Daily Speculations

The Web Site of Victor Niederhoffer and Laurel Kenner

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


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The Daily Spec Archives

May 2005 Posts

The Iceman, by Victor Niederhoffer

Oetzi the iceman was freeze-dried about 5300 years ago near Northern Italy and discovered by a German tourist on a walking expedition. A replica is in the Smithsonian Natural History Museum and the original in a refrigerator in an Italian museum. His clothes, with nicely layered grass with wood seams, show evidence of a tailor. Perhaps an ingeniously developed snowshoe or backpack is visible. His copper weapons, his bow and arrow, and his fire-making tools (including a flint, an axe and knife) show considerable ingenuity, use of mechanics, and know-how. His grain diet and many other wondrous aspects of his life have been reconstructed from the remains.

What would a similar reconstruction of a trader-analyst show if he were examined 5000 years from now? I can only speculate -- a book on candlestick analysis, some stochastics (with spurious moving averages), a price earnings ratio (without interest rates), a head and shoulders template, a protractor, perhaps a ticket to a seminar on advanced derivatives analysis, and a magazine story on Buffettology advising staying away from individual stocks because they were too expensive an the beginning of the 21st century, and shorting the dollar because of the trade deficit -- you fill in the blanks.

I wonder if we all will fare as well, as archaeologists recast the tools and know-how of traders of today.

Sushil Kedia replies:

5000 years hence might be roughly 20 times bigger a chunk of time than the roughly 250 years history that the exchange markets and organized trading has seen so far. Assuming that the growth function is a non-linear, arithmetico-geometric kind of function the degree of complexity in the tools of the trader then might at this moment appear like one which is not even captured in the most verbose sci-fi movies of our times. Letting imagination run loose for a while, here's my visual of Oetzi2005 in 2007:

  1. The nano-computing devices being in vogue by then and ones that would be embedded in the palm-tops (may be thumb-nail-tops by then) that might be soliciting mega-servers scattered in distant corners of the universe with less lethal versions of gamma-ray-type connecting carriers would still be driving delight on the archaeological find from the huge desk-top size servers being accessed by the laptop in the hands of the Oetzi2005.
  2. The debate about history being created by victors or not existed in 2005 AD would be accessed from one of these digital archives connecting to reverse engineer the architecture of the laptop so found and a reference to Mr. Sogi's argument on recency being found so valid even then would cause the archaeological find to drive further excitement. For the debate would still be relevant. Because despite the development of all tools in 2005 like the fax and the SMS devices becoming absolutely cheap then even in 7005, "The public would always remain behind the form." The relevance of the Fifth Discipline being still there in 7005 would be exciting then that the dilemma was identified as long ago.
  3. Returns would still not be sought without assuming some risk then and the discovery of scanned pages from the Prac Spec on the hard disk of the laptop would corroborate the understanding of the man of 2005 to have caught the idea sufficiently early. Man would possibly till then be living with the equation that, Certainty = probability + uncertainty and will continue to debate the degree of accuracy in the philosophy in the equation above being contradictional to the very definition of uncertainty. Language that would continue to have the same limitations as have been identified by now would make Oetzi2005 a great find in 7005 proving that the debate existed at least 5000 years ago, but even in those times as in 7005 there will be doers who continued to operate while there would still be skeptics who would chose to abandon doing in the absence of a certain idea of uncertainty. The Oetzi2005 find would corroborate further that it is in doing that all the difference exists.
  4. The Rolex on the wrist of the Oetzi2005 and the Gucci adorning his feet would still confirm the prevailing theme in 7005 that perception drives value and that issues like need, want, reality is different for different people. Branding and super-value would be found then to be ideas that are 5000 years old. The voodooistic "world's number 1 trading system" rankings of 7005 would find their origins and confirmations from the Rolex and the Gucci. Value being different for different people making the same price attractive for buying and selling for two different traders would be confirmed from a "trans-planetary-debate" on the possible implications of the Rolex and the Gucci names printed respectively on the two objects and certainly a credit-card slip payment found in the coat-pockets of the trader would confirm the perceived value of the same because two different cards, each exhausting the remaining credit limit from each of the purchases would corroborate that.
  5. A voters' slip would possibly be found on the Oetzi2005 proving again to the archaeologist in 7005 that the struggle to control the creation of money is at least 5000 years old and not a recent phenomenon of the 7000s.
  6. The under-garments of Oetzi2005 with markings such as, "Made in China, Child-labor free, 100% natural" would corroborate to the mankind of 7005 that emotion sells and that scarcity motivated purchase decisions than any advantages of natural ingredients and that global trade had 5000 years ago achieved such glory to have been able to incentivize the manufacture of under-garments in one corner of the globe, labeled in another and sold in yet another.
  7. A compilation of e-books on a CD spanning from the Hebrew Kaballah to Buddhism on one hand and from Japanese Candlesticks to Statistical Inference on another would be in addition to a detailed psychometric testing report on mind-body profile ensconced on a dat-tape would prove beyond doubt to the audience sitting before a blaring C#BC even in 7005 that traders would allow themselves to be as confused and as bewildered as much as the % drawn-down tolerated by the risk-management desk of the hedge funds they work for right since 2005.
  8. A post-it note affixed neatly inside the Oetzi 2005's wallet reminding about the deadline for the 'returns-finalizing' meeting with the tax-attorney, visit to the dentist and an over-due visit to the monthly get together of the Parent Teachers' Association meeting are all on the same day would confirm that time management is a challenge for the trader that is about at least 5000 years old.

John Bollinger responds:

Assuming our future archaeologist is a trader, I suspect he would recognize our tools and techniques with little problem. Technician, quant, fundie; all are concerned with the same thing, a proper understanding of the supply/demand curve. While our future observer might think our tools and techniques quaint, they'll be facing the same challenge we face and would likely recognize a kindred spirit. Perhaps he might even find our work of interest, much as we draw inspiration from past masters.

Kim Zussman responds:

Also interesting that Otzi was evidently murdered. Detailed scans reveal a flint arrowhead lodged in his shoulder, so he probably exsanguinated or died of infection. Maybe a margin call?

James Sogi responds:

Modern technological changes are small steps compared to the ancient technology of agriculture, fire, stone blade, metal, wheel, clothing. The phenomenon of recency magnifies recent developments.

Consider that human capital is the amount of production of one person in excess of subsistence. Consider the growth in productivity over the ages combined with the population explosion since Oetzi's time, and its no wonder that the course of human existence is bullish. Growth should parallel the rate of productivity growth and population growth. Until one cancels the other world growth should continue unabated over the centuries.

Phil McDonnell responds:

A true archeologist would make the safe choice. As can be seen from hundreds of years of archeology the safe theory to explain dimly understood artifacts and structures is always to claim they had religious significance. The spurious cycles induced by moving averages could easily appear to relate to cycles of the moon and planets. The dark and light of candlestick charts would document the periods in which the forces of good and evil prevailed. Head and shoulders patterns are easily interpreted as tracking sunspot activity for some poorly understood religious purpose. A protractor would seem indispensable for calculations involving the conjunctions and alignments of astronomical bodies. There can be little doubt that the religious hypothesis would be the safe one for any future archeologist.

Although I believe the religious theory has been greatly overused in archeology simply because it is always safe and hard to disprove, nevertheless in the case cited above it would be the correct theory.

Thomas Miller offers:

In the future, there wont be any trace of these books and indicators with spurious moving averages. When enough people lose more money than "they have a right to," these "techniques" will be thrown away, replaced by the next "holy grail." Future archeologists will find evidence that successful traders, of our day and future, used scientific methods of counting and testing and the latest revelations in psychology. Some laws from physical sciences such as biology will be applied to investing, like they were applied to economics back in the day. Two books that will survive into the future are the Chair's books; his arguments will have been proven correct and finally accepted by the investing community. Don't ask me when this will happen.

The Moscow Rules, by Victor Niederhoffer

Back from that reverse horn of plenty called Washington, I'll share some spy techniques that undercover U.S. operatives developed to deal with their lethally deceptive opponents in Cold War era Moscow. The Moscow Rules, a laconic set of principles from the firing line, provide a proper basis not only for spies hoping to survive the game, but for speculators hoping to profit and to defend their lives against the market mistress. A few examples, with thoughts on their applications in the market:

  1. Assume nothing. Test, test, test.
  2. Never look back. You are never completely alone. There is always inside information about every announcement and event.
  3. Any operation can be aborted. Once you enter a trade, do consider closing it out. You don't have to lose everything.
  4. Maintain a natural pace. Don't play double-or-nothing or risk everything or rush to put the trade on. It will attract the enemy.
  5. Lull them into a sense of complacency. Do not boast about your profits and always let them know about your losses. No big quantities at limits.
  6. Build in opportunity. Prepare to change your battle plan as conditions improve or worsen.
  7. Don't harass the opposition. Let the other side have its moments of glory, its seminars, its degrees in derivatives expertise, or whatever.
  8. Once is an accident. Twice is a coincidence. Three times is an enemy action. This one must be tested.

Bcoached responds:

Most human beings are hardwired to make bad financial decisions because of the limbic rat brain. The rat brain is not capable of evaluating risks and projecting them into the future. It reacts immediately, instinctually and without thought. Inexperienced traders, and even some of the most experienced, when faced with a conflict between rationality and emotions, will act on emotions. The old rat brain wins the battle and it wins over and over again.

Aversion to loss, which is a disproportionate fear of risk makes a lot of sense from an evolutionary standpoint when we were in the jungle running from wild animals, but makes no sense whatsoever in the markets. When we see a stock or future position falling, our brain (and body, but that is another topic altogether) reacts as if we are being threatened. Dumping a position when you see it falling is like running up a tree because you think a lion might be lurking. Running up a tree won't hurt you, but dumping a position on emotion can wipe you out. That is panic selling. How often have you done this? Panicked out of a position only to see it turn around without minutes to days? That is your rat brain in charge and your logical (new) brain completely taken over by emotion.

It also works the other way. When you see a stock going up and up every day, the rat brain tells you that it will continue to go up and you better get in now because you are missing out. This is panic buying. You get in and the stock starts to fall so you panic out of it as well.

The rat brain loves heuristics. These are mental shortcuts which link past patterns to potential rewards or losses. Such is the case with irrational exuberance and irrational nonexuberance. This is why most traders buy high and sell low. Their rat brain takes over and they are powerless against it. The rat brain wants results now. The new (non-rat) brain is patient and waits and analyzes.

Dr. Robert Gilbertson responds:

Excellent point, Bcoached!

As one of the first card counters in Nevada in 1963, my limbic system kicked in full tilt for the first few days. As the inevitable loss runs occurred, I tended to avoid putting up enough money at the proper time. If I had too much money bet, I sometimes refused to double down or split on mathematically close calls. Since my advantage was about one percent, this was enough to eliminate my profits. To solve this problem, I stopped betting money and only bet chips!

This may seem a ridiculous distinction, but it works. Upon entering a casino, I would buy $1,000 worth of chips at the cashier and mentally turn them into green, red and black chips to be used at the appropriate times. It worked so well that I never lost over any 4 hour period until I retired a year later.

I use the same approach to investing in the market. There are many days when my personal portfolios decline more than $100,000 but I experience no panic or even negative feelings. Why? Because I have established the probability that I will always win in the long run by years of "playing" and, prior to that, by extensive mathematical modeling. Therefore, I bet the correct number of "chips" every time.

Grandmaster Nigel Davies responds:

There's been a lot written about rat/lizard brains on the list lately, yet my experience as a chess player has taught me that my 'gut feel' for a position is usually right, even when I can't quite put my finger on the 'reason'. Perhaps I can find the 'proof' after the game, perhaps not. But it's 'feel' that guides a chess player in his choice of candidate moves and positional assessments. Relying on purely systematic thinking and conscious methodology we'd be hopelessly 'wooden'.

I think that the list has been missing something here and that the gut of a master craftsman (honed on massive experience) is a very different thing to the untrained instincts of a rat or lizard brain. Perhaps one of our resident psychologists can explain this!? Of course then there's a problem in identifying which is which, is it your rat brain working or the gradually awakening instincts of an apprentice craftsman?

The following position is an interesting example of Grandmasterly intuition vs. computer or the intuition of a weaker player.

1.d4 Nf6 2.c4 e6 3.Nc3 Bb4 4.e3 c5 5.a3 Bxc3+ 6.bxc3 b6 7.Bd3 Bb7 8.f3 Nc6 9.Ne2 0-0 10.0-0 Na5 11.e4

Chess computers (calculations unlimited) want to play 11...d6 here (11...d5 is also considered). Beginners will make the same choice. But the majority of Grandmasters will play 11...Ne8 without thinking about it for a second.

This move would not even occur to players below a certain level because it is a 'retreat'. So how come it would be the instinctive choice of Grandmasters?

Dr. Bill Egan responds:

The key for me is that in my profession I try to explain those feelings (I am a chemist/statistician who works in pharma on drug design). Dr. Brett has studied how to accelerate the learning curve in trading by exposing traders to many more trades/virtual days of trading to move them further along the learning curve than where their actual experience puts them. Similarly, in the last seven years I have spent much more time than many colleagues digging through the scientific literature and databases of molecules in order to better understand what makes or does not make a drug. This is a big help because it broadens my experience base tremendously. The situation for traders is that they need experience, but by the time they get it, they are broke. Study history, or you will just make all the old mistakes again. Someone else paid that tuition bill; don't you pay it, too.

When I look at a molecule a chemist is proposing to make, I often have a strong gut reaction. I have spent a great deal of time trying to understand my instinctual responses, and relate them back to the many studies of drugs, clinical candidates, non-drugs, and failed drugs I have performed. In each new study, I first get a gut feel from the molecules, and then work to explain and understand it. There are too many molecules (and too many days of trading) to memorize all the specific examples. What is the rule? Is it statistically significant? Is there a mechanism we know is valid, even in only a few situations? Is the molecule too greasy? Too polar? Both? This leads to insolubility and/or poor gut absorption. Do I like it because I have seen a similar core structure or chemical fragments among oral drugs? Do I think it is "weird" because that core structure/fragment has never been used in oral drugs before (or at least I don't recall it)? Is one of the parts of the molecule similar to part of a toxic drug or a withdrawn drug, and we know why it's bad? Is the fragment pattern for cardiac toxicity present? Unlike chess, drug discovery is a team effort, and I have to frequently explain to colleagues why I want a test done, or a molecule made, or not made, to get them to do it. Not so different from trading in a group, and dealing with the boss watching your trades or trying to understand the collective exposure/risks of all the traders- "why do you want to make that trade? why did you take that position, you idiot/genius?!"

Explain the gut feelings. Why do you like/not like the market action today? Drill down and ask specifics. Volume? Speed of move? Extent of move? Relation of move to recent action pattern? Some combination of all the above? And sometimes you can't, but you can still use the feelings if you have a solid base of experience to draw on while doing so. The mistake is using the feelings too early and not understanding them better, so you do something dumb. Young chemists new to the industry make all kinds of classic mistakes, and part of my job is to teach our new chemists the "lessons learned" so they don't learn them the hard way. Vic teaches that counting is the way to approach the market, and that is so correct, because it lets you explore these instincts, insights, and observations and test their validity. You learn the lessons earlier, and thus survive longer, and maybe even prosper.

Sushil Kedia responds:

Intuition and instinct in many of its qualified nomenclatures like for example, 'cop-instinct', 'woman's-intuition' etc. do bring to mind a question repetitively that has been to my mind answered in the positive by the GM bang on the point: "Is intuition a class of mental algorithms that are organized through experiences and which comes to elegant solutions without the mind having recognized the structure of those algorithms?"

Now, would someone agree at some point, 'experiences' are again modeling, testing and thus programming borne out of mind's observations. Mind, as Edward de Bono describes is a self-organizing pattern seeking system.

Connecting at this point the difference between seeing and observing that was discussed recently adds up to gaining perspective. I have 'felt' the gradual gain of perspective helps survive situations of deception in prices,

the false breakouts, the oscillations of the emotions that hits several times inevitably during the course of holding an average position and all things including oscillations in prices that are contrary to the direction of your trade.

Often read, "know not only the rules, but know enough when to break them". Guess, that level of consciousness is achieved when one starts attaining perspective - that is borne out of sharpened intuition, evaluated experiences and matured observing.

Gibbons Burke responds:

The tradecraft known as "Moscow Rules", complete with brass tacks, yellow chalk, and fallbacks, figure prominently in the plot of John le Carr's Smiley's People, the excellent BBC mini-series TV production of which is available on DVD along with its predecessor, Tinker, Tailor, Soldier, Spy. Alec Guiness becomes George Smiley in both. Highly recommended.

George Smiley: You are Counselor Anton Grigoriev of the Soviet Embassy in Bern, yes? Anton Grigoriov: Grigoriev? I am Grigoriev. Yes, well done! I am Grigoriev! And who are you, please? Al Capone? Who are you? And why do you rumble at me like a commissar? George Smiley: Then, Counselor, since we cannot afford to delay, I suggest you study the incriminating photographs on the table beside you.

With Apologies to Superchicken, by George Zachar

Composing alternative verses to fondly remembered childhood cartoon theme songs is better than "forcing" trades on a quiet day.

When you see a bunch of bubbles,
When the debtors ask for trouble,
When Donald Trump's the idol of all men.
There is someone frowning,
Who will hurry up and bury you.
His name... is Alan Greenspan.

If you think the curve is sacred,
And won't invert,
You're just a simple yield hog
and a carry pervert.

He will ratchet rates much higher,
And your outlook will be dire.
He'll retire to a book-filled den.
There is one thing you should know,
Before your clients' cash is blown,
Watch for Alan Greenspan!
Watch for Alan Greenspan!

Against all Odds, by Deon Gouws

Deon Gouws is CEO of Sanlam Multi-Manager, based in London.

Against all odds?

FA Cup Final, 21 May 2005: Arsenal beats Manchester United 5-4 in penalty shoot-out, after 0-0 draw

European Cup Final, 25 May 2005: Liverpool beats AC Milan 3-2 in penalty shoot-out, after 3-3 draw

In the past ten days, the supporters of two English football clubs had much reason to celebrate. Not only did Arsenal and Liverpool win two of the most important trophies in the game in a breathtaking five-day period, but both these teams also did so in a manner that defied all odds.

Numerous lessons for financial market participants were to be found in the FA Cup and European Cup finals, both of which ended in improbable penalty shoot-outs, with the spoils going to the eventual underdogs in each instance. If one equates betting on the outcome of a soccer match to investing in shares, I can just imagine the way in which the typical portfolio manager might have rationalised his "stock calls" to clients after one of the most amazing weeks in the history of English soccer. "This was never supposed to happen" he might say, or "no-one could have predicted such an outcome". The more statistically-minded ones might even go as far as stating that either or both of these results amounted to "six sigma events".

To be fair, the actual results in these two cup finals were not all that unlikely if one assessed the matches in advance of the kick-off (or on an ex ante basis, as investment professionals often like to say when they try and impress an audience). Not only had Arsenal, for example, finished higher than FA Cup Final rivals Manchester United in the Premiership, but they also did so by scoring more goals (at a much higher strike rate) than Sir Alex Ferguson's team. However, Thierry Henry, who had been responsible for most of Arsenal's goals this year, would miss the final due to an Achilles tendon injury. And don't forget that Manchester United were the victors the last time these two teams met in the league... All in all, one might say the match was quite nicely poised.

