a minute.

As to what makes a good executive, Getty believed that the ability to lead is key and that leadership should be done by example -- every job that your employees do, you should know how to do better. After teaching his employees, Getty would then give them the latitude to execute the goal on their own. One rule that Getty follows which every good businessman might do well to adopt is always to praise an employee in public and criticize him only in private.

In addition to making money in every aspect of the oil business, Getty made fortunes in stocks and real estate. He has chapters on the techniques he used in both fields. His stock market tips boil down to buying stocks when they sink low and holding them for the long term, and he describes how he made a fortune by doing this in 1932 during the height of the depression. Unfortunately, anything like this strategy in the 2000-2002 season would have caused untold harm and disaster, with many stocks that dropped to seemingly good prices -- like half of their former -- then proceeding to drop another 95% from that level. Again. The rest of his advice is the kind of untested thinking that so many of the value investors are prone to, like to wait until stocks fall below their book value and then to buy them. The problem is that during the periods that you are waiting you will be foregoing the steady beat of the 10% a year return for a random selection of individual stocks, that we have seen over the past century.

One of the most poignant and useful chapters for me was on how to deal with adversity. Getty points out that everyone in business is going to have to deal with disaster now and again. He recommends being prepared for adversity and then regrouping to attack the enemy.

When his troops have been rested and reinforced, and his supplies replenished, the successful General launches the carefully planned counterattack ... He makes feinting and diversionary assaults, aims his major blows at the weakest point in the enemy lines, and holds back his reserves until he can commit them at the decisive moment.

The business of wildcatting oil depends on good research, strong business-like habits, the ability to come back, proper leadership. It depends on all the important input qualities necessary to create a proper balance of reward relative to risk amid a constantly changing landscape of uncertainty, with its innumerable dry holes and the ultimate return for undertaking risky adventures. It is very similar in its broad outlines to our own field of spec-investing.

Getty's book is far better than all other self-help books, which tend to be written by great salesmen of self-help books rather than by businessmen successful in innumerable fields and in every kind of positive and negative economic condition, as Getty was. I can give this book my highest recommendation as it is filled with useful tips drawn from the real-life experiences of one of the most successful business persons ever. Those who absorb the lessons of How to be Rich, a book written by a master businessmen -- the Ted Williams of his field -- will be much augmented in all of their undertakings.

Robert Lenzner's The Great Getty is a worthwhile read as well, though a little more soap opera in that it detailed many of Getty's loves, marriages and other notable social aspects of his life (he was considered by some to be a Nazi sympathizer). Getty seemed to approach everything in a business-like fashion, including art collecting. Art critics derided Getty's massive art collection (although secretly envied it) because he sought deals on art, he went against the the norms of the art world and rather than talk about the merits of his newly acquired pieces he would always discuss them in terms of value. I look forward to reading How To Be Rich.

19-March-2006
Avalanches, from Tyler McClellan

This year has been one of the deadliest on record with regard to avalanches throughout Europe. As an avid backcountry skier, a thorough knowledge of avalanches is necessary for survival. There are in fact many similarities between avalanches and the market, and a return from two weeks in Switzerland and a close call or two, starts the wheels spinning.

First it is helpful to categorize the variables involved in avalanche forecasting. Two variables are always and everywhere acting the same and three are highly dynamic. As in the markets most of our focus will be on the dynamic processes.

The quantity of snowfall is obviously highly correlated with the incidence of avalanches but in and of itself this is an uninteresting dynamic. It is the equivalent of saying the market over time moves upwards. Certainly important to know but not helpful with regards to the specifics of forecasting. The second static variable is the steepness of the slope in question, namely the steeper the slope, the greater the effects of gravity and thus greater the force capable of causing slides.

The three dynamic variables then are length of time between snow falls, temperature variation, and wind speed and direction. A season with very heavy cumulative snowfall is not more likely to have serious avalanches than a season with low cumulative snowfall. The duration between snowfalls is much more important. If six inches of snow fell every day for a month, all else being equal, the avalanche risk would be substantially less than if 18 inches of snow fell every two weeks. Thus, though the total snowfall in the first scenario being 84 inches per two week span or more than four times the total snowfall in the second scenario, the latter is substantially riskier. An obvious hypothesis for markets would be that the probability of a dramatic move is not related to the total magnitude of price change over a period, but rather to the amount of time between moves of a given magnitude. I forgot to mention that the cause of this phenomenon is the lack of bonding between snow layers from spread out snowfalls. The ability of snow to form a stable bond is most directly related to the amount of time between contact.

The second dynamic variable is temperature variation. This variable actually works in conjunction with the first. Temperature variability allows the water content in the snow to change over time, as snow melts in the sun of the day and then refreezes over night. This refreezing overtime creates slabs that are very difficult for new snow to bind to. If the temperature always remained constant then the time between snowfalls would be irrelevant, but since temperature and the effects of the sun vary widely the snow changes dramatically over time. Anyone who has skied on un-groomed a couple days after a fresh snow can attest to this phenomenon, as what once was rippable powder has become agonizing crud. The relation of temperature variability to price variability, namely volatility is quite similar. Both by definition explain the likelihood of an extreme event occurring.

The third dynamic variable is wind. Both wind speed and direction are probably the most difficult but necessary forecasting variables. As the wind blows from a given direction at a given speed it picks up the snow on the windward slope and deposits it on the leeward slope where all sorts of dangers form. Cornices, ridges, etc.. are all under the umbrella of wind-loading. Wind loading is the process by which snow is moved from its natural equilibrium to dramatic disequilibrium determined by exposure. The conclusion of this phenomenon is an avalanche. The snow collapses under the pressure and weight of the new snow the wind deposits. The relations to the market here are perhaps the most interesting. One could generate many a hypothesis about how the duration and magnitude of a move in one market (wind) might increase the tendency of a dramatic move in another market (avalanche). If we could identify the market that acts like the wind to another market and the direction of this effect we might find a meal for a lifetime. One thinks of the obvious example of the oft-repeated claim that the equity markets are sailing into the headwinds of rising interest rates.

This analysis of avalanches has been simplistic and there are many other relevant forecasting variables (altitude, surface, humidity, etc..) but hopefully other mountaineers can comment and perhaps generate more interesting questions.

To add to Tyler's interesting post about avalanches, I too have had some experience in this area having lived in the West for six years and skiing often in the backcountry. Avalanches, like the markets, are somewhat predictable, can be measured, are affected by specified variables, and have probabilities of occurrence based on history. In market practice, avoiding those 50 point avalanche down moves in the S&P could add a lot to P/L.

Avalanches need four main components; a slab which is the block of snow itself, a grade which gives it velocity to move, a lubricant or separation of layers in the snow pack, and finally a trigger to set it all in motion. They often occur within 24 hours of a recent snow fall, and when temperature is varying above and below freezing level. The ideal grade for them is 30-45 degrees of slope. This means that in very steep and cold places like Alaska, where many extreme skiers are often filmed, they are less likely though they still occur.

There are some interesting trade offs when it comes to avalanches. Skiers want to get fresh tracks in the backcountry right after a big storm but are tempered by not wanting to get caught in a slide. It is better to start the day early when it is colder, but that means rising well before dawn. The grade too is interesting. The really steep grades above 50 degrees are actually more stable as the weak snow layers slide off more gradually. But a 50 degree grade is basically a blind run, meaning you can only see about two turns ahead, so quite an adventure. Before you ski in avalanche terrain one always looks at the run out or escape route. Couloirs and drainages are the most dangerous, but often the most challenging and attractive for adventurous types.

In the markets one could make some trading rules to perhaps avoid getting caught:

1. Never trade within 24 hours of a big move. Wait for things to settle before jumping in.
2. Look for weak layers, no recent slides, few down periods, bonds in decline for example. One of the ways they prevent avalanches in resorts is to trigger them by bombing while they are still relatively small. Some small bombs in the markets make it safer.
3. What announcements, fed actions, or expirations though not predictive in themselves could act as a trigger?
4. Look for signs in the terrain of past events, no trees for example in an otherwise wooded area. Look at the data, past events are fairly easy to recognize.
5. Stay away from terrain you do not know and have not researched. Digging a snow pit provides a history of the snow pack to access. They same can be done in respective markets.
6. If you get caught have an exit strategy or run out.
7. After an avalanche of course is the best time to ski that terrain. If you have been able to avoid the blast now is the time to dive in heavily.