Fewer neutral followers of football, on the other hand, would have given Liverpool much of a chance before last week's European Cup Final. AC Milan was a team that practically owned the trophy, with their captain playing in his seventh final, having already been part of the winning team on four previous occasions. And against them you had Liverpool, a team that many (with the exception, possibly, of die-hard Liverpudlians) would agree should never even have been in the final: they qualified for this year's Eurpean cup by finishing only fourth in the Premiership last season (and then went on to slip one more position this season, finishing in fifth spot); they were also massive outsiders who had to beat some of the toughest teams in this year's competition, such as Juventus and Chelsea.

Before the match started, Liverpool knew that, in the very unlikely event that they went on to win, they would not even be able to defend their title as they had not managed to end high enough in the English Premiership this year. And they very nearly did not even get through to the knock-out phase of the European Cup, with Olimpiakos being a mere three minutes away from eliminating them before a sublime volley by captain Steven Gerrard saved the day. Then the team from Beatles country went on to beat more fancied rivals Bayer Leverkusen, Juventus and Chelsea in a succession of low-scoring matches, all with most unlikely outcomes. And there are of course still question marks about that last "goal" which put Chelsea out of the competition, the one that never actually crossed the line according to state-of-the-art computer analysis... Importantly, however, AC Milan looked jaded in their last few outings before the final following the disappointment of losing the 'must-win' match to fellow Seria A title contenders Juventus on 8th May. Arsene Wenger, the manager of Arsenal, even predicted that Milan would lose against Liverpool - was his opinion based on the five goals AC Milan had conceded in their last two league games? "Probably", as Carlsberg, the proud shirt sponsors of Liverpool might choose to reply!

Investment Lesson number 1: The most unlikely investment opportunities sometimes lead to the biggest gains.

It was however the way in which the victories of Arsenal and Liverpool were achieved that was beyond belief, defying all statistical analysis. The FA Cup Final has not finished in a goalless draw in more than 90 years, and the home of the trophy has never been decided in a penalty shoot-out (although it has to be said that the Football Association's decision which makes such a conclusion to the match possible was only taken relatively recently).

Investment Lesson number 2: The fact that something has never happened before, or that it hasn't happened for a very long time, does not mean that it won't happen next time when you choose to invest.

In addition, Arsenal only attempted four shots at goal in the 120 minutes of the FA Cup Final (including extra time), against the 23 of Manchester United. More importantly, however, United had eight shots on target (they even hit the woodwork twice!); this, compared to one singular attempt by Arsenal. Furthermore, United had no less than 12 corners, Arsenal again only one. And so one can go on: in nearly every important statistical category, the boys from north London were thoroughly outclassed and outplayed by their arch-rivals from Manchester... except of course in the final score-line. Arsenal might never really have featured in the match, but they did manage to take home the trophy; the surprised look etched on the players' faces after coming through the game and winning on penalties was there for all to see after Patrick Vieira scored his penalty.

All these statistics from the Arsenal-United encounter beg the question: if you could rewind the clock to the period between the end of extra time, and the start of the penalty shoot-out, who would you put your money on to go on and win the match? Yes, this is now an academic question, and many people might now pick Arsenal with the benefit of hindsight. But most analysts will surely agree that a bet on Manchester United would have been the most rational one at most points after the start of the match... even though this would ultimately prove to be a losing bet.

Investment Lesson number 3: Sound fundamental analysis does not always guarantee investment success.

A mere four days later, Liverpool took the field against AC Milan in the final of the European Cup. Everybody predicted a low-scoring match: Liverpool had, after all, not conceded a goal in nearly 300 minutes in this competition, and AC Milan are also notorious in defence. Surely the two sides would play a classic defensive match, hope for either a 1-0 win or at worst a 0-0 draw, and then try and emulate Arsenal's most recent achievement by winning on a penalty shoot-out. Or would they?

As it happened, 300 minutes without goals proved to be about as useful a statistic as historic rainfall numbers might have been at the time that Noah was building his ark. Less than a minute into the match, Milan's captain Paolo Maldini found the back of Liverpool's net. And before the half-time whistle blew, the score was 3-0. In the build-up to the match, there were many who said that Liverpool should never even have been in the fnal; by the time the second half started, most of their supporters probably wished they weren't.

I wonder if Arsene Wenger had actually placed a bet on Liverpool, given that he had made such a prophetic prediction a few days before the match? And if he had, I wonder if he stayed with his position when he saw the scoreline going against him (assuming he had access to a real-time betting exchange, on the internet for example, where he would have been able to close out his position at any stage in the first half of the match - albeit at a sizeable loss)?

Investment Lesson number 4: Some market winners will often look like losers for a very long time; the market will often test your patience and conviction as an investor.

Speaking of betting on the internet, it is interesting to note that losing bets amounting to GBP242,208 were matched on just one such site (Betfair) at odds of 1 to 100 at half-time, i.e. people risking 100 pounds (or multiples thereof) in order to win just one pound. In addition, a total of GBP249,407 were lost on Milan at odds of 1 to 50. In short, there were lots and lots of people who were betting that Milan could just not lose from such a strong position; this was a sure bet, if ever there was one...

Investment Lesson number 5: There is no such thing as a "sure bet" in the market.

But it's also important to remember that this form of betting is a zero-sum game, and there was an equal number of hopeful punters who were taking the other side of a bet which may have seemed most unlikely at the time. The rest is of course history: in six glorious minutes at the beginning of the second half, Liverpool drew level, and they went on to win the most nerve-racking of penalty shoot-outs. Those who were betting on the long shot at half time were indeed handsomely rewarded...

Perhaps the most important lesson of all, is that many of those outcomes that appear the most unlikely, do in fact occur much more often than most of us would ever guess. This is true in sport, it is true in the stock market, and it is true in life. Tiger Woods does not win every golf tournament, and even Warren Buffett loses money sometimes.

It is in fact not possible for the human brain, even when armed with the most sophisticated quantitative techniques and computer processing capability, to estimate the true probability of a range of uncertain outcomes. It seems trite to say that there is never actually any certain answer before the event, but this is in fact the reason why financial markets exist in the first place. And this is also why none of us should ever put all our eggs into only one basket, or expect of any portfolio manager to consistently perform better than all others.

Jens Carsten Jackwerth and Mark Rubinstein, as quoted by Roger Lowenstein in "When Genius Failed" (an excellent book describing the failure of hedge fund firm Long-Term Capital Management in 1998) state that, based on historic volatility, the odds would still have been against the now-famous stock market crash of 1987, even if the market had been open every day since the creation of the Universe. "In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically 'unlikely'" (Lowenstein, 2001, p.72).

Yet, it happened. And, of course, many investors lost huge amounts of money in the process. What's more, chances are that, one day, something like that might happen again.

In the meantime it is however important to make hay while the sun shines. Which means that investors would be well-advised to follow a diversified strategy, to place their money with proven and trusted managers, and to have realistic expectations.

You might not agree; you may in fact believe that lightning never strikes in the same place twice. In which case you should probably never bet on Liverpool again, either. But, as some of my friends who have steadfastly refused to take off their red shirts over the last seven days now insist, you will do so at your peril...

The Four Percent Solution, by George Zachar

For round numba groupies, in bondland we're wearing a groove in the screens as benchmark on-the-run 10 year treasuries re-re-re-flirt with the four percent yield level, but can't seem to trade though and print with a three percent "handle".

I have no deep thoughts here, other than musing about what notions are running through the minds of the Fed Chair and the Sage today.

Sogi-won-jim-sogi reports from the Pololu system:

Oh Masters of the Speci Council. I send greetings. The Speci Knights perform well when Fear and Confusion do not cloud their judgment in difficult situations. Mastery of the physical aspects of their counting skills and mastery of themselves, their emotions, give the power to perform calmly and well under difficult circumstances against powerful opponents. Greed and jealousy avoid, we must. Counting, practice it, you should.

Fear, pessimism, negativity all lead to the short side. An imbalance in the Market-Force, there is. Sense the Short-Side strong, I do. Beware the Short-Side of the Market-Force.

May the Market-Force be with you.

For NYC flora lovers, by George Zachar

During my tour of the Rose Garden at the NY Botanic Garden today, I learned that every year the facility manages its bloom/blossom schedule to generate a floral explosion for the last week of September, to coincide with a fundraising extravaganza.

As autumn is counterintuitive for such an exposition, it's likely a good time to go up there for some uncrowded flower gazing.

On the Euro, by Shui Mitsuda

I lived in Europe between 1972 - 1976 and 1988 -1994. I traveled in over 20 countries by rail and was amazed by the difference in people's behavior, just across the country border.

Germans and French are very different. Swedes and Spaniards, Turks and Norwegians are nowhere near. Even within Italy, northern Italians and southern Italians behave differently, and likewise in Yugoslavia as the Bosnian war proved.

In 1992 I never thought single currency concept for the EU would be possible, simply because productivity of each country in Europe was so different and yet every government wanted to take hold of the power of currency control. In fact who is currently controlling the euro currency? I wonder.

Anyway my European colleagues say the single currency system has smoothed business transactions tremendously across Europe.

Despite the difficulty, I hope the European currency will be successful, because it sets the example of my dream. Though it is unlikely, my biggest dream if for a single currency for the whole world - fair opportunities for all.

Ask the Chair

Allen Gillespie: I believe the lastest Sports Illustrated requires me to ask the Chair for his thoughts.

"Baseball's Incredible Shrinking Slugger (It's not just the juice) Why the Home Run Era is Going...Going..Gone."

Key article points and stats:

Compared to last year:
1) Complete games up 50% through May 22
2) Complete game shutouts up 47%
3) Runs per game down 4% (down 15% from May 22 of 2000)
4) Home runs per game down 9% (down 25% from May 22, 2000)

At the current pace home runs will be down 668 this year and down 910 compared to 2000.

Cardinals pitcher Matt Morris says, "That pitch down and away is a fly ball out, whereas five years ago it was out of the park."

"This year 38 of the 62 pitchers with an ERA better than 4.00 are in their 20s."

"People are going to put it at steroids doorstep," Astros manager Phil Garner says. "But I see better pitching coming into our game, and I think the offensive numbers would have been down no matter what. I think we're going to go through the Decade of Pitching now."

Protectionism is no Dead Horse, by Don Boudreaux

Sadly, protectionism is no dead horse. So as long as it's still kicking, I'll kick it back.

31 May 2005
Editor, The Washington Post

Dear Editor:

According to Rep. Sherrod Brown ("An Unbalanced Trade Policy", May 31), improving the well-being of people in poor countries requires legislation and treaties that guarantee worker safety, clean environments, and other benefits that we Americans enjoy. Therefore, he opposes trade agreements that do not mandate such benefits.

Rep. Brown has matters backwards. Safer working conditions, cleaner environments, higher wages, and most other material benefits that people everywhere desire are not and cannot be prosperity's preconditions. Rather, they are prosperity's results. Because freer trade is key to increasing prosperity, Rep. Brown's rejection of freer trade with poor countries helps condemn people there to the very tribulations that he claims he wants to save them from.

Sincerely, Don Boudreaux

Forbes CEO Compensation, 2000-2005, by Gabe Carbone

The tendency for markets to work harder and reverse after a bad year has been well-documented in both EdSpec and PracSpec. Contrary to the idea that performance reflects pay, I hypothesized that low-paid CEOs will show a tendency to "work harder"; and that their companies' stock prices would benefit from same.

To test my hypothesis, I examined the Forbes CEO compensation survey from 2000 through 2004. The ranking information is available on or about May 1 of a given year, so I used stock price performance from May 1 through Dec. 31 of a given year. I compared the performance of the companies with the top 10 highest paid CEOs with the performance of the bottom 10 paid CEOs.

In summary, the low paid CEO companies did underperform the high paid CEOs over the period, although the results were not significant. Interesting as well is the performance of the 10 low-paid stocks relative to market in any given year, as they beat both the high-paid stocks and the S&P in every year except 2000, where they underperformed badly. Results below:

Average (%) Return by Year and HIPAY/LOPAY Classification:

2000200120022003 2004MeanStdev
HIPAY-9.9-16.7-20.9 21.8 11.5-2.6 31.4
LOPAY-32.5-0.8-16.9 43.8 29.6 3.8 49.7
S&P-3.9-10.0-19.8 17.4 5.4

Citarella opening in Harlem, by George Zachar

High-end NYC grocer Citarella is opening an outlet on West 125th St.

While I always expected Harlem to "come up", I never quite expected to see *this*.

Tony Corso responds:

They are next door to Fairway on the Upper West Side, and now they are next door to Fairway in Harlem . . . . . this is under the iron work overpass of the Riverside Drive [the ironwork that holds up the drive as you pass Grant's tomb] Dinosaur bar-b-que is right nearby and a great place to watch a game and grab some ribs and beer on a Saturday afternoon whilst your better half is shopping Fairway and Citarella. . .['though "RUB" bar-b-que on 23rd street is easier has prettier scenery, possibly better bar-b-que, and the additional attraction of deep fried snickers and Ore os]

An In-Depth Look into Mark Hirschey's Book "Tech Stock Valuation" by Victor Niederhoffer

It is a pleasure to recommend the book Tech Stock Valuation by Mark Hirschey as one of the best books on investment of all time and a worthy successor and follow-up read to the Dimson, Marsh and Staunton book, The Triumph of the Optimists. Hirschey's book contains 10 chapters:

  1. The Tech Bubble
  2. What Caused the Tech Bubble?
  3. Investment Advice on the Internet
  4. A Dissertation on Tulips and America Online
  5. The Crash of 2000-2002 and Imminent Rebound
  6. Stock-Price Effects of Research and Development Expenditures
  7. Valuation Effects of Patent Quality
  8. Goodwill Write-off Decisions: Do They Matter?
  9. Shark Repellents and Research and Development: Does Management Have a Long-Run Perspective?
  10. Corporate Governance and the Legal Environment

In an interview with Mark Hirschey, he told the Chair the lessons he'd like the reader to come away with after reading the book are:

  1. Most stocks, most of the time appear to be fairly priced. There are always a few, say 30 or more, that are out of whack with economic reality. They might be outright frauds, or short squeezes, or unfairly dumped long-term winners. What was so unusual about the market peak in 2000 is that 30 stocks with silly prices were so big.
  2. In the long run, stock prices follow economic fundamentals. In the short run, investor psychology can take over.
  3. Investors should be fearful after periods of exceptionally positive stock-market returns; investors should be greedy after periods of exceptionally negative stock-market returns.

The interview started with the following exchange:

Chair: "What is the foundation for your work in this field?"

Hirschey: "That knowledge of microeconomics is the key to success in investments. That things like barriers to entry, the structure of an industry, the stages, the cross elasticities, competition, pricing practices, are the key variables. It's amazing that economists like Stigler, Caves, Porter, haven't applied their work more directly to investments. However, the greatest micro-economist of all time is.. . Warren Buffett." (Every year, Hirschey leads a pilgrimage of his students to the Berkshire annual meeting in Nebraska as a practical tribute to the Sage.)

Those who know the Chair's thoughts on this subject will realize that Hirschey's views are not geared to garnering a favorable review, but it's a mark of the book's excellence that despite Hirschey's completely erroneous and harmful views on this subject the Chair can still recommend the book, along with the Aswath Damodaran's Investment Fables: Exposing the Myths of "Can't Miss" Investment Strategies as among the best of the last five years.

The problem with most investment books is that they are either written by practitioners who don't have the scholarly background to support their points with analytical principles and scientific inquiry, or scholars who are so far behind the form or out of line with reasonable applications that the book belongs in an ivory tower. The former are motivated in the main by a desire to promote their current or future activities in the field, and the latter by an effort to cement their positions, or memorialize their previous credentials.

Hirschey gets around this because he is a practitioner. He is the kind of researcher who likes to go through Value Line page by page to find great undervalued stocks that have been hit by a one-off event and are ready to bounce back when the problem is solved. He has obviously lived and lost and made a fortune in the tech bubble, and is wealthy enough and has written enough (his book on Managerial Economics is a classic, already in its 10th edition) and is established enough as a professor at the University of Kansas that he has no need to impress.

The heart of the book's argument that tech is ready to rebound is contained in Chapter 5. The book was published in 2003 and was finished in the middle of 2002 when the Nasdaq 100 was hovering at the 1000 level, down from 5000 in April 2000, amid calls for Nasdaq 300 by the chronic bears, the cults led by the Weekly Financial Columnist and by Hirschey's mentor. The current level of 1500 vindicates Hirschey's main point.

However, the thrust of the argument is a statistical one -- that annual returns in the major averages tend to be negatively correlated. That since the Nasdaq was down 50% by the end of 2001, an imminent reversion to the mean was in the cards. The problem with the author's evidence on this score is that it is highly dependent on the time period and methodology chosen. The author carelessly glosses over such things as the fact that it is guaranteed to happen that after "a sustained market correction" a bull market is likely (in retrospect), and after the 10 worst markets it is likely that no subsequent months will be among the worst. His use of cumulative overlapping 12 month returns (see chart below) is also guaranteed to lead to the appearance of spurious cycles as Slutsky and Yule have pointed out in their academic papers on spurious cycles in moving averages, and all technicians using oscillators and stochastics find out in practice.

He reports as statistically significant a negative 10% correlation in annual returns for Nasdaq from 1971 to 2002 but with only 30 observations the standard error of the correlation coefficient is approximately 2.5 times as great as the retrospective time sensitive correlation he observes. (Indeed an investor who bought Nasdaq on its negative path from 5000 to 1000 based on negative correlation would have found himself a dead duck)

Hirschey's argument for the the rebound in Nasdaq is on much firmer ground with the foundation he lays from microeconomics, with such factors as: stocks in industries with high barriers to entry can maintain higher returns than those with few barriers, that technology and patents make for great barriers, that the major technology companies are becoming like the phone companies of the past as computers become used for communications as well as computing, and that because of the risk involved with constantly changing technology tech investors are graced with higher returns.

The chapters on how investments can be geared to balance sheet analysis are refined and resilient. Particularly interesting is the post-announcement effect on goodwill write-off, where negative moves of 11 % after the announcement continue over the next year. The results on corporate governance and enforcement actions by the SEC are not as clear-cut, as most of the effect occurs during the announcement period, and the effects after the announcement are marred by multiple comparisons.

The Shark Repellent chapter, while very interesting, is also not as useful. The major conclusion is that companies adopting them are good companies with better than average performance measures. Similarly, the chapters on research and development and patent quality while highly suggestive from a barrier to entry economic analysis standpoint but are too granular for any practical investment conclusions to be drawn.

Some of the best chapters in the book involve a description of the woes of the Japanese Economy and AOL, and the excesses of the Tulipmania. The anecdotes here are interesting but the problem is that it's hard to find a bubble prospectively. And despite his poor results from shorting, Hirschey does not draw the conclusion that one should never short stocks as the inevitable upward tidal movement over time, and the irrational heights that bullish sentiment can reach, are too difficult to overcome.