19-March-2006
Thoughts on the Term Structure, from Steve B

The term structure of interest rates (also known as the yield curve) is the most studied and reviewed fundamental variable among institutional investors such as asset allocators, hedge funds, pension money managers and plain vanilla mutual funds. As it commands attention from traders action that is able to move the markets then others may benefit by front running these firms. Three important questions arise from our study of rates and the markets:

1. Why does the yield curve impact equity prices in the short and long term?
2. Is risk premium a factor in the yield curve?
3. What other significant risk are faced by bond and equity investors?

Expectations as expressed by John Maynard Keynes are the guiding principle for traders to front run "what average opinion expects the average opinion to be". The uncertainty over the path of interest rates sets the yield curve in terms of investor risk aversion. In general it is expected that long-term yields equal the average of short-term yields. The further one goes out on the yield the more uncertainty exists for the investor and thus must be compensated with higher yields. Many models assume the risk of rate changes to be constant over time but in practice it varies over time, thus models are constantly tweaked (changed) to account for changing investor appetite for risk. Some of the more sophisticated models also attempt to take advantage of technical stop loss positions. Short term yields changes are minor compared to the price impact on longer dated bonds, thus risk is actually contained in t-bills but open for longer term bonds.

Risk in the equity markets is an open ended question, but in the US Treasury market the risk is simpler and limited to interest rate fluctuations. The term structure gives little value to investor sentiment but much value to investor sentiment to risk appetite. The yield curve is a direct measure of investor risk and value in the equity markets, volatility is generally more related to future risk but that risk is generated from a derivative price (option trading) of the security. Volatility is an estimated measure of equity risk and the risk is used by investors to determine the suitability of stocks as an alternative to bonds. However, this is where risk for bonds and equity part as the risk is different for every stock but the risk is the same for similar bond classes. However, in most cases it is not necessary to determine equity risk but to focus on yield curve risk premium. This is necessary as bonds are the first choice of low risk investors and the need to take further risk is precipitated by low returns.

Investor sentiment may play a role in equity investing but "Prices move until the marginal efficiency of other assets falls in line with the rate of interest" according to Keynes. In this context when the yield curve is rising the economy is expanding and equities will likely outpace bonds and as the economy slows the yield curve will flatten and possibly go negative. In our quantitative analysis the level of the curve is not crucial but investor appetite for risk is critical. It is the future attention that will eventually determine a successful stock/bond allocation. Attention will focus on equities when interest rate returns become poor according to yield curve risk.

19-March-2006
Steve Leslie on Golf and Life

Golf is so interesting a game because it requires a mastery of different skills and a proficiency with different and complementary tools to accomplish its task. There are 14 clubs allowed in a bag and each has a well defined purpose.

I have always taken pride in my relative mastery of the driver. What a joy it is to stand up to the first tee when you are in full view of the groups waiting to tee off and you smack one 280 yards down the middle of the fairway. As you walk to your cart and replace the weapon of choice, you hear the ubiquitous murmuring from those behind and you may hear a comment from your playing partner for the day say something like "That's my partner". Or "Do you guys want to just give us the money now?" Some such gentle needling. You puff out your chest a bit, pull in your waist, and off you go to enjoy a 4 hour excursion along some pretty expensive real estate that you have rented for the day.

However that is usually where the enjoyment ends. Soon you come to the realization that during this odyssey, you will be faced with a vicious variety of labors that rival anything Hercules had to endure. Many times you will be faced with the question as to why you even tried to learn such a stupid game and spend countless thousands of dollars on equipment and proper clothing and waste endless hours of grueling practice and complaining from the wife.

Here is where I shall share the greatest lesson I ever received in golf. The one lesson that unquestionably helped me reduce my handicap from a good golfer to a low single digit.

Every shot counts the same. Whether it is a 280 yard drive or a tap-in put, they all count as one stroke, and the true goal of every golfer is to get a small white object ball into a cup in the fewest strokes as possible. The professional golfer understands this clearly. That is why they properly devote their practice time among the various aspects of the game. Therefore if putting is 50% of the game, they spend at least half of their practice devoted to putting. Usually more. And they work on their weaknesses. If they are poor in their short game, they will devote a extra work along this area. They also are honest with themselves. They enlist the help of fellow professionals. It is often said that professionals take more lessons than anyone else. They pay attention to detail, they are students of the game and are always trying to improve in all the aspects not just a few.

The amateur or high handicapper rushes to the driving range brings out the 'big dog', whacks a few thunderous blasts and trudges onward to the first tee. Is it any wonder they never improve. I often tell them, instead of buying that brand new Big Bigger Biggest Bertha driver buy a knock off and spend the balance of their allowance in lessons.

The analogy to success in business, investing, and life should be obvious. It is the decisions and choices that we make along this continuum that ultimately decides our successes and our failures.

19-March-2006
J.P. Highland contributes to the Daytraders' Forum

Focus and determination are the difference between a successful Day-Trader and the pack. You can know a lot about methods and indicators, count as much of you want, but if you do not have the inner strength to fight for your right to party, you are doomed.

The best trades do not come easily, they give no time to hesitate, to get in you have to overbid other guys and dare to take risks others don't. From my Day-Trading experience I dare to say that the most profitable trades do not happen in stocks like XOM or WMT in which there is always a Bid and an Ask at hand that can offer the opportunity of an easy escape in case of an inconvenience. The most profitable trades happen in illiquid stocks that can move 20 cents in just one print, these stocks are like the Roach Motel, they are absolutely scary, but the big rewards do not come easy.

17-March-2006
Open Gaps, by Paolo Pezzutti

Many daytraders and short-term traders fear the opening gap so much that in most trading books you find the advice not to carry positions overnight. Motivation for this is that risk is too high and that it not possible to forecast the gap direction. Basically, the theory behind these assumptions is that the opening price is determined randomly.

But, is there a possibility that instead of being a risk, the overnight gap is an opportunity? Almost every trader knows that there is a tendency to close opening gaps. I'm rather interested to see if there exists some technical situation that influences the next day's open.

To read the rest of Paolo's post ...

17-Mar-2006
Phil McDonnell on Data Mining

Q: If we pursue data mining with wild abandon, using our computers to plough through considerably more than 400 permutations, aren't we guaranteed to find one study that will past both in-sample and out-sample studies?

A: The question has an implicit false premise. It presupposes that all of 400 hypotheses would be allowed to pass on to Phase II Significance testing. That is the reason for the emphasis on only one hypothesis being chosen to pass through to significance testing. Thus the odds of that one getting through the 1 in 20 hurdle by chance is still 1 in 20 just like always.

Q: Also, since in-sample/out-sample is simply doing a two-period study but looking up the second period results only after the first period results have been satisfactory, why not do a 3 period study? or a 4 period study?

A: You could but it is equivalent to increasing your significance level to say 1% or even more. Remember only one hypothesis can come out of the data mining stage. Data mining is only useful for generating hypotheses. Significance testing is meaningless in the data mining stage.

Q: Isn't this all just an exercise to minimize the probability of a false positive result? And aren't we achieving this by requiring our test results show greater consistency over time?

A: No. To reiterate: Phase I is to find a single hypothesis. Phase II is to test a single hypothesis. If it passes Phase II we can only assume 5% significance. We have to ignore Phase I significance at all times!

Q: Doesn't this then run into the problem of how long it takes for the everchanging cycles to take effect?

A: Everchanging cycles require agility on the part of traders. We must adapt ever more quickly to the changing cycles. If data mining helps generate new hypotheses then the technique can help one adapt more quickly.

Q: More on changing cycles ...

A: All the data mining procedure does is help one achieve the same 1 in 20 chance oresult is not random. If the cycle turns it can be considered to be at random. If it comes back it will effectively be at random.

Q: I guess this is when advice that your testing period should include all kinds of market conditions instead of just aiming for a sufficiently high quantity of observations might take on some relevance.