The book raises so many interesting points, the analytical framework is so good, and the presentation of the data is so clear-cut, that despite my reservations about much of the methodology, and many of the conclusions, there are golden nuggets available, lines of inquiries to pursue, and potential investments to make for all readers. This book definitely belongs on every investors' bookshelf.

Mark Hirschey adds: I greatly appreciate your kind comments on my Tech Stock Valuation book. Still, your comments make me think I could be clearer in making my point.

In Ch. 5 of my book, I try to distinguish between the familiar statistical "regression to the mean" concept, and what I call "return reversal." They are distinctly different. The return reversal concept is based upon economic theory concerning the mean reversion in business profits over time, and the overreaction hypothesis, which is based on investor psychology.

1. For both companies and industries, expansion and contraction occurs based upon the relationship between the internal rate of return on investment and the marginal cost of capital. Capital expenditures rise when the internal rate of return on investment exceeds the marginal cost of capital. Capital expenditures fall when the internal rate of return on investment is less than the marginal cost of capital. At any point in time, firm and industry profit rates vary widely. Over time, however, expansion and contraction cause these profit rates to converge toward the overall average annual rate of return on invested capital. During the twentieth century, the overall average annual rate of return on invested capital has averaged roughly 10 per cent per year. During the Post World War II period, the overall average annual rate of return on invested capital has averaged roughly 12-14 per cent per year.

2. Experienced and rational investors know that competitor entry and growth in highly profitable industries with minimal barriers to entry causes above-normal profits to regress toward the mean. Conversely, bankruptcy and exit allow the below-normal profits of depressed industries to rise toward the mean. However, inexperienced and emotional investors appear to extrapolate recently good or recently bad industry performance into the future. This causes positive overreaction and stock prices that are "too high" in periods following robust firm revenue and earnings performance, and negative overreaction and stock prices that are "too low" in periods following poor revenue and earnings performance

3. For some investors, especially those with a strong background in statistics, the idea of return reversal in market returns might be misinterpreted as a simple "regression to the mean." However, the statistical regression to the mean concept fails to explain return reversals in the S&P 500, where returns following vicious bear markets substantially exceed long-term averages rather than regress toward long-term market norms. The regression to the mean concept also fails to explain return reversals in Nasdaq following vicious bear markets and boisterous bull markets.

In short, the statistical regression to the mean concept predicts normal stock-market returns in periods following either abnormally good or abnormally bad performance. The return reversal concept, based on economic theory and investor psychology, predicts abnormally good long-term (12-month) returns following long (12-month) periods of abnormally bad stock-market performance. The return reversal concept also predicts abnormally bad long-term (12-month) returns after long (12-month) periods of abnormally good performance.

Nobody should be surprised about the lack of negative serial correlation in daily, weekly or monthly returns. That's just noise. For the effects of investor psychology to come into play, longer time frames must come into play. Bull markets have height and duration. Bear markets have depth and duration. In a bear market, like 2000-02, investors eventually "puke out" their positions when the bad news never seems to stop. You could say that I looked at 12-month returns to get a simple and convenient handle on return reversal over an arbitrary "long" period. However, many investment managers are paid on an annual basis, and my results suggest that 12-months may be as much indigestion as the pros can stand before "puking" out their losing positions.

I was predicting abnormally good tech stock performance in the period following 2002, not merely normal market returns.

I hope this clears up my point.

Vic asks Professor Hirschey:

I wonder if your worship of your mentor extends to his analysis of balance of payments accounting and his reasons for being short the dollar, as well as his avoidance of individual stocks?

Professor Hirschey responds:

I also enjoyed your comments about Buffett. My college-age daughter Jessica jokingly refers to Buffett as my hero. I've followed him since 1969, hold lots of BRK.A (but less than Jimmy Buffett does), and carefully consider everything he has to say. He's a really smart guy, and I do find him interesting, but the "hero" idea seems a stretch.

He's had an odd personal life, living in Omaha for years with a woman that his wife (who lived in San Francisco) introduced him to. Buffett has also had a much less than ideal relationship with his kids, which put his current comments about the importance of family in an interesting light. He's older and perhaps wiser now, and trying to make amends, I guess.

Buffett has also made lots of arbitrage investments that do not square with his public persona to buy and hold quality companies. Buying into the airlines (US Air) and the investment bankers (Solomon) with convertible bonds were mistakes, despite the advantages of fixed income instruments for an insurance company. Buying shoe companies was also a (now admitted) mistake; I think he may also come to regret taking on a big position in furniture retailing, a business that is now morphing into very risky electronics retailing. Power utility stocks look like a sensible way to 10% returns going forward, but they are no path to big returns, that's for sure. Buffett's currency bet is a big departure for Berkshire shareholders. I also think it's a bad bet. I could be wrong, of course.

IMHO, Buffett is very, very good. He's also been very lucky at key points (Washington Post, Cap Cities, Buffalo News). He's been very good and very lucky. His $43.2 billion payoff is at the way upper tail of a reasonable distribution of what might be expected. I've attached a spreadsheet that might give some perspective on Buffett's performance. As $43.2 billion, Buffett's results are such an incredible outlier that they just shouldn't be able to occur (you really couldn't flip a coin and get heads that many times). The only way I could get any kind of odds on it was to set up the simulation assuming that you have the best of the best manage a portfolio with an average return of 15% with a standard deviation of 20% and let them take over in 1966 with $25 million. If you would have done that you would have had a 3.74% chance of ending with $43 billion. The catch is, of course, that Buffett earned a 29.5% annual return for 13 years to get to $25 million in 1966.

Essentially, most mortals have little chance of becoming the next Warren Buffett. Not me, for sure. I'm working real hard, and I'm not worth 1/10,000th as much.

Alacritous Buying, by Victor Niederhoffer

The alacrity with which the managers are rushing to take the remaining contracts and shares at the 1200 S&P level reminds me of what Art Bisguier always used to say after I got myself into a bad position and then reflected as I tried to get out of it: "Now... you're thinking ?!"

Much more helpful was the approach of Tom Wiswell who would scratch the cap or cane 50 moves before and quietly say "You have a good move". Such can help you build a stately mansion on the "board".

Up the Ladder, Down the Chute, by Chris Hammond and Charles Pennington

Laszlo Birinyi's firm recently prepared a table that partitioned the time from 1962 through the present into periods of rally and decline for the S&P. Among the questions it suggested, one of the most prominent was "Is this behavior consistent with randomness?" Before we could begin to answer this question, we had to first decide how to reconstruct the data using some algorithm. Using monthly data for the S&P since 1953, we settled on the following procedure:

  1. Select a point as being a potential maximum if the price of the S&P at the close of the month is greater than the price at the close of the previous six months as well as the next six months (which means, of course, that one cannot identify such a point until six months after it has occurred). Minima are selected in the same fashion.
  2. Order the set of all maxima and minima. If there are several maxima before a minimum, throw away all but the last one. Do likewise for minima. One is left with a set of points partitioning the time from 1953 to 2005.
  3. The periods from a minimum to a maximum will be called rallies, and the periods from a maximum to a minimum will be called declines.

The results of performing this procedure to the S&P are shown below. For each period, we take note of its duration in months, and the annualized percent change in price over the period. This provides a reasonable approximation to the Birinyi table. However, it is also a little finer, giving us a larger data set.

In order to address the question posed, we found the percent change over each month, and we stored it in a list. We then simulated the S&P time series by starting at the same initial value and moving to the next month's value by randomly selecting one of the percent changes in our list and using that as the current month's percent change. We sample without replacement, i.e., we use all of the same values but in a random order. We perform our algorithm on each of the simulated time series and keep track of the data. Twenty trials were performed.

We find a significant distinction between the actual S&P data and the simulations. The average duration of a rally in the S&P is 22 months, and there were 17 rallies. For each simulation, there was an average rally duration. Taking the average of these yields 15 months, with 25 rallies on average. The standard deviation is 3.4 months. The actual value for the average rally duration is about 4 standard deviations away from the mean, a significant finding. This indicates that actual rallies tend to last longer than in the simulations.

This could be the result of correlation in returns between successive months, meaning that when you are rising, you tend to continue doing so, making for a longer run. When you remove these correlations, you get choppier time series. However, there are some misgivings regarding this approach. One objection is that "If its not predictive, then it is consistent with randomness," and our study has no predictive value. These are questions that ought to be addressed and which will require significant thought.

Table 1: Rallies and Declines in the S&P 500 Since 1953, Monthly Data

                           Duration        Annualized Return
Stage     Start   End      Rally  Decline  Rally Decline
Rally     Aug-53  Jul-56      35            0.29
Decline   Jul-56  Feb-57               7           -0.20
Rally     Feb-57  Jul-57       5            0.28
Decline   Jul-57  Dec-57               5           -0.35
Rally     Dec-57  Jul-59      19            0.30
Decline   Jul-59  Oct-60              15           -0.10
Rally     Oct-60  Dec-61      14            0.29
Decline   Dec-61  Jun-62               6           -0.41
Rally     Jun-62  Jan-66      43            0.16
Decline   Jan-66  Sep-66               8           -0.25
Rally     Sep-66  Sep-67      12            0.26
Decline   Sep-67  Feb-68               5           -0.17
Rally     Feb-68  Nov-68       9            0.29
Decline   Nov-68  Jun-70              19           -0.22
Rally     Jun-70  Apr-71      10            0.54
Decline   Apr-71  Nov-71               7           -0.16
Rally     Nov-71  Dec-72      13            0.23
Decline   Dec-72  Sep-74              21           -0.30
Rally     Sep-74  Jun-75       9            0.71
Decline   Jun-75  Feb-78              32           -0.03
Rally     Feb-78  Aug-78       6            0.41
Decline   Aug-78  Oct-78               2           -0.43
Rally     Oct-78  Nov-80      25            0.22
Decline   Nov-80  Jul-82              20           -0.15
Rally     Jul-82  Jun-83      11            0.63
Decline   Jun-83  May-84              11           -0.11
Rally     May-84  Aug-87      39            0.27
Decline   Aug-87  Nov-87               3           -0.76
Rally     Nov-87  May-90      30            0.20
Decline   May-90  Oct-90               5           -0.34
Rally     Oct-90  Dec-91      14            0.31
Decline   Dec-91  Jun-94              30           -0.02
Rally     Jun-94  Aug-00      74            0.22
Decline   Aug-00  Sep-01              13           -0.29
Rally     Sep-01  Feb-04      29            0.04

Average                     22.1    12.3    0.31   -0.25

Table 2: Results of Simulating the S&P Time Series

           Rallies                              Declines
           Number Duration  StDev   Annualized  Number Duration  StDev   Annualized
                                    Return                               Return
Average     24.55    14.94  11.80   0.33         24.55    10.40   8.74  -0.23
StDev        2.52     1.68   3.40   0.05          2.40     2.04   3.11   0.03
StErr        0.56     0.38   0.76   0.01          0.54     0.46   0.70   0.01
Actual         17    22.06  17.47   0.31            16    12.29   8.94  -0.25
T-score     -2.99     4.23   1.67  -0.41         -3.57     0.93   0.06  -0.64

Summer Reading: Jack Welch's Winning and Bill Gross on Investing, by Victor Niederhoffer

"Winning" by Jack and Suzy Welch has a testimonial from Warren Buffett on the front cover -- "No other management book will ever be needed" -- and that says it all. If you really believe the way to run a business is to try to be No. 1 or 2 in every division and to the devil with rates of return, and if you really believe that you should tell by words and deeds one-tenth of the people that they're on the firing list, and another eight-tenths they're drones, and another one-tenth reward with celebrations and perks and options, you'll love this travesty. 

"Bill Gross on Investing" is even worse. Almost every page is pure egotism, Dow 5000 is here unless you buy bonds, and untested dogma to help his positions along, leavened with religious and hateful dogma. The one good thing is the anecdote about his son Nick who, when asked by the father what would be the one thing he would like most from G-d, said it would be "not to go to church."

Greg Cohen comments:

I bought and read "Winning" after Jack Welch came to Wharton to give a lecture on "leadership" and the like. Unlike the gracious authors of PracSpec, Welch pretty much used his entire speaking opportunity to promote his book and probably came on the condition that the school bought tons of his books, which he spent hours signing after his talk. I did not get the book signed but lots of people waited in the long line to do so.

Consensus was that his speech was not that great given he was "manager of the century" and the No. 1 choice to join a company board. Instead, he was rather unprepared and spent a lot of the time talking about how he should have fired people sooner than he did; note: when you fire someone, don't allow them the easy way out by citing personal problems; hang them for all to see and let everyone know they screwed up so it doesn't happen again; defending his ethics; note: he received the apartment, use of the plane, the rest of the compensation package five years before he retired; and talked about things like the 4 E's (stuff which is obvious) and the standard plug of Six Sigma (although not in detail); and how he actually blew up a plant in Pittsfield back in the day.

Perhaps the most amusing part of Welch's talk, however, was when the interviewer asked him to defend his ethics regarding the comp package and his affair with Suzy, who was head of the Harvard Business Review at the time, etc. To an eruption of applause he said, You want to ask me about ethics? Why don't you ask my wife! And pretty much dodged the question as far as I can remember. But I only heard him for an hour in a talk at a business school, not a great place to see the man's persona when he is actually at work.

Laurel Kenner adds:

Some of the maxims in "Winning" seem reasonable, if a bit obvious (e.g., "reward good performance with money and recognition"). Recommended Practice #1, "Elevate Human Resources to a position of power and primacy in the organization," is usually a tip-off that a company is about to start sliding toward mediocrity. As Greg's report suggests, Jack does go into great detail on firing -- but that's the sort of thing that the HR types spend a lot of time writing detailed procedures for in their manuals, which are typically pastiches of other HR manuals from completely unrelated companies.

The chapters on strategy all sound very fine, but I recommend Dr. Ross Miller's insider account Rigged, available free online.

Strategy and Tactics, by Nigel Davies

Strategy and tactics require two entirely different types of thinking. A good strategist needs to see ideas in flowing, general terms whereas a tactician must be very concrete.

Usually people are capable of either one or the other and at some stage find themselves coming up against barriers to improvement. But the best players can do both and integrate these two aspects seamlessly.

Why Count? And, Count What? by Hanny Saad

There is no doubt that counting, testing and quantifying plays a significant role in trading. I would be the last person to argue this fact (I am using the word fact here in the Popperian sense) as I try to incorporate the scientific method to the best of my limited abilities. Counting is the cornerstone of many of the list's speculators and Vic's correspondents.

I would like to go back to the basics of counting. I don't mean technical definitions of standard deviations, Z scores and so forth (you can find that in any decent stats book). What I mean here is the whys and whats of counting.

Why do we count? The "why" in my mind is not so complicated. We count to gain an edge in the markets, a verifiable and testable edge. It's as simple as that. 

What do we count? This is the more complicated question. What do we really count? Is it only today's price action compared with yesterday's, last week's, last month's or some other period? In my opinion it's more complicated than that. This is where my theory of observing versus seeing comes in. This theory plays an important part in my trading. In order to make my point clear, I have to cite a couple of stories that taught me much.

I was approached in 2002 by a trader who labeled himself "a quant". He showed me, by the numbers, how similar this "1999 bear market" is to the 1929 crash and how we will not recover for a long time. His presentation was very eloquent and convincing as he "saw" and made me "see", by the numbers, the similarities between both periods. He saw that in his charts but didn't stop to observe for a minute that the market evolved much since 1929 and that any testing for more than 5 to 7 years back is almost irrelevant since neither the economy nor the stock market is static; both are constantly evolving, dynamic animals. The market evolved a million times since 1929 or it would have not survived today. His naive counting made him very confident to sell short and hold. I got the same pitch from chartists, value investors, and quants. The chartists "saw" similarities between the charts of the two periodsts, the value investors couldn't find value anywhere around and the quants were counting the wrong thing to reach the wrong conclusion.

I was reminded of this story as I read the Anonymous Mapo Tofu Chef's magnificent post about China. It's magnificent because not only is the analysis so comprehensive but it's contrary to the mainstream public opinion. While the globetrotting capitalist (and very public personage) saw value in China to the point of trying to learn Chinese and hiring a nanny to teach his infant daughter Cantonese, the Mapo Chef observed bureaucracy and corruption.

My second story is unrelated to trading but makes the same point of "seeing" versus "observing." The Egyptian president Nasser allied with the Russians in his wars against Israel that ended in a shameful defeat of the Egyptian troops. He found the Russians, unlike the Americans, organized and trustworthy as they always went through the proper channels of communication before signing any deals whether related to arms or otherwise. While Nasser "saw," his successor Sadat, on his first dealing with the Russians, "observed" how bureaucratic they were and how allying with them could be detrimental to his plans and the speed of his actions. He left Russia surprised how a nation with this much bureaucracy not only survived but became one of the two major world powers. He predicted openly to the government officials who accompanied him on his trip a fall of the Russian empire. Remember, this was in the '70s. Sadat subsequently expelled the Russians and allied with the Americans. While both men looked at the same thing, one "observed" and one "saw."

The moral: While counting is a major factor in trading, a trader, in order to stand out, has to count and test what he observes and not what he sees. You see, everyone sees the same thing but what sets us apart is observing. The more indirect your observation the higher the profit possibilities as long as it's counted and tested. Analogies between trees and markets, animal kingdom and markets, purchases of certain eBay high-end items and tops and bottoms are all indirect observations that if quantified, tested and verified can be more profitable than following the obvious chart that everyone else looks at.

Tom Ryan comments:

I believe that forensic sciences, such as archaeology and, yes, geology, can help us in our counting to the extent that these are sciences that very much rely on counting of things, but show us how the counting is most effectively used when that counting is put into a context. This is also one of the more important lessons at the University of Hard Knocks. You can count, but without placing it within a context, "your mileage may vary" -- e.g., a recent mention of the positive context between bonds and the refunding at this particular time of year.

For another example, one could count three-day patterns for stocks for all data going back for so many years, or one could look at the same three-day patterns for the context when bonds were up in that period versus down. Or you could look at the context of the number of days expired since the last big down day, or the context relative to the time expired since the last x-day hi/lo, or the proximity to the x-day hi/lo.

In the markets can be observed an infinite variety of ever-changing circumstances or contexts that go beyond the pure "if-then" nested loop in the code of your choice. The Chair often posts many of these contextual ideas with the hope that we will pursue such clues with some follow-up counting. I take this as what Mr. Saad means by "observing."

And this is of course another reason why fixed systems ultimately fail, as they don't take into account the ever-changing circumstances around which prices form during the course of the trading day, week, month, year, as prices in markets don't form in a trading pit vacuum (OK, well, sometimes for brief periods but....) but rather in a web of relationships between securities, industries, trading desks, firms, currencies, swaps, contract expirations, etc., etc.

I am reminded of a sunny morning in the 1960's when I was on a hunt with my father on the Kaibab plateau. Walking casually through the bush, my father suddenly unslings his rifle off his shoulder and into his two hands and takes the safety off with his thumb. I whisper, "What?" and he says matter-of-factly, "Wind has picked up and is now behind us."