A: Some say test periods where the beginning and ending prices are about the same as it covers bull and bear markets. My philosophy is to test using similar periods to the current one. For now that means the last 750 days since the Iraq invasion. But in all honesty I haven't got a clue.

16-March-2006
Some Applications of Series Parallel Circuits for Increasing Reliability in Markets and Machines, by Victor Niederhoffer

A breakdown in machines or trades can cause terrible consequences in factories or trades, thus, one of the rules that it is best to follow is to always have multiple paths to extricate oneself from disaster, or more generally to prevent breakdown. I often refer to one of my favorite proverbs in this connection, 'the mouse with one hole is quickly taken', and this one I often follow, never putting on a trade unless there are at least two or three ways I can get out of it with a profit. If there's just one, the mistress will preclude it from occurring and guarantee me a loss.

One analogy as to how to do this comes from electric circuit theory, where parallel wires are often used to provide alternate paths for the input to reach the output, and series paths are used to provide a high chance of a breakdown, as in Christmas tree lights, which are always strung in series. This concept has been employed in reliability theory where parallel paths are often used to increase the chance of exiting a trade, and combinations of series parallel paths with bridges between them are used to maximize the chances of getting from input to output, while using a minimum number of components. An excellent discussion of these series paralled and bridge circuits with particular reference to the exponential, (constant hazard rate), distribution and the Weibull distribution is contained in another book I am reading to increase my knowledge of probability applications, Elementary Applications of Probability Theory by H.C. Tuckwell. The discussion of how to compute the reliability of combined circuits draws on elementary truth table calculations that we are all familiar with from our college logic courses, and it's quite instructive in how to design circuits that give the greatest reliability, or its converse, the least chance of failure.

I asked Doc Castaldo to prepare a brief introduction into reliability theory for the readers, and it appears below.

16-March-2006
A Sixty Second Introduction to Reliability, by Dr Alex Castaldo

Reliability theory provides a way to analyze a complex (multiple component) system to calculate its overall reliability, the probability that the system will work. The reliability is, by definition, one minus the probability of failure:

R = 1 - F

Series Systems

When, for the system to work, all the components must be working, the components are said to be arranged in series.

`----- A ----- B ----- C -----     Three components A, B and C in series.`

Thm 1: For components in series, the overall reliability is the product of the component reliabilities. In our example R_system = R_A * R_B * R_C [of course this is equivalent to (1 - F_A)*(1 - F_B)(1 - F_C)].

Parallel Systems

When the system continues to work as long as at least one component works, the components are said to be arranged in parallel.

```     |--- A ---|
---|         |---
|--- B ---|                                                                                                                                                                                                                   Two components A and B in parallel```

Thm 2: For components in parallel, the overall failure probability is the product of the failure probabilities of the components. F_system = F_A * F_B. In our example the reliability can be calculated as follows R system = 1 - (1-F_A)*(1-F_B) (recall that the reliability and failure prob are complements, i.e., add up to one).

Other Cases

There can be more complicated dependencies between components as well. Sometimes they can be represented by combinations of series and parallel connections. Two simple and extensively studied cases are:

A series-parallel system is composed of k subsystems in parallel, where each subsystem i = 1...k is composed of n_i components in series.

A parallel-series system is composed of k susbsystems in series, where each subsystem is composed of some number of components in series.

Here is a simple example of a series-parallel system:

```
|--- A --- B ---|
---|               |---
|--- C ---------|```

The reliabilities are R_A = 0.7, RB = 0.5, R_C = 0.9. What is the overall reliability? The answer is 1 - (1 - R_A*R_B)*(1 - R_C) = 0.935. In words we analyze A-B first, which is a system in series, and find its reliability to be 0.7*0.5 = 0.35 (or equivalently a failure of 0.65). We are left with two subsystems in parallel so we multiply the failure probs together: 0.65*(1-0.9) = 0.065. Don't forget to convert back to a reliability: 1-0.065 = 0.935, to get the desired answer.