Every Tick Tells a Story, by James Sogi

Like the law, the market slices through the middle of life. Every tick tells a story. All the participants, like drops of rain joining together to form an ocean, interact, join and flow to form the markets. Each tick is memorialized in real time before us each day, but is more than just an empty blip on your screen; it represents the fulfillment or loss of someone's hopes and dreams. It's the young girl going to college on profit from SUNW; it's the retiree's last Social Security check gambled on a market  longshot. Let's take a little trip through the magic quote screen and see the stories behind the ticks.

Downtick 1. Their mother had been suffering from cancer for years. In the 40's, when she was a secretary, her boss had given her a few shares of a penny stock for a new fangled invention. Just a longshot, called International Business Machines. They made adding machines used at the office. The mother had lived her retirement in comfort and style on this one stock holding, which over the years had ballooned into a fortune. On her death, the children sold the last lots to pay the medical bills. It was straw that broke the camel's back as IBM gapped down 10 points.

Uptick 2. The partner was coming home that evening from a seminar on which he was a panelist. Many in the audience that evening had agreed with his pessimistic presentation of the market, and a few young traders had come up after the program to describe their short positions. He knew it was time to cover. The market had been dropping relentlessly for nearly a month. His traders had hammered every pop, but as it hit the yearly lows he instructed the traders that morning to look for a spot to cover. As the market dropped through the bottom of the yearly low, they bought, in quantity at 2:37. The market rallied 1.5% in an hour.

Downtick 3. The market had been dropping for a month. The atmosphere at the retail brokerage was grim. Clients no longer stopped by for coffee and for a chat. The broker wasn't calling to chat anymore, the phone calls were margin calls. The image I get is the herd running for the door, panicking, looking over their shoulder at the tsunami, just as the pros above were covering above. The broker told his clients, You know, it's a good time to buy, but they stared at him in disbelief.

The stories are varied and endless and could make a great screenplay. It helps to know the life of the markets and helps to see, not just to observe.

Schismogenesis, by Mark Mahorney

With hedge funds regressing to the mean, who will make the wealthy feel special? Are there public companies that stand to profit in this niche? Perhaps the old auction houses and international real estate companies, Sotheby's et al.

When junkyard Joe antes in to the same fund as old-money Anthony, I suspect Tony's going to go where the highbrow horde goes.

What Color Swan? by Steve Wisdom

It's been 22 trading days since the last down open to close day in INTC:

28-Apr-05 23.3323.20-0.13
29-Apr-0523.36 23.520.16
2-May-0523.5123.54 0.03
5-May-05 24.1524.250.10
6-May-0524.43 24.490.06
9-May-0524.4224.80 0.38

Textbook "Professional" Market, by George Zachar

Today, the front end of the credit market was influenced by:

The long end was influenced by:

A Note from Hobo

Diesel Dyson, my grinning partner, is proving to be a capable traveler. Crazy good trip. Long bus rides in southern Canada for days. Caught a freight in Saskatoon in the rain, icing through the mountains. Greeted next day by Edmonton Mounties and expelled, though not after one seemed to be convinced to try hoboing. Bus pass was the answer, combined with hitchhiking. Just had a ride with macabre Maude of Harold & Maude along the Alcan Highway toward Alaska. Dumped last night along a junction in a hailstorm in green Yukon. Walked to Watson Lake (at the library now) where a native who was stabbed by his wife for cheating just provided the rest of the tribal rules -- in case we choose to join, I suppose. Folks are nice in this neck, although the hitching is dismal. We walked three hours to get to Greyhound, me with a calf cramp from recent hiking training, and we'll catch a bus tonight to Edmonton. We'll continue on our bus passes to Calgary, then we'll hop a freight to Vancouver.

Understanding the Movements of the Dow, by Victor Niederhoffer

It is interesting to contemplate the occasions when the Dow has not been above its level many years before. Such periods are of interest of course to those of a doomsday bent because they can immediately proclaim such things as "Ha, ha, in 30 of the last 100 years, you would have lost money if you had bought the Dow 6 years ago, and held until some time in the month. Stuff your buy-and-hold, your Dimson and your Lorie". Of course, such observations are completely consistent with random walks with drifts of 5% a year and it is good to quantify such moves to prove this.

A more important reason to look at such periods is that the Dow has an inexorable tendency to rise. It started the 20th century at 65 and stands at 10500 today. That's a 4.8% a year compounded return. When you add in a 4 1/4% a year dividend return, ( 5% from 1871 to 1945 and 4% from 1946 to 1996) you come up with that 9% a year compounded return that the Triumphal trio has documented in almost all countries.

It stands to reason that if the Dow has such an inexorable tendency to rise, that it's good to buy it when it's in one of its down drafts. In other words, that dollar averaging, putting more of your chips in the Dow when it's down than when it's up might give you an edge. But like all such interesting queries, this must be tested as most plausible things of this nature are a bunch of hot air. And worse yet, because they aren't tested, one can never differentiate the tested from the untested.

In any case the Dow closed 1999 at 10700 and closed 2000 at 11000 versus its current level of some 10500. Thus, at least 5 1/2 years have gone by when an unlucky investor who bought in 1999 and didn't receive dividends would actually have a loss. What happens in such situations, and what variability is attached?

To test it, the Professor, his student Chris Hammond, the master simulator Tom Downing and I looked at all those months in the last 100 years when the closing price was below the year end 4 years earlier. For example the Dow price at October month end 1907 was 57.7. This was lower than the price at the end of 1902 which was 64. That's 4 years and 10 months without a profit.

During the period from 1900 to date there were 1264 months examined. 270 or 22% of them showed such a loss.( the dry years) The average 1 month price appreciation the next month was 0.8% + - a standard deviation of 7%. This compares to a return of 0.5% a month with a standard deviation of 5% on all other months. Such a difference is merely a 1-in-10 shot to have arisen if indeed there was no difference between the months. In the usual terms, the difference was not significant. The question arises if the price appreciation over bigger periods was more significant. For example, in the year following the dry months, the average price appreciation was 14% versus 5% in the bountiful months.

Because of the clustering of dry months, without a gain, it was necessary to do some relatively sophisticated simulation to determine the likelihood of such differences arising by chance. We chose to do it by assuming that the distribution of intervals between dry months was our total sample. We chose a random price from the full 105 years, and then classified it as to whether it was a dry or bountiful year. Then we chose the next 12 months skipping an appropriate number of months based on the distribution of intervals between consecutive months of dryness in the sample. The results show that the difference is about 1 in 40 to have arisen by chance. Thus, there is some support for the idea that dollar averaging works and the idea that buying is best when the doomsday scenarists are gloating the most. 

Mutual Funds vs. Hedge Funds, by Philip J. McDonnell

Recently there has been a great deal of negative talk about hedge funds. Supposedly some big fund is in trouble because of its trading in GM. Out of 8,000 funds it would be surprising if none lost any money on GM. The entire campaign has been conducted via rumor and innuendo. No facts have come forth, only accusations and suspicions.

This underscores some fundamental differences between the mutual and hedge fund industries. Some think the line between the two has blurred. Hedge funds use leverage, futures, derivatives and other exotic trading vehicles. Many mutual funds do as well. The real difference is in the fees and the management incentive structure.

Mutual funds argue that their fixed annual percentage of assets is ideal for the client because their managers are motivated to practice conservative policies which will preserve assets for both the client and the fund. Hedge funds are typically compensated with an annual fee plus an incentive from 20-25% of profits. Hedge fund managers argue that the best managers move to hedge funds because they are paid better.

Regardless of which argue rings true for you there is an inescapable point to be made. Mutual funds don't particularly care about costs to the fund which are relatively small relative to assets but large relative to return. Managers care mainly about asset size of the fund. The easiest way to increase asset size for an open ended fund is through sales to new investors. This is the job of the brokerage industry.

There exists a long standing symbiotic relationship between the mutual fund industry. The brokers expect the fund to give them commission business and the fund expects the broker to sell their fund shares to new customers. This is the main reason that mutual fund managers don't care about commission costs. The more they spend in commissions the more new money comes in. New money is the fastest way to increase the size of their fund assets. This phenomenon also helps explain why mutual funds consistently under perform the market averages.

It also accounts for the war of words against the hedge fund industry. The mutual funds enjoy a very profitable relationship within the status quo. The recent rise of hedge funds with their performance based incentives is inimical to the way business is done in the mutual fund industry.

Testing and Foraging, by Jay Pasch

Testing is much discussed and no doubt rightly so; one offers a like thought on foraging and testing, and that is foraging for that which the Mistress has tested, to locate what she has found palatable. Given the evidence of ever-changing cycles, the hunt requires constant effort, as the easy meals are quickly found and plundered, eventually leaving the landscape bereft of sustenance, requiring the quick re-location to more suitable grounds. Now, to actually test what the Mistress has tested, that is the real goal, but one step at a time.

Ask Vic

The Chair's view on DC real estate is given considerable support in the article "Capital Gains" on p B1 of today's WSJ. The article describes how "the bursting of the stock market bubble and the Sept. 11 terrorist attacks" transformed the "sleepy Washington, DC real-estate market into one of the nation's strongest."

Dept. of Doomsday: Multiple Scenarios, from Kevin Byrant

I am becoming increasingly worried about the multiple theaters that appear on the verge of eruption and long term complication and conflict: Iraq, Syria, Iran, North Korea, Taiwan, the former Soviet Union, etc. Is it just me or are we approaching a tipping point in global tensions and what impacts might we see in global markets? Is it just media hype? It would be interested to see what probabilities those who study war theory might be attributing to a major skirmish in one of these locations. Is there a particular source or geopolitical expert the market tends to heed in this regard? Has anyone done any counting with respect to multinational conflicts, the kind that impact home, hearth, and wallet in some significant way? Where are we in the count?

A Note from Jack Tierney, President of the Old Speculators' Association:

CNBC was one of nine stations I was able to  receive in hospital; had it on regularly though my coherence was generally low. Overall clouded impression: Big up days were viewed as naturally occurring developments, big down days generally met with indifference. All the potential big, bad events that overhung the market seem to have been reviewed and are now re-cast as handleable. Haven't seen any figures but bear voices seem to be far more  muted than I can recall in a long time.

Am also reconsidering   my opinion of hedge funds. It's curious that the same period which has witnessed the proliferation of these entities has also experienced record lows in volatility. Haven't the slightest idea whether there's any correlation or not, but wouldn't it be ironic if these potential carriers of leveraged mass destruction were, in fact, acting as stabilizers?

Mark Mahorney responds:

With regard to hedge funds:

"Wouldn't it be ironic if these potential carriers of leveraged mass destruction were, in fact, acting as stabilizers?"

This may very well be so.

An increasing number of funds equals more choices for investors and increased competition among funds. I suspect what we have witnessed is the end of the 'vandal's crown' era, with assets now relatively less concentrated within alternative investment funds, instead being spread across many. Thus leading to a reduction in; concentration of power, the ability to manipulate and control markets, and ego/hubris among managers.

I think we're seeing a similar trend in the world as a whole, with increased international trade and business leading to a reduction in concentration of world power such that no country will be able to dominate politically or economically to the degree that they will be able to control or manipulate markets and other countries politics as in the past. Thus eventually leading to a reduction in conflict and increased meshing, merging, and blurring of cultural differences, as countries find it increasingly necessary to allocate resources towards competing economically versus militarily.

Kim Zussman adds:

Rather than speculating on the effects of increased hedge fund activity,

  1. It could be fruitful to simulate a large (and as a control, small) number of leveraging arbitrageurs taking all sides of a random walk with upward drift.
  2. What then would be effect of market shock? How would this compare to markets with much less risk re-re-re-re-re-allocation?

from George Zachar:

An alternative explanation for the decline in realized and implied volatility concurrent with the ascent of hedge funds is the possibility that they, net, engage in the selling of volatility/premium/insurance, and dampen moves in the underlyings to defend their positions.

Ranges by Week, by Victor Niederhoffer

Week Ending# Ranges >10

In short, the number of days of the last five with decent ranges above 10 where the market gyrates enough to really make the public lose more than they should, and hurt the collar traders , and help the breakout boys, is at a running five-day minimum. What does is portend? What evil lurks in the hearts of the market mistress for us? Only the Shadow, and those who test, can hope to make an intelligent guess.

The Candlestick Menace, by GM Nigel Davies

There is a certain psychological menace held within candlestick charts when black (a color associated with jolly things like death) is used as the standard color for down bars. If you have these on your trading screen I suggest they can reinforce negative feelings when the market goes down.

With this in mind, perhaps it is better to color them green or even pink, and perhaps have something neutral for up bars.

Dept. of Personal Finance: Dante's Assisted Living Inferno, by Ken Smith

We have toured a dozen retirement centers. Some are independent living apartments, some are mixed with independent apartments and assisted living units in the same complex. Some provide meals and require that you take meals and pay for them.

What at one time were known as nursing homes are now the assisted living accommodations.

There are duplex units, triplex units, single cottages, and apartments in multi-floor buildings which stretch around a full city block or two. All built to house seniors from age 50+ to 101.

Then there are homes one can buy, built as developments just like any other development, in huge acreages complete with golf course, community building, swimming pool.

Amazing how people sell their home of a lifetime and move to a home for 50+, only to die. That's what's in store for them. No matter how you cut it, you just go somewhere to die, and not smartly either, but slowly, dangling on prescription medications.

The Collab comments:

My 80-year-old mother lived alone fairly happily until taking the classic bathmat fall last year. As she recuperated in a convalescent center from a spinal fracture, I, too, visited a dozen assisted living centers and nursing homes. I concluded that "assisted living" is for conformists who like group activities such as bingo and don't require much in the way of assistance. "Nursing homes" seem designed to throttle any vestigial zest for life, with small dark viewless rooms. I ended up renting an ocean-view apartment and paying for 24-hour care, with the approval of her doctor. Alas, the visiting hospice nurses simply drugged her into oblivion. Maybe the moral is that there's no place like home, provided you have a rubber-backed bathmat.

Target Practice, by George Zachar

My opinion as to why Fed adoption of a Bernanke-esque inflation target would be wrong:

Waves, by Laurel Kenner

Im sailing just off the coast of the Big Island on big rolling swells coming 2,000 miles across the Pacific. The swells are met by a second type of waves, choppier and shorter, created by the proximity of land. Patterns from the light wind ripple across the surface.

Hawaiian navigators have been expert at reading ocean currents since ancient times. Im learning the basics during a sunset sail on the catamaran of Mr. and Mrs. Surfer Spec, Jim and Sarah Sogi, my hosts for a short holiday last week.

Hawaii is a magnificent living textbook of geology, oceanography, climate, botany. Geologists say it is the only place on earth where a cache of magma is so close to the surface that it wells directly up through the surface of the ocean. Elsewhere, volcanoes occur along the ridges and trenches created by clashing tectonic plates. 

In Hawaii, the cooling, solidified lava adds acreage to the island every day -- land in the process of creation, right before your eyes. Above the hot spot of magma, the Pacific Plate is drifting northward. As it moves, it leaves behind the island it created. The hot spot remains stationery, more or less, and the magma starts bubbling up through another place in the ocean crust. Over millions of years, this has created a 1,800-mile stretch of islands of which Hawaii, at 500,000 years of age, is the youngest. The older islands erode; most are below the ocean surface. Eventually the Big Island, too, will disappear beneath the waves. It will be replaced by a new island, Loihi, now being built up underwater. (If you're interested in the revolutionary developments in geology and concurrent breakthroughs in the knowledge of evolution since the '70s, I recommend Richard Fortey's "Earth:  An Intimate History," and "Darwin's Ghost" by Steve Jones.)

Because Hawaii is simply bubbling up out of the ocean, it lacks a continental shelf to break the force of the trans-Pacific swells. This makes for tsunamis and great surfing. Today, were on the leeward side of the Island, and the ocean is calm.

Sogi's results in the market have been, shall we say, not entirely unsatisfactory since he forsook scalping WorldCom a couple of years ago in favor of trading stock index futures -- indeed, he's not far removed from triple digits. He finds inspiration for trading in the ocean. The long, rolling trends, day-to-day choppiness, the minute-to-minute swirls and fluctuations are metaphors for the financial market. Like trading, the ocean is complicated but not totally random. Just as surfing and navigating are possible, so is trading if you pick your spots.

A surfer, for example, waits just beyond the breaking surf to catch a wave as it crests. To avoid subsurface reefs on the way to shore, he visualizes a path by lining up two markers on shore.

Sarah Sogi, like Jim a highly respected lawyer (she is known around her law firm as the Pit Bull Wahine) and a surfer, told me that a surfer must stand up at the very crest of the wave. Of course, that is the moment when the heart is in the throat. Each second of delay makes gravity harder to overcome. Every speculator knows the feeling. The time to trade is just when the fear is greatest.

Jim learned statistics over the last two years by reading Snedecor, Vics recommendation, five times. Believe me, there are many less arduous stats texts than Snedcor. In fact, when I told Vic about Sogi's studies, he was amazed especially since he has never had time to read Snedecor all the way through himself. Jim also taught himself the statistical programming language R.

Here are some of Jim's surf tips:

In honor of Jim and Hawaii's waves, here is a chart of Hi/Lo waves in the S&P Mini.

MonthStart DateExtremeEnd DateExtreme Change
Jan1/21103.51/261155.0 51.50
Feb2/41122.02/111158.75 36.75
Mar3/51163.753/241084.75 -79.00
Apr4/81154.54/301103.75 -50.75
May5/11075.255/41127.5 52.25
Jun6/11112.56/241146.25 -33.75
Jul7/11143.757/261077 -66.75
Aug8/121060.08/271109.75 49.75
Sep9/11098.09/211132.5 34.50
Oct10/61143.7510/251088 -55.75
Nov11/11126.2511/291191.25 65.00
Dec12/91173.512/311219.75 46.25
Jan1/31221.251164.251/24 -57.00
Feb2/11179.51214.752/28 35.25
Mar3/71229.751166.753/29 -63.00
Apr4/71195.751135.754/18 -60.00
May5/131146.755/231199 52.25

In this small sample -- too small for statistical generalizations -- there were nine rides to shore (an up move from extreme to extreme) and eight riptides. A 52-point move was the norm. Most of the waves started quite early in the month and ended late.

This month's low was 8 points below the high in January 2005, and this month's high is 21 points beneath from last December's 1219.75, the high water mark for 2004.

Stay Away from the Popular Lines, by GM Nigel Davies

Sometimes I've tried to play popular variations, but what has invariably happened is that my opponent has been waiting with some important novelty towards the end of known theory. Perhaps I didn't study the lines concerned quite deeply enough, but I think it's difficult to get an edge in something that everyone Tom, Dick and Harry is playing and talking about.

Things have tended to work out much better when I've deliberately avoided the most popular paths, either by coming up with my own ideas or looking for new twists in games from old books (particularly those that haven't been entered into computer databases). You only have an edge when you know something that the other guy doesn't, and this is achieved by continually developing your game.

Hoodoo Haiku, a Continuing Series by George Zachar

Fiorina Is Writing Book After Leaving Hewlett-Packard -- May 23 (Bloomberg) -- Carly Fiorina, who was ousted in February as Hewlett-Packard Co.'s chief executive officer, said she's writing a book and that she's more likely to seek a job in public service than one running another company.

And now, the book deal.
Dilbert fans will understand;
Carly is Dogbert.

"It's more likely that public service is in the future rather than a corporate role," Fiorina, 50, said today in a speech to the Detroit Economic Club. "Who knows, I may be back to count your votes."

Carly counting votes?
Recall her old firm's slogan:
HPQ Invent

Lucent, HP, wrecked.
What? "Public service" is next?
Please, call Hillary.

In her first public appearance after her ouster, Fiorina told students of North Carolina Agricultural and Technical State University in a May 7 commencement address she had "no regrets" over her tenure at Hewlett-Packard, was "at peace" and that her "soul is intact."

Her "soul is intact",
after twenty million bucks.
We can sleep soundly.

Memory, by GM Nigel Davies

Memory varies amongst players, for example Pillsbury had a phenomenal memory whereas Lasker advocated not remembering anything apart from the method.

I tend to side with Lasker's view: the big thing is to be able to hang any variations on hooks of understanding. They found that strong players (i.e. those with good understanding) can remember 'typical' positions better than weak players, but if the position is random they're on equal footing. The same applies to variations, strong players will 'remember' because the moves make sense to them.

Elmer Gantry's Market, by Ken Smith

"Gantry turns into an evangelizing, Bible Belt revivalist preacher. Exhibiting tremendous showmanship, Brother Gantry, with rolled up shirt-sleeves, preaches hellfire and brimstone, thumps his Bible, performs miracles, and leads repentant sinners to conversion in the Bible Belt tent meetings...."

Notice Elmer's talent is showmanship. He puts on a great act. And Elmer can tell a story, invent a story, make you believe his story, even though he has just now made it up. In the movie you see Elmer on the stage, he does near gymnastics with his body, emphasizing his words with great gestures.

Elmer takes the meme from the audience and adopts it to his theme of the day. Elmer uses the mind that melds the minds in the crowd. He does not have to speak to each individual, he speaks only to the mind of the crowd. The crowd has only one mind. Elmer needn't concern himself about convicting each person, he convicts the crowd and that is sufficient.

Mass marketing by television, CNBC, MSNBC, others. These media adopt the meme or create the meme, then wrap it around their theme of the day. The mind watching their show, their showmanship, becomes mesmerized by the flashing ticker, red, green, yellow symbols blinking like the shinning object hypnotists use to focus attention.

Print media, the Financial Times, the Wall Street Journal, Forbes, Fortune, others, these capture the malleable mind of the crowd. The crowd is any and all readers, the sophisticated and the plain, the literate and the clod. All are prisoners of crowd mentality when they gather together or singly in isolation to read or view the same subject matter.

Elmer would be at home on television. Elmer would have as much wealth as many a Forbes 500 member (Pat Robinson is a member). Then, of course, we can look at television's financial preachers - smart money talkers, and speculate what their seven figure incomes are.

Elmer speaks to fear of hell and brimstone. Hucksters speak to fear of losing out on a good thing. Elmer speaks of your future in heaven. Market hucksters speak of your future rolling in money.

Elmer lusts after beautiful women. Market hucksters put beautiful women on the screen, often with cleavage. Elmer gets drunk, gets in fist fights. Market hucksters roll their eyes, widen their brow, as if intoxicated by the speculative opportunity they present to you. You are challenged to fight pessimism, shake off your vow of safety, put your money in a stock, a sector. And do it now.

Elmer asks you to come to the altar, confess your sin, throw off your sinful habits, take on the cloak of salvation, embrace the love of J-sus. Market hustlers ask you to come to your internet broker, speak out your desire to be rich, remove your cash from that savings account, put everything on the table of speculation and renew your vision for a life of ease and luxury.

When asked if he will carry on Sister Sharon's work in the lucrative revivalist business, Gantry quotes scripture to explain how experiences have matured him, and why he will not continue:

"When I was a child, I spake as a child. I understood as a child. When I became a man, I put away childish things. St. Paul. First Corinthians. Thirteen eleven." [1 Cor 13:11]

St. Paul has much to say to investors in this century. Elmer, one of the greatest ever, passes on this wisdom to us today. Give up the illusions of instant wealth, pass over the petroglyphs enticing you from space-age charting screens. Take up the cross of prudence and learn to count - get quantitative. Save yourself.

A Rare Event, by Victor Niederhoffer

The S&P 500 today is lower now than it was six years ago. This is one of those rare market events that give the bears unusual hope but is nonetheless completely consistent with a random walk along the path of 6% a year capital appreciation and 1.5 million percent-a-century drift. It's hard to countenance, however, and many people have been,  are, or are closely related to those who have been "snatched" -- so bereft of optimism that they lurch glassy-eyed toward financial ignominy, grateful for a negative 1% return so long as someone assures that them that there is absolutely no risk involved therewith.

Yes, it's precisely at such times that articles appear saying that commodities are so much better than stocks, and pointing out that this or that sector is underperforming . Bloomberg has a nice article in this connection on the recent underperformance of a white shoe brokerage house's IPOs. This brings to mind the 2003 forecast that the Collab and I made that all IPOs that made it to the front in that environment were destined on average to double within a reasonable time.

On another front, the market is quietly approaching the round number of 1200 on the S&P and readers are beginning to write in asking such questions as whether companies beginning with alphabetical letters A and B are better than others.

All these questions and the myriad related ones call out for some counting. and we will not be remiss in that regard in the imminent future.

"The Mountains are High and Emperor is Far Away", from Larry Williams

Thats the way the Chinese stock market was described Singapore this week by one of the leading journalists. The point is, they have found here in Singapore that it is very hard and difficult to get accurate data about Chinese stocks. Investors here have turned jittery for a variety of reason, including suspicions about the truthfulness of financial accounting for these stocks.

Its no wonder; the government-owned China Aviation Oil blew up here, costing investors over $1 billion in losses. Due to this, and the trust issue, Chinese stocks here have been shunned by locals and sell for P/E ratios about half of what local stocks sell for.

Another Chinese disaster was New Lakeside, a juice company that juiced their books and when the truth came out the share price took a 50% hit and no one is looking for it to rally soon.

Its no wonder a newspaper headline here said, "In Singapore, China companies are spurned."

Sushil Kedia responds:

Some days ago I said, "Chinese numbers are like Chinese toys, good only for short duration play".

Now with the rising symphony I might add, "Chinese numbers are like Chinese toys, they draw attention for their fun value, but beware of attaching any serious value beyond that for now."

Please refer to the latest in brokerage house after brokerage house joining in only now in their contributions to the now nearly cacophonous pitch.

If the arguments in the link above have merit, which I am inclined to believe, then the gangrenous knees have started wilting under the weight of the barbells.

Steve Ellison adds:

Larry, I recall your saying that in some ways there is more freedom in China than in the U.S. From the Chinese point of view, Americans must contend daily with a complex web of laws and regulations. By contrast, in China, it is often possible to do anything one wants as long as one does not come to the attention of a government official. Hence, "the mountains are high and the emperor is far away."

I had a conversation with a university student in Turkey who expressed nearly identical sentiments. He had visited Italy and felt stifled by all the laws and regulations. In Turkey, he told me, the possibilities for "initiative" are much greater.

An Anonymous Mapo Tofu Chef contributes:

I covered Asian equities for some time, which covered two booms in interest in Chinese investments. I followed about 20-30 Chinese companies over that time, and would estimate only 1/3 did not engage in activities that would send them to the front pages of the WSJ and/or bankruptcy, if done in the U.S. The rest engaged in ordinary mismanagement and empire-building. None showed much true interest in shareholder value, though by 2000 most leading companies had found MBAs who knew how to lie in ways that foreigners favored. My better half, an accounting graduate from a Top Chinese School, has some accountant/auditor classmates who tell horrific stories- apparently local auditing companies can extract such fat bribes from audited companies that they are willing to actually pay (not be paid by) a referring auditor to win an audit assignment. All hearsay, but considering how big and unclean the banking/property/infrastructure nexis is to China's economy and stock markets, I expect more surprises to come.

The one thing that stuns me now, and which I do not understand, is why big investment banks are allowing their public faces to say negative things about China's prospects. Historically, investment banks have let their analysts say nothing but good things about likely investment banking clients, and Chinese officials similarly have historically punished and excluded "China disbelievers" from lucrative mandates. I would have thought that investment bankers would have had sacked all Asia Strategists not super bullish on China's economic/political prospects, just as they did with tech stocks in those days. Perhaps they have decided that they need a negative strategist to provide reputational insurance in case something really hits the fan in China.

It's amazing that many libertarians are so in love with China, despite the financial system being primarily a government bureau, and official regulation and state ownership remaining heavy, and corruption total perhaps becoming the largest in the world, in absolute $ terms. As an Othodox Objectivist I find this totally ridiculous, and suspect that libertarians of the an "anarcho-capitalist" bent are thrilled to see as "competing govenments" one government official beating out another to build a skyscraper expropriated by the government, funded through one state-run channel or another by a pool of government-directed savings. In any case, there are many more Orren Boyles than there are Hank Reardens over there, because the former is rewarded by and the historical norm in a mixed economy. Anarchism isn't freedom, and companies making money in China sooner or later find themselves stuck to numerous leeches - paying off officials to avoid regulations, texes, etc.

Remember those 1996 stories about "Cowboy Capitalism" in Russia? Remember learning a year later that the caviar and champagne was mostly paid for out of swindles, and that the "capitalists" were simply former bureaucrats with friends helping them loot the public purse? A certain motorcyclist has played his small part in building a third boom in investor interest in China, this time the China fever seems to be reaching a much wider audience, and is progressing much further helped by the various kernels of truth scattered amongst the pitchbooks. Now American brokerages are assembling lists of "China Plays", amongst their stocks, and American companies are bragging of their growing Chinese exposures, suggesting to me that the tide may soon turn again to revulsion.

Bud Conrad adds:

Excellent observations that dovetail with my worries about the central control of a Communist state.

As one small addition to "selling the rope to the hangman on the way to the gallows": VC firms in Silicon Valley now expect a "globalization plan" as part of the startup. For a software product this means using offshore programmers to do the development.

If we read the press on China's taking over the world, one would expect their stock market would be soaring. The Shanghai index (SSE) is actually down significantly, from 2300 to 1030 in 4 years.

from Russell Sears:

The value of the individual spirit is impossible to quantify precisely. But it can be counted in some ways. An actuary, in many ways, is a person trying to do the impossible, scientifically count the individual spirits.

China has made a pact with its devil, it owns everything, but has allowed some people to control their own destiny. This expanding leash of the human spirit is responsible for its phenomenal growth. Many believe that they will overtake the opportunities in the US by sheer force of numbers. However, until I stop seeing their smartest and brightest stars finding there way to the US as our leading scientist, engineers and even business men, I will be saying, but your own man says otherwise. Further, the western investors that claim to have had the most success in China have nurtured their political connections, rather than their cultural/artistic, academic or scientific connections. In short like China's govt, the investors believe they can rule over rather than nurture the human spirit. They have tied their boats with the politicians. I believe most are in for a rough ride. This is not to say that there won't be a Sage of China, but he is most likely to come from a rural China province, like our Nebraska.

Yet, it is not just China that ignores trying to count the individual spirit, in the name of precision. I see our current battle over Social Security as US trying to do this. George Z ask "what hell would they force upon us?" One only needs take a tour of the veteran homes, to get a vision of Dante's inferno awaiting the boomers. Yet, one only needs consider Viagra, to get a glimpse of the heaven that could be.

Also quality is almost impossible to fairly consider in inflation. But most difficult is defining quality of "care" and quality of life. An what is retirement, if not the young caring for the elderly.

2005 Regime Changes, by Kim Zussman

  1. January effect in December
  2. Return of volatility once Expert's on sabbatical
  3. A well oiled roller-coaster (oil welled?)
  4. Market rallies only once; all the easy reversion patterns have been arbed and smashed
  5. Sell in May and say Oy Vay
  6. Resurrection of trend followers only after the weak ones lined up and shot and anti-reversion icons like moving average break-outs start working
  7. The new trend: best predictor of low volatility is low volatility
  8. The next Almanac: January effect in October

Do You Have Dandelions in Your Portfolio? by John Lamberg

With spring comes dandelions. One thing I noticed is that if you pick the flower and discard it, it will still go to seed. It is also a tough plant to kill by hand weeding as you must remove the entire taproot or the plant will come roaring back. Now, how to make my portfolio more like a dandelion?

"...Some dandelions are apomictic and polyploidy is common. Some varieties drop the "parachute" (called a pappus, modified sepals) from the achenes. Ergo, there are "species" (apomictic and polyploid races) that grow only in a single meadow. This is one reason for there being a large number of described dandelion species, especially in Europe where botanists tend to be "splitters". As an example, some botanists list a few hundred species of dandelion from Finland alone. Others are inclined to "lump" these all into Taraxacum officinale.."

...Finally, some plants have developed a way to produce seeds without their flowers being fertilized. In apomixis, an embryo is created from a diploid cell in the ovule. Then the ovules mature into seeds. The dandelion is one plant that uses this form of vegetative reproduction.

A Libatory Contribution from a Southern Spec

For those looking for a little punch for your summertime bbq, this is how we create wine down in the south to go with lunch when "the man" takes over your still and blows it up.

Dandelion Wine

1 Gallon of Dandelion Blossoms (cut off top of milk jug and fill up)
1 Gallon of Hot Water
Cut Lemon in Half and Squeeze Juice into Container
3-4 lbs of Sugar
1 Cake of Yeast

Place Blossoms and water in a crock and let stand for a day then strain into gallon jug. Then add rest of ingredients and let stand for three weeks then place in individual bottles. Age bottles for two months.

If you do this properly then you got a good drink that will put a hitch in your step by the end of July. Fried chicken, watermelon, and slaw go good with Dandelion Wine. Notice it's the exact opposite of regular table wine where you match wine with food. Here you match food with Dandelion Wine. Never drink on empty stomach, and if you develop Jake Leg don't blame me.

Now if you want to talk about a tough plant to kill look at "wire grass". my Pa Pa used to tell me "boy, you could rake all that up, put it in a pile, strike a match to it, and the ashes would take root". My persistence, willingness, and attitude seem to be like dandelions and wire grass.

The Webmeistress comments:

A favorite book: Dandelion Wine, by Ray Bradbury.

Bulls and Dogs, by Bo Keely

I'm hopping freights in Canada with 'Diesel', who writes spec stories for Bill Bonner's Agora. Good guy. Brit, young, smart, enthusiastic about all. He lives and works in Baltimore. Anyway, we got busted today by Mounties on cold freight approaching the Canadian Rockies. I may switch to 'The Dog' tomorrow but Diesel is heading back to the yards.

Life as a Battleground, by Ken Smith

Lay minister down the street came by recently to talk with me. He works for Campus Crusade for Christ. Wanted me to join a prayer group that meets at 9 AM every Tuesday. Because I talk the talk, know the lingo of evangelicals, charismatics and Bible thumpers, he expected me to accept his invitation with enthusiasm.

He believes I have a strong message that if I were to give my talk others would be influenced positively. In short, he wants me to give my hype in the interest of proselytization. As if I will put on a good 'show' for unbelievers and they will turn the corner, sing a Gospel song, come to the altar, confess their unworthiness, fall to their knees, and renounce Satan and all his works.

That would be so easy to do.

About the same way publishers solicit trading experts to write books about the market. Hype the game, get the suckers excited, lead the unwary to Wall Street, get their money into the swirling pot, have them bend over and hoist their rectum to the Big Board.

Admit it: Capitalism Here is Guilty as Charged, from Don Boudreaux

To the Editor of Boston Globe:

Thad Williamson says that an American's purchase of Britain's famed soccer team Manchester United means that Brits lose one to capitalism. And he sympathizes with United fans whose world has come crashing down because of this bitter truth of capitalism that professional sports teams are bought and sold.

Mr. Williamson is correct. This bloody tragedy would indeed never have occurred without capitalism, for without capitalism, there would be no Manchester United to buy and sell. Indeed, there would be no professional sports of any kind for mass audiences. It took capitalism to create leisure and prosperity in such abundance that many ordinary people today sincerely regard a team's losing season or its sale to a foreigner as a genuine calamity.

Call and Response, by Kim Zussman

Probably this is obvious to derivative experts, but this study shows that when OTM calls get expensive relative to the corresponding puts there is predictive value for S&P 500 (it goes up). This suggests options traders have better information since they have correctly bid up calls, and is in contrast to contrary signals such as the put/call ratio.

Speaking of volatility, and again probably for reasons obvious to many, VXN (NASDAQ 100 vol index) closed at a new low on Friday. Since options traders are smarter, they must be right for selling so many of them (or the corollary: the best predictor of realized volatility is implied volatility?).

Jordan Neumann comments:

I am not ready to credit the decline in the VXN to heady option traders. In the nine month period ending April 27th (can a Vic posting on the markets and human gestation be far off?) at least 17 closed-end funds dedicated to covered-call writing were listed in the US, representing $10 billion in 'investment.' On April 27th alone five funds came public with $1 billion in assets.

These are not options traders, these are mutual fund managers taken in by CBOE research which shows that a portfolio of covered calls performed in line with the S&P 500 over the last 18 years with one-third less volatility. This would more appropriately listed in the Ever Changing Cycles Department. As the market advances, the underwriting spreads disappear. As the funds move to discounts to their net assets, and as the funds write away their right to any appreciation for the low premia represented by the low VXN (and VIX), it is a lock these funds will underperform the market by 20% over the next year.

Waiting in a Tree, by Victor Niederhoffer

Nice Lobagola in crude oil from 46 to 60 and back, with the elephants starting their annual migration at 46 in February and then retracing their path. Lobogola might be waiting in a tree for them at 49'ish with a view to the inevitable influence of incentives on extraction and finding.

Your Own Man, from Steve Wisdom

Few J-ws Allowed In the city's ultra-high-end real estate market, subtle but persistent anti-Semitism still lurks, new book reveals. Gabrielle Birkner - Staff Writer

In another passage, veteran real estate powerbroker Alice Mason implied that some co-op boards expected their J-wish members to do their dirty work.

"This is the way it works," Mason explained in the book, which is due out June 1. "There's one J-wish person on the board, and that J-wish person is the one who vetoes all the other J-wish people."

Orchestration, by Victor Niederhoffer

Symphonies often increase tempo and loudness and pitch range toward the end, building to a fortessimo climax with the whole orchestra playing. It strikes me that certain brokerage house reports, with their peculiar pitch, dynamics, and, shall we say, orchestration, play climactic roles in the market symphony.

Take the report released at 12:30 p.m. May 13 from the chronically bearish chief economist at a major brokerage house talking about the possible implosion of securities markets; good for an immediate 2% decline in U.S. stock markets. Now, with oil down 20%+ from its high,  we have a forecast from a certain gold-plated firm forecasting a major resurgence in energy.