Historical Notes

According to legend, reliability theory developed in World War II when engineers working on the V-1 and V-2 rockets were puzzled that the rockets were so unreliable even though the components were believed to be highly reliable. Furthermore in each system failure that they analyzed a different component seemed to have failed. Upon closer examination the rockets had a large number of components in series (that is each of these components could trigger the failure of the rocket) and whenever that happens the overall reliability is going to be very poor. When the engineers began to add backup components arranged in parallel, progress (albeit for the wrong side) began to be made.

Reliability theory developed further in connection with the early vacuum tube computers, which again were very unreliable. Von Neumann's famous article "the synthesis of reliable organisms from unreliable components" (which introduced triple modular redundancy and other ideas for improving reliability) was a landmark in the field. Paradoxically, developments in semiconductors solved the reliability problem more directly and made these issues less important, at least for computing.

There is a similar situation in chess. Amateurs tend to commit heavily to a single sometimes highly tenuous idea, leaving them in serious trouble should it not work out as anticipated. Professionals on the other hand will tend to play multi-purpose moves and aim for positions which don't easily 'snap'.

In the context of trade exits, as I understand in the original communication from the chair, a serial connection would cause a single break down at any one point making the circuit go down, while a parallel circuit would not necessarily break down if one or several circuit breakers did come by in the path between input and output.

The terms voltage and impedance could well be ideas applicable to a totally different thread on the markets. Say, for an example any given state of the market could represent a particular level of impedance (say it could be a particular amount of total market cap, or a particular value of the market cap divided by appropriate denominators like the total value of debt or say the price of gold etc) and for a certain amount of current to flow through in either direction (say percentage moves) a certain amount of voltage difference would be necessary.

Now in this model, voltage difference is akin to the contrary opinions existing in markets. A zero voltage difference would be consensus and a rising debate across media, volume, open interest reflecting the struggle for finding expectations of the market direction represent a rising voltage difference. Consensus is reversalist and confusion amenable for flow of the trades and current. Without thrusts of information (real and created) markets are dull.

James Lackey responds:

Another solution is to have two systems in series that produce more power or have less resistance. An example of this is in most auto racing. In Top Fuel cars they run 2 Magnetos and 2 sets of plug wires and 2 spark plugs per cylinder. This is not for reliability, you actually need 2 spark plugs to ignite the massive amounts of nitro methane to produce 8,000 horse power for a 5 second run at 330 MPH. However if one Mag fails the car will still make it through the run.

In Nascar they run 2 separate MSD ignition boxes. When the engine starts to miss fire the driver flips a switch to the other system, each individual box is in series yet a separate is in parallel for a back up. The problem with electronics in race cars is vibration and heat. You think a server farm is hot? Try 50 laps in a stock car, I hated it.

In trading you can design many systems in parallel to correct short term failures. However a good system which has the most power or bang for the buck would be in series. The problem there is that once any part of the system fails, the system fails. The solution there is a back up system. Plainly stated, cash in other long term accounts that can be used to finish the annual Baja 1000 or yearly panic!

Russell Sears responds:

The problem with comparing the market with electronics is that electronics the circuitry is well defined and generally is difficult to change.

Much of the current in electronics can be modeled similarly with a slower but more visual model of liquid flowing.

This seems to me to be a better model of money flow and the markets. Because new channels are constantly being dug. Old channels are damned and then reopened.

Perhaps this explains the additional yield above default risk. Diversification of high yield bonds works as parallel channels in normal times. Defaults are random, liquidity is fairly level. However, in times of recession many of the channels are blocked and re-routed such that the channels are now in series.

This would suggest that a cane strategy with a 1-2 year holding period would work well with high-yield bonds. I leave it to the reader to test this idea.

16-Mar-2006
The High Yield-Bond Premium, by Phil McDonnell

Standard finance theory explains that bond pricing is primarily based upon the risk of default. Treasury bonds, notes and bills have the presumed lowest risk of default and are priced solely on prevailing interest rates and their specific term structure. However for the case of high yield bonds, otherwise known as 'junk bonds', most studies have shown that they tend to outperform any reasonable estimate based solely on their default risk. They appear to have a risk premium which is higher than could be explained by default risk alone. It is a clear case where the data does not agree with the prevailing theory. When the data says the theory is wrong, it's time to get a new theory.