I'm reminded of the time Henry Kaufman first became bullish on bonds. Just five minutes before, the brokerage house he worked for had shown me a fantastic bid for bonds, which I accepted to my seven-figure cost. Such cadences become a regular part of the market symphony.

Such cadences would make a nice CD.

A Major Quant adds:

My favorite orchestration is the Wagnerian Tristanian unresolved dissonance, endlessly deceptively leading to a false climax, as in brokerages et al making the public and short gammas endlessly lean the wrong way, then repeat. not unlike trying to strike a Taijiquan master.

Freakonomics, Bagels and Holidays, from Victor Niederhoffer

In his book Freakonomics the economist Stephen Levitt describes many methods of cheating in baseball, sumo, minority testing at public schools, and bagel stealing. He is good at coming up with algorithms that find cheaters and this might be highly applicable to market moves. He is excellent at explaining such things as increased cheating on bagel eating before Christmas and Thanksgiving when employees are more anxious, and less cheating around holidays like Labor Day and July 4th when there is no anxiety. A change occurred in the results but he attributes this to post 9-11 stress. But this is the promiscuous hypothesis squared that so many behaviorists at Chicago are rightfully accused of, and alternate explanations are available for all of the regressions that Dr. Levitt likes to report.

I examined whether holidays in the stock markets tend to show this same bias with negativism around Christmas and Thanksgiving, and positivism around the others, and whether there was a 9-11 shift. I looked at the moves in the one and five day periods before and after these holidays for the past eight years to see whether any predictive hypotheses might be confirmed.

To bring the holiday study into some systematic and refutable form I looked at the moves in the prior and subsequent one and five days for each of the holidays from 1995 to 2004 with a view to accessing the consistency of any one, and the difference between enthusiasm for the stress and non-stress holidays.

Move From N Days PriorMove to N Days After
MLK Day+6.3+2.2 +1.4-12.3
Labor Day+4.1-12.9 +4.9+4.1
Memorial Day-2.8-6.5 +2.3+10.8
Good Friday+3.5+1.2-2.1 +7.7
Presidents' Day-8.3-3.1-2.7 +1.2
July 4th+4.4+13.8-1.6-8.5
Christmas+5.6+10.0 +1.5+5.4
Thanksgiving+0.2 +1.2+4.2-2.7

Since the standard deviation of each one day move is approximately 10 points, and the standard deviation of each five day move is about 25 points, it is apparent that not one holiday shows a consistent pattern even approaching one standard deviation.

The results of the individual holidays are even more glaringly consistent with chance. Consider for example the most hopeful: the moves five days after Memorial Day averaging +10 points, and the moves following MLK Day averaging -11 points. The moves the five days after Memorial Day were: 1995 +13; 1996 -11; 1997 -2; 1998 -19; 1999 +35; 2000 +89; 2001 -10; 2002 -44; 2003 +36; 2004 +20.

The period started out with a large negative cumulative sum thru 1998. You might have played it that way until 1999, at which time you would have lost a fast 124 points on the short side. Then when you played it in 2000 for a long you'd have a nice -54 points in 2001 and 2002, and then if you shifted back or called it a day you'd miss or lose 56 points in 2003 and 2004. The results for each of the holidays was completely consistent with randomness. No holiday showed a consistent performance. The anxious holidays were no different from the non-anxious ones. There was no tendency to go up before or after to an inordinate degree. All in all, a very disturbing result casting grave doubt on seasonal sages, and economists given to promiscuity.

Vince Humbert reviews Hardball: Are You Playing to Play or Playing to Win?

I'm about halfway through Hardball, Are You Playing to Play or Playing to Win?, mentioned by Ken Griffin in his Bloomberg interview. The title doesn't do the book justice but essentially the authors, from Boston Consulting Group, take the Harvard Business School approach of teaching through case studies of how and when to really turn up the heat on your competition. The first chapter lays out the reasons for running corporations in the most efficient, profit maximizing manner.

A couple of pages in is a good quote from Milton Friedman, in the 9/13/70 edition of New York Times Magazine, "...There is one and only one social responsibility of business-to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception and fraud..."

So far, I would recommend the book especially to those who lean towards fundamental equity analysis since it provides real world examples of winning and failing competitive strategies somewhat off the popular financial media's coverage.

Ryan Carlson responds:

I also recently read Hardball at the prompting of the Griffin article.

After the initial excitement of the first couple chapters, I felt the book got a little limp towards the middle and I had to drag on to the end. But it is a quick read at 159 pages and one that I would rate a B+.

This is the second Boston Consulting Group book I've read. The other was Clausewitz on Strategy, graded an A in my opinion. And I would like to read more of the articles generously made available for free.

Good to Great is the other book Griffin listed as required reading at his firm and that book is going along on my vacation which begins today.

The Chairman adds:

Good to Great is one of the worst books ever written, with retrospection upon retrospection and preconceived conclusions favoring the kind of companies the Sage likes to buy, with returns below the risk free rate.

Mr. Greenspan Meets Mr. Rogers, by George Zachar

Greenspan's fairly standard energy spiel this afternoon held one nugget for energy speculators, emphasis added:

Reflecting a low short-term elasticity of demand, higher prices in recent months have slowed the growth of oil demand, but only modestly. That slowdown, coupled with expanded production also induced by the price firmness, required markets to absorb an unexpected pickup in the pace of inventory accumulation. The initial response was a marked drop in spot prices for light, sweet crude oil. But that drop left forward prices sufficiently above spot prices to create an above-normal rate of return for oil bought for inventory and hedged, even after storage and interest costs are accounted for.

I'd love to hear from the energy gurus if this is in fact true, or, for that matter, what a "normal rate of return" for holding physical oil might be. And if physical oil holders can make an "above-normal" return after hedging (presumably selling futures), what does that say about those folks buying the futures?

But Where's the Champagne Room? by Professor Pennington

I don't know whether Professor Siegel uses government funding to pay graduate students to accumulate the data he uses in his books. That practice is fairly standard, I think. But after shelling out for his books, I was disappointed to find out that he wants to charge me again to look at the raw data and other items on his site.

The website has several levels of membership, ranging from "FREE" up to "PLATINUM".

A useful feature listed for the "FREE" version is "access to purchase all our other products".

The "SILVER" level costs $150 per year and gives access to "cutting edge commentary".

The "PLATINUM" level at $500 entitles you to "email Professor Siegel one question a month and receive his personal reply" and a " personalized autographed copy of Professor Siegel's Stocks for the Long Run, 3rd edition."

I'd imagine that students in his courses might even be entitled to pose one or two questions to him.

Lloyd Johannesen replies:

Siegel and Shiller follow in the tradition of Modigliani in providing extremely useful applied insights. They each show broad insight in their research that is useful to all who are interested in investing, whether or not one agrees with them on every point (and they disagree on many between themselves). I always learn something when either writes an applied piece.

And the Senator mentions:

Money Central gives you all the fundamental ratings for free, as does Kiplinger.

Hunting and Markets, from Abe Dunkelheit

J.T. said: When hunting you usually have two shots: 1) the first one or 2) the more accurate patient one. I was thinkin' though if I were in a pistol duel and had to count off ten paces then turn around and fire, I would much much rather have first shot than accurate.

What would be the ideal strategy in a duel? I think the intuitive answer to have the first rather than accurate shot is based on a fallacy. We tend to think that whoever shoots first, i.e. is quicker, survives the duel. Maybe we were exposed to too many Italo/Western movies in the 60s and 70s. 'Speed' [reaction time] is only the arbiter of truth if we [and our opponent] are highly-skilled, that is, if each of us always [or almost always] hits the target when we shoot regardless of how accurately we aim. In this case getting the first shot becomes essential. If we are not very skilled [and also our opponent isn't] we should let him shoot first because he most likely will miss and we have time to aim accurately afterwards. Needless to say that if our opponent is much more skilled then we should not get into a duel at all.

Analogy to the stock market: If you are not skilled you must not get involved; if you are skilled your ideal strategy is to be quick or patient dependent on context but here it is the exact other way around: Usually, in the markets to shoot first is a bad move but sometimes it is the only move, that is, if your opponents are very skilled they will try to make you move first or they will make you think they are not skilled so that you let them move first without realizing that there will be no second chance. Or in other words: Usually you must not chase a stock but sometimes it is the only way.

The real question though is how do you become skilled in a game you must not play unless you are already skilled?

Are Diamonds Forever? by Sushil Kedia

A perfect diamond pattern formed, spanning more than 18 years of monthly price bars. The Diamond Pattern is described in standard Encyclopedias of Technical Analysis with such dread that a 'downside breakout' wherein prices would travel lower below the red line on the right would have caused a breath-taking down-move going possibly to 300 or 200 as in the chart below.

Only thing is the much dreaded downside breakout also happened, and the Dow Jones Industrial Average not only bounced back up right into the diamond but carried on higher and higher right up to 11000 also, so far!

See the chart next showing the breakout and the ruin of the forecast based on the diamond pattern:

Thankfully, I was not grown up enough in the early '80s when this Diamond broke and I had not read the TA manuals that simply have proclaimed the Diamond and such other patterns to be working. But having read about the near mystical potency of the pattern in the '90s and then having visualized the lifetime remorse that may still be harbored in the hearts that acted on the pattern then gives me all the more stronger reasons to know that the only viable way to the bank is through the rigorous streets of counting. Technical or Fundamental a decision rule has to hold through the sieves of counting if it is going to hold any water.

The Capitalist Mentality, from Susan Niederhoffer

Interesting interview with John Mackey, founder of $7 billion market-cap retailer Whole Foods, on business and libertarian issues, including this thread on why business is seen as evil:

I was very inspired by Ayn Rand's novels, like millions of other people have been. However, I don't agree with some of her philosophies. For example: I don't think selfishness is a virtue and I don't believe that business primarily exists to make a profit. Profit is of course essential to any business to fulfill its mission and to be successful and to flourish and I will defend the goodness and appropriateness of profits for business with great passion.
However, profit is not the primary purpose of business. Renee and I didn't begin Whole Foods Market to maximize profits for our shareholders. We began it for three main reasons: we thought it would be fun to create a business; we needed to earn a living; and we wanted to contribute to the well-being of other people.
The fact that business philosophers and economists articulate a philosophy that business should only care about maximizing profits and shareholder value (and has no other compelling ethical responsibilities to any of the other stakeholders) has done incalculable harm to the reputation of business.
There is a fundamental paradox that I call the "paradox of shareholder value". The best way to maximize shareholder value is to not make maximizing shareholder value the primary purpose of the business. Why not? Because it is the business that satisfies customers best that has the most customers, the highest sales, and the most profits. The best way to satisfy customers best is to organize the entire business around satisfying the customer.
Let me give you an analogy that may make this point better: What is the key to happy marriage? Is my wife's happiness an end in itself for me or is her happiness merely a means to a different end -- my own personal happiness?

Finops Noygobi adds:

Games are essentially for pleasure, but they happen to produce health. They are not likely, however, to produce health if they are played for the sake of it. Play to win and you will find yourself taking violent exercise; play because it is good for you and you will not.

That's C.S. Lewis. There are many businesses that are "games played for health." By contrast -- and it is really only one example -- I have been a Whole Foods customer for many years, and it is literally a joy to go there. What's good for the customer is good for the shareholder: I haven't minded owning the stock by any means.

The idea here is key for trading as well; you have to play first and foremost to win; profits keep score.

Housing, by Jeff Rollert

I look through the world in groups of three: up, down, and sideways. Sometimes my probability profile on interest rate actions and credit can come across poorly. This may be one of those times.

The credit cycle appears to me to be winding down, and this is a long cycle view. I'm not forecasting a recession, nor depression. I do view that the big three of oil, interest rates, and credit availability will have long-term dampening effects on security price volatility and GDP variance. Under this view, returns will more likely come from group rotation into mean reverting areas that have gotten whacked (that's a technical term) than from traditional growth areas.

So in a nutshell, the fastest way to remove lots of traders may be a long, dull market.

Negative Autocorrelations in Futures Markets, a Paper Review by Dr. Alex Castaldo

This paper is from a heads-in-the-clouds academic (he thinks the bid-ask spread on S&P futures is "usually equal to 25.0 dollars") and the results are a little hard to believe, but it may nevertheless be of some interest:

Do Futures Markets Overreact? Changyun Wang, Renmin University of China


In this paper, we examine the profitability of contrarian portfolio strategies at weekly intervals in broad futures markets. Following the methodology developed by Lo and MacKinlay (1990), we document significant profits to the one-week contrarian strategy implemented in a sample of 24 active U.S. futures markets. A strategy of buying past losers in the previous week and selling past winners over the same period gives rise to an average return of 0.31 percent per week (t = 2.70) or 16.1 percent per annum. Further decomposing the contrarian profits to determine the sources of profits, we find that the profits derive solely from the negative serial dependence in returns of individual futures contracts. We also show that the contrarian profits remain significant after corrections of a one-way transaction cost (commissions and one half the bid-ask spread) of up to 0.16 percent, which is substantially higher than the cost that a typical trader incurs in trading futures.


This study analyzes weekly data on settlement prices for a sample of 24 actively traded U.S. futures contracts over the July 1983 - June 2000 interval. The data are collected from Datastream International. Our sample consists of four currencies (British pound, Deutsch mark, Japanese yen, and Swiss franc), five financials (90-day Treasury-bill, 10-year Treasury-note, Eurodollar, NYSE composite index, and S&P 500 index), eight agriculturals (corn, cotton, feeder cattle, live cattle, soybean, soybean oil, world sugar, and wheat), and seven commodities (cocoa, coffee, gold, crude oil, heating oil, platinum, and silver).

we define the weekly futures return as the continuously compounded return over the Wednesday -Wednesday interval, using settlement prices of the contract closest to expiration except within delivery month in which the price of second nearest contract is used.


The first-order autocorrelations (rho1) are negative for 21 out of 24 markets, and significant at the 5% level for 15 markets. The coefficients of first-order autocorrelations range from -0.097 (platinum) to 0.007 (heating oil), and the magnitude of the autocorrelations is roughly comparable to that of individual stock returns.

Table 2 presents the mean profits and returns of one-week contrarian strategies implemented in the 24 futures markets over the July 1983 - June 2000 interval. The portfolios use weights based on the deviation of the return on ith contract in the previous week from the return on an equal-weight market index over the same period.

Per week (t-stat in paren)
Winner profits 0.009 (0.83)
Loser profits 0.028 (3.01)
Average profits 0.037 (2.72)**
Return (%) 0.311 (2.70)**

FNMA's Mortgage Portfolio, by George Zachar

FNMA's mortgage portfolio, a simple first approximation of outstanding MBS debt, sees roughly 1/4 - 1/5 of its paper prepay every year.

Extrapolating this to the idea that an average term for someone to hold a mortgage is five years (in keeping with the ~3 year duration of nominal 30 year mortgage paper), I checked to see how much principal would be repaid over five years with an ordinary amortizing mortgage.

Bloomberg calculations:

Period 30 Years
Loan Amount $100,000
Points 0.000
5/19/05 to 5/19/35
Interest Rate 6.000
Scheduled Pmt 599.55
Effective Rate 6.00
Prepay Freq Monthly
1st Sched Prepmt 6/19/05

interest principal
6/19/10 29492.7 7079.9

So, after 5 years, barely 7% of the initial principal is repaid. Even assuming no house price/general inflation over the span, it's hard to see how this materially differs risk-wise from an IO obligation.

Kevin Bryant replies:

You're quite right; though my angle is a bit different in terms of risk. The high percentage using IO mortgages suggests to me an increased level of financial engineering to make the numbers work, more marginal buyers (by the way mortgage origination is still running at a brisk clip though it may be down from the peak). If the fed is truly determined to deflate the housing bubble "so it shall be written, so it shall be done". Mortgage rates will either follow the fed's lead or increases on the short end will cool the economy sufficiently to cause problems for marginal buyers/owners. though I question the fed's ability to make things better, I have little doubt in their ability to make things worse. the issue for me is not about expecting Armageddon but it's about positioning to take advantage of what seems inevitable, an interesting intermediate term trade.

Justin Klosek responds:

I'm a consumer of ARM mortgages personally, and I need to pipe in about the supposed poor decisions by homebuyers to use these financially engineered products.

Yes, I pay too much for the rate caps and prepayment optionality that's built into the loans. I have a lower rate for three years because I have surfed the curve, then I have a (probably higher) rate for the following three years, but it's capped. That gets me six years out from today. Will my payments be higher? Most likely.

But this doesn't worry me. Why? I am bullish on myself. I believe that my income will increase enough to cover the increase in payments brought on by an increase in interest rates. And furthermore, I can't see two years out in my life, much less six years. Will I still be in my house in six years? Maybe. Maybe not! I do know that the financial engineering "miracle" of the 3/3 ARM allows me to buy a somewhat larger and more desirable house, and it's a house that, if our family expands, I won't be forced to move out of.. It's a house where I can take in my parents to stay with us as they get older.

The beautiful thing about mortgages is this: the collateral behind them is not marked to market. As long as you can pay, there is no margin call. Things might be a little leaner for me later, but I won't get forced out of my home as long as I can write the checks.

Should I be less bullish on myself, perhaps? Well, if I am, then where am I, and what am I doing here? I am able to adapt, and I will find a way to survive and earn and provide for my family.

We close tomorrow on the new place.

Deadliest Catch, from Phil

"Speculation, in its most primitive, natural state."

"Deadliest Catch" is a television documentary on the Discovery Channel, Tuesday at 9 PM Eastern. It's about the fishermen who try to catch king crabs in Alaska's Bering Sea. It's a short (4 to 12 days) and dangerous job: "20-hour shifts in subfreezing weather, exposed to the harsh elements on a slick deck pitching to and fro. The harried, exhausted crew pursue one purpose: catch as many king crabs as possible" " the difficulty [is] in knowing precisely where to drop the pots in order to catch the most crab" it pays well, and the annual harvest is worth $64 million. Some fishermen can live for a year on the money they make in this short period.

War Stories, a new segment

James Tar:

"Your first loss will always be your smallest loss, remember that kid" -Steven Kambour, 1997, New York City.

I really did not know the brilliance of these words when I first heard them. My immediate reaction was that of disbelief. Disbelief that a DVP (delivery versus payment) customer would DK a trade ("Don't Know", slang for failing to settle in the DTC system) that when marked to market, amounted into a $20,000 trading error, which of course, would have to be credited to my P&L at the end of the month's business, and at a 50% payout, that would negate the potential, first ever paycheck in the 5 digit range. "No way", I said, "Sean has done 5 trades with me the last 2 months, he has made money, Stevie. He has settled everything. I'll get a hold of him and have this settled, no worries". "OK, kid, I'm sure you will", Stevie returned, thus offering encouragement rather than scaring me to death.

As you may imagine, I called and called for the next three days. Sean, who's account was set up like a glamorous institution, under the name Christy Trading LLC, was not to be found. The stock was PictureTel, and I was facing a sellout at the biggest loss I could have ever imagined. I got a 2day extension to settle the trade. The next day arrived and I was happy to get to the office early and settle this misunderstanding. No answer. I called from 8am until 1pm. I was freaking out. "Maybe something happened to him", I thought to myself, "How can this guy not settle this as he booked 5 winners, all off of my calls, and now he came in with this 25,000 shares with a nickel on it to pay me back for my calls?" I was getting really really nervous as the following day I was going to be forced to close out at 3:59pm. It was 1pm in New York City (the day being T+4), just as it was in Rockville, Maryland. He had to be there, he had to be there. Without knowing what else to do, I jumped into my buddy's car (on borrow) and drove on down.....

I got there around 7pm that evening. I scoped out the office. Nothing impressive. 2 stories. Central entrance with internal staircase. About 16 office suites from the look of it thru the front glass door. Nobody there, went to Bennigan's, had 6 or 7 beers as I plotted my conversation for the morning, slept in car.

Woke up foggy headed at 7am, heart already pounding. Walked over to Denny's for breakfast keeping eye on the office building. "Maybe that is him....no, this has go to be him, Sean is a great guy, and I bet that is him getting out of that new BMW." Thoughts such as these went thru my head over and over, but I knew I had to be professional and show up at the decent hour of 9am. (You have to give people the time to get set up for their day.) 8:45 rolled around and I was all pumped up, "No worries, walk in, say hello, meet Sean, and he'll settle the trade, no big deal, nice easy ride home, maybe swing into Atlantic City on the way home."

I decide to make a pre-emptive phone call from the Denny's pay phone.....The phone is answered by Doug, Sean's supposed colleague. I explain that I drove down as it was a definite emergency and I wanted to make sure that it was a misunderstanding, etc. I tell him I am across the parking lot at Denny's. He asks me to hold. I quickly tell him I will be right over and hang up. I walk around the first floor of the office complex, no Christy Trading LLC to be found. I walk upstairs, no Christy Trading LLC. What the #^@!?

I walk back down stairs and into the office of a realtor. The lady says she does not know of a Christy Trading, but there are some guys, one named Sean, upstairs whom she thinks trade stock. "Ah hah! that must be the place then."

As I am walking up the stairs, the guy who got out of the BMW is walking down the stairs and I ask him if his name was Sean. "Uh, no, Guy", was the reply. I walk up and in to the office I was directed to, but there was no Christy Trading LLC on the door. It had some Bogus Financial name instead. No secretary, just some desks with your typical PCs on the top and one Instinet Machine. A guy asks me what I want and I tell him my story. Turns out this is the Doug I had been speaking to. Nice guy, but he says he asked Sean about the trade and he did not know it, and that I just missed him. "Red BMW?" "Yeah, that's him." He explains Sean was heading out for 2 weeks of vacation.

"I am sorry, James, I would really like to help you, but there just isn't anything I can do."

Numb like you can not imagine, I call my office and tell Stevie what had transpired.

"Let's sell it now, kid, the market looks like sh#t today." The loss netted over $26,000.

You can imagine what the 5 hour drive back to Manhattan was like. I do not need to explain. 25 years old, dead broke, and I just lost the biggest paycheck I would ever have received.

How could Sean do this to me?

Though I am proud to say that that was the last time I was ever DK'd and sold out, and though it was not smaller than other losses I have taken since, those words, "Your first loss will always be your smallest loss", certainly ring true when examining many of the other losses I have taken in the several facets of my career........I never have considered, nor will I ever consider myself a wealthy achievement. I am, after all, lucky to be alive, and that is worth more than anything in the world. I assure you that there are several people out there doing things far more important for the advancement of human kind, and I just hope that those who win at our game, those who I lose to, or those who I take from, are happy to share in their victories.......Who says Wars are always ugly?

Justin Klosek:

OK, here are two stories "passed down through the ages" to me. Who knows how true they are, but they did bring a smile to my face.

The first comes from a large hedge fund where I used to work and get paid cash for my rent. 1994 or so. One of the partners comes over to a newly-hired junior trader and says, "These mortgages look cheap. Let's build a position." OK, the junior trader rolls over to his turret and starts working the phones. At the end of the day the trader finds the partner and proudly shows him the $100mm position he'd purchased. The partner says, "That's not a position." He grabs a phone, stabs a direct, and says, "Offer me $3 billion......done", hangs up the phone, and says to the junior guy, "Now that's how you build a position."

The partner walks away, get halfway out the door, looks back and says, "Uhhh, maybe we should sell some Treasuries against those?"

Next story comes from my second job. The formerly-private firm was bought out by a large bulge-bracket firm, and the principals were basically handed more cash than they knew how to spend. One fellow decides he wants a Ferrari, and heads to the local dealer (yes, there was a local dealer). He walks in, says I'd like to pay cash for a new Ferrari, and is told that he's number 28 on the list! Hmmmm.... I don't want to wait that long, he thinks to himself. What can I do? OK, I'll buy two Ferraris. And is told that, great, now you're number four on the list!

He took down the two cars, and drove them on alternate days.

Allen Gillespie:

At the tail end of 1999 (December), a guy I rented office space from on Park Avenue, was apparently short ISLD among other stocks. After the stock gapped up $40 (before falling to less than $5), he started acting strange. He seemed to be high all the time and when his phone rang he would run out the door to the bathroom. Needless to say, when he called me a few days later to say that I would need to find new office space, I wasn't surprise to hear he had received a major margin call.

I then went by to sell some research to a tech fund, and I told them I had just seen the last short get a margin call, and it was December so it was clearly selling time come Jan 1. In addition, I warned, gold had spiked and a significant gold move deserves special attention because it has frequently served as an early warning signal as it can indicate a culmination of inflationary/deflationary pressures (see Yen Gold 1989, Peso Gold 1994, ...Gold, Russian Gold 1998, US gold 1999, EUR Gold 2000-2001, US Gold 2003, US gold 2005). I take it as an indication that are beginning to seek return of principal not capital gains (except when deflation turns to inflation like in 1933 and 2003 and you get a rise in both stocks and gold). I wanted part of the carry on a massive short for this information. They thought I was crazy talking about gold but gave me a few bucks for the research on momentum stocks and soon lost their Park Avenue address as well even though they held up turning the first turn that March/April. I guess they thought their momentum names were special.

Me, I started selling all the EMC, CSCO, GLW, and INTC that my clients were willing to pay the taxes on. I have never forgotten the first piece of advice I received from a 30 year vet when I entered the business. The secret to this business, he said, is hanging around, implicitly stating, "because the cycles are ever changing."

Vince Humbert:

Back about 2002, I was working for long-short shop and we were long some Philip Morris and short RJ Reynolds based on prospects for the two companies and the sum of the parts valuation discount on MO. It was a relatively common trade on the street; just a matter of what multiple you put on the pieces. The only thing weighing on our long valuation, short term, was a looming court case that could have had ugly implications regarding possible federal class action status. But if it went against MO, RJR would be affected too. Anyway, my boss had trouble sleeping at night and wanted some protection so she bought 1,000 MO puts a few pts out of the money 2 months to expiration, approximately the time when the verdict was supposed to be released.

Fast forward 2 months to expiration Friday for equity options, the third Friday of the month for near month options. As I recall, it was summer and usually some of the other trading strategy groups are long gone by 4:15-4:30 on a lazy day in the summer. We usually hung around till 6:15-6:30 finishing up work, etc, especially on option expiration day. Post the close, our MO puts were expiring out of the money; about 1 pt out and we had unwound the original long-short stock position profitably a week or two earlier. The puts were still on the sheets since we couldn't get a real bid for them. Lo and behold, the verdict is decided against MO at 5:15, early by 1 or 2 days relative to the on ground street intelligence.

Suddenly MO gaps down and immediately we are "in the money". My boss is busy talking to a fellow PM at the firm in the hallway about nothing special and I look at my boss and yell, "we gotta exercise MO puts right away and we can cover our short at the same time...". Only problem is...Can get a hold of our back office folks in Texas to get a hold of Goldman and make certain they assign the stock creating the short for us. Technically, equity option terms dictate that one can exercise up to Saturday (I've long since forgotten, mid-day?) after expiration Friday but no one is ever really around to do so past maybe 6:00 pm on Friday if you are very lucky. I'm on the phone begging our back office guy to get Goldman to exercise the puts and he's doing it in pieces, so at the same time, I'm buying stock against the just created short MO position. We made about $125K in the span of about 20 minutes post the close, with little to no risk as long as everyone involved kept the procedure and position numbers straight and after most everyone else in the firm had left. We needed every shekel we could generate as I remember and all I could think about was how mad we would be at ourselves had we left early and let an easy $125K slip thru our fingers.

The Strange Tale of Bare-Bottomed K, by Tom Ryan

"Suffering from a strange malady - something economists describe as a lack of "aggregate demand" - in essence an inability to make use of available global capacity to produce."

Isn't it Mr Dow 5000 who has threadbare clothes? OK, sure, one can make an argument that $50 oil is partly due to hedgefund specs and Middle East troubles, Hubbert's Peak, etc, but how does one explain the price rises in copper, lumber, steel, cement and nat gas since 2001? Folks are getting sacked at the companies we work for for even the slightest shortfall in production. This doesn't fit with "a lack of global aggregate demand" for goods. Isn't it the case that areas where in the last cycle there was underinvestment tend to see the largest price increases and the areas where in the last cycle there was overinvestment tend to see the smallest price increases?

And why is a inflation rate of 2-3% and a long bond of 3-4% absent of recession bearish for equities exactly?

And finally this comment strikes me as another one in the spirit of  'your own man' right up there with the Omaha native and the Palindrome.

"But in recent years, America's growth has been stitched together more from the iron fist of government policies than the invisible hand of a dynamic free enterprise economy. (In a world deficient in aggregate demand, the case for free markets and the invisible hand grows weaker as PIMCO's Paul McCulley has pointed out.)"

The Sciences of Hitting and Trading, by James Sogi

Ted Williams's The Science of Hitting is the one of the best books for trading I have read ever and at the price of $4.95 for a used copy, the best deal in the investment world.

Ted's top advice:

  1. The single most important thing for a hitter is to get a good ball to hit. Bacon calls it the overlays. Wait for the 80% play, when p = .0005. Wait for the layups. Why strike out?
  2. Proper thinking. Have you done your homework? What's this guy's best pitch? What did he get you out on last time? Hitting is 50% from the neck up.
  3. Be quick with the bat. Don't sit there and stew over the entry. When the signal hits, enter the orders. Adjust as you go. When you have a good profit and play is run, take it. Don't sit and gloat over the profits till they're gone.
  4. Don't let anybody change your style. Your style is your own.
  5. Know where the strike zone is. Learn where your high percentage happy zone is. Everyone has his bag of trades. Look where the odds are the best, and swing. If its not in the strike zone, pass. Know what the range and percentages are. Know the expected variance or risk and your margin. Know where the sweet spot is.
  6. Guess! That means anticipate where the ball will go. In baseball you read the pitcher. In the market if like last week, the market is dropping, the pullbacks are going to be hard. They were. Anticipate that. This week, its going up like gangbusters, no pullbacks. Anticipate where the market is going to go in the situation. The pros are watching certain numbers, in anticipation.
  7. Mechanics. Study the mechanics of the swing. Know your gear and platform and the rules. When is the market open. The mechanics of your system.
  8. Don't hit at anything you haven't seen. Williams always let the first ball go by. He learned from it. In fact he waited for a fast ball. In the market, how many buy at the market on open? Take a bar. See what it's got. Take a few. When you see what it's doing, then be quick.
  9. Adjust. The reason hitting is so tough is that even the best can't hit all the balls just right. To do so is a matter of corrections every minute. Adjust your approach to different market conditions. In a breakout market entries will be different than in a range. Down market entries differ from rallies. Adjust.
  10. Get in the game, know what's going on, know the reason when that pitcher takes the bread out your mouth.

As to batting, Ted breaks the strike zone into about 40 areas, with the .400 zone right in the sweet spot in the middle and the odds dropping towards the edge. The market doesn't pitch sweet ones all day, but when it does, it's a good time to swing. On less than sweet pitches he talks about swinging for average, "getting some wood on the ball". On 0-2 he talks about conceding the to pitcher and batting defensively. Choke up, push the swing, get the ball on the ground. He talks about anticipating the pitch. If the pitcher struck you out on a curve last time, watch for the curve. At 0-2 swing for the curve. In the market, after it has been dropping for a month, after the turn, the pull back won't be 100% or more like in April.

The trader has the big advantage, hopefully beating Ted Williams .342 average. The trader is always on home field, always can watch pitches. Can walk all year long with the risk free rate of over 4%. Can hit grounders all day long for .850 or better. Can watch all the others. We have our odds all set out for us ahead of time. Most systems should bat over .600. The trader can adjust leverage to bunt, single, or swing for the fences. The trader can cancel orders, move them around.

Tom Ryan responds:

I was coached in the philosophy of "just don't swing at bad pitches", rather than "wait for the perfect pitch". The problem with waiting for the perfect pitch. E.g. Barry Bonds's lifetime stats:

After 1-0  .340
After 0-1  .235
After 2-0  .299
After 0-2  .123

I propose trading is not altogether different. It's not the perfect pitch we want -- just a good pitch to swing at.

Philip J. McDonnell offers:

Good Pitching Dominates Good Hitting

A Long Time Ago in a Galaxy Far Away I was a PAC 8 pitcher at UC Berkeley. Some may recognize it today as the Pac 10. The point of this essay is that good pitching dominates good hitting. All of the lessons apply to trading.

The pitcher's goals are to obtain strikes while providing as few pitches to hit as possible.

My rules:

1. If the batter swang at the last pitch and missed, then he proved that he can't hit that pitch. Back it up (Repeat the pitch).

2. The Inside Pitch. Hitters like to pull the ball. The idea is that the bat starts on the shoulder and if the pitch is inside (close to the batter} then the batter wants to hit the pitch in front of his body. He thus has a long path from his shoulder to the point of impact in front of his body. The greater distance allows more time for acceleration of the bat. The slang is that the batter can "pull" the ball resulting in maximum distance. The disadvantage to the batter is that time to swing through the longer zone simply takes longer. The rule for the pitcher is "hard in". Do not give the batter time to react to the inside pitch.

When the market makes a move, it moves quickly. It doesn't allow traders time to react.

3. The Outside Pitch. From the batter's perspective the outside pitch is the hardest pitch to see. It is farther away. For the batter the idea is to wait and hit the ball with the fat part of the bat to the opposite field. This means right field for a right handed batter. The delay makes the batter susceptible to timing tricks. So the strategy from the pitcher's perspective is to alter the timing. He pitches slow on the outside part of the plate.

The market continually changes timing. It is quiet, only to be followed by volatility. The trader is kept off balance.

4. Throw strikes early in the count. Many hitters look at the first pitch. When a pitcher gets ahead in the count the batter suffers. Many hitters look for a fast ball when they are behind in the count.

Many good rallies begin with a succession of positive days which surprise traders. Traders get caught watching the very profitable early leg of a new rally.

5. Curve Balls. A curve ball is a good pitch to throw when you have two strikes. With two strikes, the strike zone is larger. The batter will swing at pitches which are "close" to the strike zone. The deceptive arc of a curve ball seduces the batter into swinging at a pitch which is near the strike zone but not necessarily "in" the strike zone.

Near the end of a move many margin accounts which have been wrong footed will be close to the edge. The markets are notorious for a final deceptive move in the direction which will force liquidation of losing margin accounts.

6. Another good pitch with two strikes is the high fast ball. Many pitchers consider this their strikeout pitch. Hitters will often chase a high fast ball especially when they have two strikes. High fastballs should be thrown with a four seam grip. They will tend to rise, thus deceiving the batter into chasing a pitch out of the zone.

7. Pitch to the situation. If you need a double play and have a runner on first a good pitch is a fast ball at the knees. This should be thrown with a two seam grip which will result in a slightly sinking ball. The goal is to get a hard ground ball which will get to the infielder quickly in order to allow a double play.

The market seems to know the positions of the players. Often the news will serve to expropriate funds from the many. News, such as announcement of "an oil spike", seems to come exactly when needed by major market participants.

Tom Ryan again:

"If you don't mind my saying so, the better the pitch, the harder one should swing. "

That may be true, but as a daytrader my point was that a takeaway from Williams' book on the take the first pitch and the sage has used this several times in his homilies, Is that one should wait for the "perfect pitch". However we know in baseball, that once you get behind on the count, on base, hitting and slugging %'s all suffer. Taking the first pitch as a fixed system is bound to put you behind in the count more often than not. I propose that most daytraders know intuitively when they are behind in the count and that is when we tend to swing at bad pitches. Better to be prepared to always swing at the ball whenever it is in the right zone even if that is for example, right at the open.

From Kim Zussman:

In a duel, if your opponent shoots first and misses, you can:

  1. Aim carefully and kill him.
  2. Aim carefully and not kill him (if he is crippled he may follow you forever).
  3. Aim poorly and miss him. A tie.
  4. Decide not to shoot and walk away a hero. How far you get depends on whether your opponent picks up your pistol.
  5. Aim intelligently and kill the woman you are fighting over. Then go with your opponent for some beers.

Big Al adds:

Which brings up a subject not visited in a while: movies, especially heroic realism. If you haven't seen "The Duellists" (1977) in a while, check it out. From a Joseph Conrad story, directed by Ridley Scott, starring Keith Carradine and Harvey Keitel. Officers in Napoleon's army, Keitel decides that Carradine has insulted him, and Keitel's Feraud is not the kind of man to let go of an insult. Ever. Grand human themes brought to life in a very specific story.

And back to Jim Sogi:

The reality in gunfights is that dozens of rounds are fired with few hits. In warfare the bullet/kill rate is low. In old duels the fighters often reloaded numerous times before one lost nerve or was injured. The market is the same. Many shots are being fired. Many misses, reversals, failed breakouts, many pivot point failures.

When hunting big game, the hands shake, the heart pounds and the gun wavers. Hunting large boar with dangerous tusks, acute smell and night vision, that travel in packs and can run 30 mph in the dead of night requires some edge. Night vision with infrared scope, multiple magazines, back up weapons, gives an edge. I watch their foraging patterns and wait for them to come along. They are predictable. One shot drops them, but even then, their throat needs to be slit to bleed them so the blood doesn't go bad. Good to develop the killer instinct: like trading.

from Abe:

If my opponent is visually picturing me as a target while walking his ten paces he most likely will do so by mentally extrapolating "a straight line" from B [his place after ten paces] to A [starting point] further to guess C [my place after ten paces]. In this case a very good strategy is to deviate from the straight path while I am making my ten steps so that when my opponent turns around I will not be where he visualized me to be, that is, rather at C I will be at D [somewhat off the straight line]. He should be confused for a split-second.

It might be advantageous staying 'formless' [having no rigid expectations] but having 'scripts' for different scenarios.

The best guess for tomorrow price is today's price [extrapolation ABC] but sometimes the market will be off by "a lot" [D]; the reason why big moves tend to take one by surprise?

There are certainly more subtleties to think about for example which way my opponent will turn around etc. Besides, should I think at all about what my opponent could possibly be doing or should I rather concentrate/meditate like in Zen where they would say that the bullet is one with its target as soon as the ego is transcended; possibly an analogy to program trading and the arbitrage business or is this rather analogue to having an automatic weapon?!