High yield bonds perform more like stocks than treasury paper. They are more volatile than other bonds and in that sense more like stocks. They perform better than other bonds, again a property more commonly associated with the well studied long term drift in stocks. Viewing them as closet stocks might be a better perspective. But is there other evidence that can support this? For instance are high yield bonds more correlated with bonds or stocks? Do they act more like a stock or a bond?

To shed some light on this question I looked at contemporaneous correlations between various assets based on their daily changes over the last 500 days. The time series were:

spy - SnP 500 ETF
dhy - Credit Suisse High Yield bond ETF (Yield ~ 9.7%)
tlt - High grade bond ETF
^tyx - US Treasury 30 yr yield (not price!)
^vxo - Old vix as a measure of stock risk perception

Correlations

```       spy    dhy       tlt   ^vxo    ^tyx
spy  1.000   .239     -.030  -.802    .028
dhy   .239  1.000      .119  -.184   -.107
tlt  -.030   .119     1.000
^vxo -.802  -.184      .105  1.000
^tyx  .008  -.107     -.950  -.081   1.000
```

Observations:

1. The correlation between dhy and spy is .239 compared to dhy and ^tyx at only -.107. The correlation is more than twice as much between stocks as with bonds. However the proper comparison is really in terms of the variance or R squared where the spy-dhy actually "explains" more than 4 times as much variation.
2. dhy is also highly correlated with the ^vxo index at -.184. In other words it responds directly to factors which might be considered risks for stocks.
3. Most stock indices and broad based ETF's have high correlations with spy on the order of 0.80 to 0.90. The vxo is correlated at 80% as well. So although dhy is 0.24 correlated with spy and 0.18 with vxo that correlation is not as strong as it would be for a broad based equity fund.

Conclusions

1. dhy acts more like a stock than a bond and viewing it as a stock is a better model.
2. The correlation with spy and vxo is much lower than for a true stock, so the best model is to think of high yield paper as more like a stock than a bond but not quite a full fledged stock.

16-March-2006
Gordon Haave on The Origin of Species and Markets

The big thing missing with a traditional comparison between the evolution of a species and speculation is that we are able to live more than one life as speculators, whereas the individual in a species does not.

The implications are that:

1. Death is not always prompt
2. Fear is often felt.

On the other side of that equation, this provides the speculator with:

1. Redemption
2. Hope
3. Opportunity

Most importantly, the fact that we can all "die" and be "reborn" multiple times means that evolution occurs within finance much quicker than it does within species. Thus, whereas in the evolutionary sense species can evolve because of a positive attribute that over time leads to the ultimate triumph of that species in its environment, what can be an attribute to a speculator can very quickly become a liability. This is because the law of ever-changing cycles affects speculators much quicker than it does a species as a whole.

Now, while the Chair discusses evolution from the perspective of the individual player caught up in it, I will instead focus on evolution's advancement of the species. The above implications of the differences between the evolution of species and of speculators results in evolution becoming a battle of individuals against each other, rather than of species battling species. In evolution, the number one job of a species is to ensure its long-term survival. One species of bee is not content simply to maintain its own turf, but rather to try to expand its turf in order to dominate the other species of bee that it competes with.

Due to the ability for the individual speculator to live more than one life, however, for the most part the individual does not seek to expand the ranks of its own species, since those expanded ranks will serve to compete with him in a future life.

In fact, each individual speculator may even seek to grow the ranks of other species, if he thinks that it gives his own short-term survival an edge. Such might be the explanation of a man who has gotten wealthy investing in growth companies such as Coca-Cola and Geico trying to expand the ranks of "value investors."

Thus, speculators turn natural selection on its head. Natural selection is a process whereby certain traits increase the population of a species over time. In many instances, this comes at the expense of the individual. For example, many insects are brightly colored, which helps them find a mate an procreate. Those same bright colors, however, also doom the individual to a higher death rate. So long as the higher birth rate resulting from the bright colors is greater than the higher death rate caused by the bright colors, natural selection will work in favor of the brightly colored insect.

In speculation, there is no sacrifice of the individual for the group. It is the reverse... the sacrifice of the group for the individual.