A Southern Spec Chimes in:

At ten paces you think thats a fallacy? I can only speak for myself and use my hunting skills and instincts based on observed math and probabilities over my lifetime but, at ten paces Abe I will gladly take the first shot. distance, velocity, and target all taken into consideration. mMvie aside, when Mr. Eastwood said "go ahead punk, make my day" the gun was already pointed, aimed and ready. he took the first shot. Counting for the first time in my life over the last three years has done just than. It allows me to take aim, get ready, be prepared and objectively look at something and then take a shot at it, instead of sitting back and waiting for the perfect pattern, trade, signal or such. That's all i meant. If i am on a range, lookin' down in the valley and see a turkey near its roost at some distance then obviously the first shot is not the one taken. If i am Mr. Sogi in the bush of HI and a wild boar comes upon me at a distance of 50ft away, then the first shot is taken! inflexibility, and not paying tithe to law of ever-changin' cycle is something this six shooter doesn't try to do anymore. for a little countin', after the first shot i tend to have five more bullets in their appropriate chambers, so if the first doesn't do the job then hope springs eternal with the others.

Abe rejoins:

I understand it is ten paces for each person, so the real distance is double, in fact, twenty paces. Anyway, you might be right and it is generally better to get the first shot but I understand that this doesn't mean I should shoot immediately and without aim. The real problem in a duel situation is the 'accurate aim' period. The longer I delay the better my aim will be and the greater my chances of hitting the opponent. At the same time, the longer I delay the higher the odds will be that I am not the first who shoots. So there is a pay off between aiming [being slow but accurate] and being the first who shoots [being fast and inaccurate]. We will be the first by not aiming and shooting immediately but will we hit? I understand that the likelihood of hitting the opponent of a distance of twenty paces by an inexperienced shooter by turning around without aiming and a heightened pulse rate [!] to be very low, probably less than 5%. Of course, there are other factors involved as well like whether we shoot with an 18th century pistol or a Walter P99.

When we construct a correspondence between "counting" and "aiming" then aiming in a duel situation is equivalent to counting during [!] and not before the trading session. So then, in fact, a duel situation is not a good analogy for trading because in trading you can count before the action takes place which, as you wrote, "allows me to take aim, get ready, be prepared and objectively look at something and then take a shot at it, ..." which is exactly what I cannot do in a duel situation.

"Counting" or proper trade preparation in trading can be likened to a time option in a duel. You effectively have something like "three" seconds to aim AND shoot first, that is, being accurate but first!

Back to Southern Spec:

While you are walking you are countin' in your head 1,2,3,4,..... you are preparing by visually picturing your target before you turn around fire? I sure ain't thinkin' what you are thinking when walking those steps "I am thinking 10, turn and shoot, your thinking 20 steps total, time vs. shooting, optimal strategical value". Same thing for me at least when looking at ticks real time, or price patterns while trading "in act "of or "preparing". shouldn't we both be prepared before we duel? Dueling certainly isn't something we should do for fun? trading/speculating/investing ain't something i do for fun. Is a bid vs. ask not a duel? Profit vs. loss sure seems like a duel to me? You can keep that zero sum game thought in your pocket because when I loose it means I am broke and that might as well be death.

Ten Variations on Leads and Lags in Industry Groups, by Victor Niederhoffer

In a previous memo, I discussed the Austrian Von Mises and Hayek theory of business cycles which in a nutshell predicts that there will be consistent leading relations whereby capital goods manufacturers turn at the beginning and end of business cycles because they are most sensitive to artificial interest rate changes induced by the monetary authorities. "Interest rate sensitivity increases with temporal distance of the investment subaggregate from final consumption".  The problem with this theory is that it doesnt take account of rational expectations, i.e., the ability of people to make the correct decisions and learn from past mistakes.

To put some meat on the bones of the more general question of whether there are consistent leads and lags, I turned to the Russell 2000, consisting of 12 sectors. I studied the period from 1995 year end to April 2005 month end, a nice 10-year period, earlier than which I would speculate that all relevance is lost because of learning and changing structures. The first question is which industries were best and worst. And here's a surprise:

Performance of Russell 2000 sectors, 12-95 to 4-30-05:

Sector9.5 yr % Return
Other energy+209.8
Integrated Oil+181.0
Producer Durables+124.4
Financial Services+120.6
Consumer Discretionary+118.6
Auto and Transport+93.8
Consumer Staples+93.5
Health Care+72.3
Materials and Processing+57.8

Who would have thought? Technology was worst and Auto and Transport was up 94%. Energy at the top is an interesting reflection of the boom in last year and a half in oil, but I wonder if the cycles are about to change.

Has there been any consistency in these rankings over time? The Professor's star student Chris Hammond computed the rank correlations as his first summer project here. And I hasten to report that the average one-year correlation is -0.02, a completely random result. And yet the two-year correlations average -0.12, a figure bordering on 4 to 1 against if there were no negative consistency over time. In other words, if an industry is good in 2002, it is likely to be bad in 2004, and if an industry is good in 2003, it's likely to be bad in 2005.

The ranking of the industry returns in 2003 was: Integrated Oil +128, Technology  +63, Producer Durables +59, Health Care +58, Materials and Processing +43, Consumer Discretionary +43, Auto and Transport +41, Other Energy +39, Other +37, Financial Services +35, Utilities +34, Consumer Staples +24. But before you go out to buy the Consumer Staples and short Integrated Oil, note for example the rank correlation between 2001 and 2003 performance of 0.56 and 2002 and 2004 performance of 0.51.

Some correlations of industry performance two years apart:

1996 and 1998   -0.65
1997 and 1999   -0.71
1998 and 2000   -0.65                 
1999 and 2001   +0.31
2000 and 2002   -0.25
2001 and 2003   +0.56
2002 and 2004   +0.51

Industry rankings YTD 2005: Other Energy +3, Utilities 0, Integrated Oil -4, Consumer Staples -5, Consumer Discretionary -9, Other -9, Materials and Processing  -10, Financial Services -12, Health Care -13, Producer Durables -13, Auto and Transport -18, Technology -20.

Variation Seven of Industry Lags:

It requires no co-integration or three-stage least squares to reject the Austrian business cycle theory in the last 10 years. Producer Durables was up each year except 1997 and 2002: 1996 +14, 1997 -12, 1998 +36, 1999 +2, 2000 +2, 2001 +5, 2002 -26, 2003 +59, 2004 +16, YTD 2005 -13.

There seems to be a tendency for producer goods to bounce back the next year. But its decline did not presage a decline in other industries in subsequent years; 1998 and 2003 were great years for all the other sectors.

An Erudite Spec replies:

Interesting question, but I don't recall Austrian economists' discussing stock performance leads and lags by industry. I've taken a look at Roger Garrison's pictoral illustration of the time structure of production, and I think he would say to measure leads and lags in terms of profit or revenue growth rather than stock performance. The Austrians said surprisingly little about stock markets, and I can't recall their saying much nice about them. Most newsletter-writers/gurus/Austrians seem to be doomsayers who say the stock market is dominated by blind fools. However, one paper that at least tangentially addresses the industry lead/lag question is Cross Industry Momentum by Menzly and Ozbas.

Kim Zussman adds:

Trivial observations in the face of great ones:

The momentum literature talks about industry momentum*, and some papers ascribe significant continuation (for 3-12 months, depending on look-back period) to industry. Also industry relationship has some explanatory power. Longer periods exhibit mean reversion; i.e., bottom performers in look-backs of longer than 1-2 year outperform. All of this is older than your study but seems consistent none the less.

One might capture much of this effect, as per your hint, with sector ETFs. Or alternately long bottom performers in recent 3 years which could be called half of DeBondt and Thaler effect.

*This year momentum doing poorly.

Pressing Thoughts, by George Zachar

The literally insane defense of the deadly Newsweek smear against US forces that is being mounted by much of the press today reminds me of the old bromide about healing. The first step in healing oneself is recognizing that one has a problem. Even the American Satan, Richard Nixon, had the decency to resign. For Newsweek to not clean house -- or even make a token firing -- is damning evidence of pathological solipsism.

The bizarre lashing out by reporters and various ankle-biters in media blogland betrays a stunningly deep pathology -- a mania -- that is simply incapable of seeing good in America, or evil among its professional peers.

These were the people who successfully turned Tet into a Viet Cong victory, helping turn SE Asia into an abattoir. These were the people who saw no evil as millions were butchered in 20th century China and Russia, but endlessly brayed about "American-backed dictators" in small, obscure nations. These are the people constantly looking for sad-sap health care stories to gin up the government's effort to seize the medical industry, while never reporting the utter disasters in every nation where the State controls health care.

What kind of hell-on-Earth would they condemn us to, given the chance?

Backoffice Backdoor, by George Zachar

Looks like some of the national central banks of the Eurozone, with lots of bodies and not much to do in the age of a single currency, are branching out into backoffice work.

Alternatively, this could be a backdoor effort to bring core banking functions under the direct control of national governments/the ECB.

Or it could be both.

In the Pits, by Ryan Carlson

I think I've recommended it before, but The New Gatsbys by Bob Tamarkin is full of exciting stories from the Chicago trading pits. After reading the book at 17, I was certain the course my life would also pass through the CME/CBOT. As it turned out, Tamarkin's son was a filling broker in the same pit I traded in.

On a somewhat related note, I just finished Only the Paranoid Survive by Andy Grove (ex-Chairman of Intel) who not only recounts some of the war stories of the tech industry but also presents the solutions which helped get the company out of their problems.

Many pit locals haven't been able to make the transition to the screen and futures trading has undergone what Grove refers to as a "10X Change." Luckily, I arrived on the scene as the markets were making the move and didn't pick up any bad pit habits in my short time down there (especially relying on a broker to feed me). Nevertheless, Grove's book continues to help me understand the dramatic shift in how industry is changing.

The Husband Does Not Fall Far from the Wife, from George Zachar

From an article in the Financial Times:

Bill Clinton is lending his name to efforts by an Austrian company to bring hedge funds to the US retail investor. One of the former president's first public appearances following his planned chest operation this week will be at the launch of a retail investment centre on New York's Fifth Avenue by Superfund Asset Management. The opening of the office, believed to be the first of its kind in the US, is an attempt to tap the growing retail demand for products previously the preserve of wealthy investors. The minimum investment in the company's funds is just $5,000, while many hedge funds require $1m or more.
Mr Clinton is due to give a speech on the global economy at the launch on March 30. Christian Baha, 36, founder of the company, formerly known as Quadriga Asset Management, said: As governor of Arkansas, President Clinton paved the way for more liberalisation and social justice. It is our goal as well to give people with a lower income the opportunity to benefit from successful investment models with double-digit returns. The company, which claims to be the world's biggest provider of managed futures funds to private investors, has been at the forefront of attempts to bring hedge fund-type products to a wider audience in spite of regulatory concerns.

For Advanced Players Only, by GM Nigel Davies

There are certain chess openings which are only suitable for advanced players - you need a certain depth of understanding and degree of subtlety to play them well. Less expert players should stick to simpler methods, otherwise they are likely to confuse themselves.

There are analogies in trading - less experienced players should master the basics before they try to incorporate more complex factors into their repertoire. A good example is news - it takes considerable expertise to be able to listen to the news, put things into perspective and understand what is important.

Lack has told me on numerous occasions to ignore the news, even to the extent of getting rid of my television. I've kind of seen his point but not really made much effort to act on this advice. But from today it's going to be different.

Vince Fulco adds:

While all things must be tested, I recall a Bill Miller speech once when he stated, "If it is in the news, it is in the stock price...". When the price moves in the opposite direction of common sense, a derivative of LACK's "get the joke..." continues to confound the public and some pros alike. I've found this theory to be quite useable.

Ecological Timescales, by Kim Zussman

A central paradigm of the spec-list is the relationship of markets to population biology. This wisdom evokes inevitable comparisons between the flow of survival and the torrential proxy-currents of numbers pushed by human fingers. Often there are discussions of trees, forests, fish, and oceans. Unfortunately these rapid evolutions require rare minds; and alas move too fast for those of us who trade mostly taxable. Which often brings me on personal homages to geologic time hiking the Santa Monica mountains to learn from the master.

Sunday on the trail pulling a map from my right pocket worried that the twenty tucked in there would fall out. Reflexively switched the map to the left where car keys lived, and chuckled at the accidental risk-quiz just flunked. More concern about losing a few bucks than keys and a way to get home?

There was a quarter mile wide wash scrubbed flat and graveled in by this year's record rainfall. Now, after drying out, a mindless ribbon creek wiggles across the wash in the shortest path to less potential energy. Surprisingly there were curving swales lower than the creek; dry as dust and isolated by sandy berms and wood detritus piles of gone violence. Even nature in her haste follows inergonomic pathways of deception. Opportunist plant life seeded of airborne diaspora flourishes creek side, shooting up their own day to germ the wind.

Winding up the canyon as it narrows I encountered one of those people* who could make cute pets for interested wives. Only this particular fellow, well fed and healthy, was missing a hind leg. The wound was old and at first puzzling that beyond managed care such disabilities could survive. However horned lizards eat ants and only have to park next to a conveyor column of food in the life of a reverse drive-through, which explained this lucky soldier. I released general Spike and his war wound back to the rocky land of his horny mistresses.

Destination "The Grotto" is a mass of jumbled creek boulders with stream water gushing and plummeting among deep crevasses. Navigating the way at first in a series of risky rock hops, which on further study showed safer paths only requiring patience. Near the top of a cliff the water tipped through a gap and dropped deep into a subterranean cavern. Eventually found a way into the cave; a thirty-foot inky cavern and a large pool filling with waterfall with earthy vapors moist on the skin. On one wall mineral precipitates archived the stream. On another an errant tree root gripped a boulder for a hundred years.

*Akira Kurosawa's Dersu Uzala is the story of a Siberian Goldi native whose insight for nature and animals was so great that he changes a Russian general's life. To Dersu a tiger is a person, and killing this person ended Dersu's graces with the spirits and his relationship with reality.

Get Stoked with this Spring Skiing Report by Andrew Moe

Kim Zussman Sheds Some Light on Regulation T

A Trade Fable, by James Sogi

Early May: Storm warning; major floods were predicted. As the floods rose over the streets where the house of worship was located, a congregation member called to the clergyman, "Let me save you, jump into my truck!:

The clergyman replied, "No, the L#rd will provide!"

The raging water rose above the doors of the house of worship. Another congregation member called to the clergyman, "Let me save you, jump into my boat!"

The clergyman replied, "No, the L#rd will provide!"

The waters rose above the roof as the clergyman clung to the spire, another congregation member called to the clergyman, "Let me save you, jump into my helicopter!"

The clergyman replied, "No, the L#rd will provide!"

As the waters closed over the clergyman's head he cried, "L#rd, why did you forsake me?"

Came the voice from above, " Forsake you? I already sent three people to help you and your turned them down each time."

Moral of the story. When your trade is taking you down the tubes, and the market gives you a nice bounce to get out, take it. Don't say, (as a friend said), "No. One percent is not enough profit to be worthwhile. The market will provide more."

(Disclaimer. Moral may not be applicable to late May trade due to change in cycle on Friday May 13. Better weather ahead.)

Yellen on the Job, by George Zachar

From an interview with Janet Yellen in the Contra Costa Times:

"In addition to our monetary responsibilities, we run businesses here. Rapid technological change has affected us, too. Until I got here, I had not realized the extent to which our business is impacted to changing economic trends and new technologies..."

So the former chair of Clinton's Council of Economic Advisors, and ex-UC Berkeley B-School prof, belatedly learns about changing cycles and creative destruction.

Alas, she has yet to grok freedom of choice.

Asked about using personally-directed retirement accounts as part of a social security overhaul, in the context of investors still smarting from the Nasdaq bubble, she said, "...people would make some of those kinds of mistakes without some restriction on choice."

No doubt, this improves her bona fides for another top Washington position, should the junior Senator from New York succeed in her quest for the brass ring.

For Whom Art Bell Tolls, by Ross Miller

Art Bell had another "we're running out of oil and civilization will end" guest on last night (the last time was right after Goldman's April Fools superspike announcement). And oil is reacting accordingly in early trading (down to near $48/bbl). He was James Howard Kunstler, author of The Long Emergency, a book which combines the oil peak and global warming in a scenario where almost everyone who lives in suburbia dies (including hedge-fundists in Princeton, NJ and Greenwich, CT). One is tempted to consider whether the saying that no one rings a bell at the top of a bull market is true?

Politics Without Romance, from Don Boudreaux

To the Editor of USA Today:

Do you want hard evidence that politicians put their own political fortunes ahead of the general welfare? Or that politicians' declarations of courage and concern for the country are lies meant to mask their greedy, grimy efforts to benefit the few at the expense of the many? Look no further than the scramble to prevent the Pentagon from closing superfluous military bases.

Sure, every huffing and puffing Senator, Representative, and Governor asserts that the base in his or her jurisdiction is more militarily strategic than the Pentagon finds it to be. But just beneath the surface of these claims festers the truth: every politician wants the spigot that pours taxpayer money into the pockets of his or her constituents always to open more widely and never to close even slightly.

Business Cycles, by Victor Niederhoffer

The essence of the Austrian theory of the business cycle is that interest rate moves induce businesses with different degrees of length of time in the production process, and debt relative to equity, to show differential responses in the prices they pay and the output they produce. "The expansion of credit due to the artificial reduction in interest rates increases the quantity of money in circulation, and this monetary increase inevitably reduces the subjective value of each monetary unit in the eyes of market participants. The producers of production goods usually borrow large sums of money to carry out their enterprises. Consequently they are among the first to respond to lower interest rates."  From a review by Bettina Greaves in Liberty magazine of Hayek's Journey: The Mind of Friedrich Hayek by Alan Ebenstein.

The theory assumes that people make irrational decisions and don't learn from experience, and that there are such things as business cycles. Furthermore, for investment purposes, that these effects somehow aren't taken into consideration by the stock market as it traverses its inevitable path. In any case, it's a suggestive hypothesis. It seems particularly relevant these days when technology stocks respond so much differently to reductions in interest rates, as on Friday, when Nasdaq was up 1% with the S&P down %. I will be presenting some empirical results sparked by these ideas shortly and am open to any specific hypotheses that might be tested with such things as the readily available Russell 2000 breakdown of stocks into 12 industry groups or the S&P 500 breakdown into energy, consumer staples, materials, financials, health care, industrials, consumer discretionary, utilities, telecom, and info tech.

An Unusual Move, by Victor Niederhoffer

Every now and then I note a drastic change in the relative moves of markets. Indeed, their relative movements has been the basis of many a speculative foray, whether based on short-term Fed model predictions, or Kira analysis as described in Practical Speculation. In this connection I had noted a move in S&P from 1225 in early March to 1157 as of May 13, in conjunction with a rise in the 30 year bond from 110 to 116. Such a 73 point differential, or in yield terms, a move of approximately 5 percentage points in favor of stocks from two months ago, does reduce the tendency to snore.

Ever-Changing Cycles, by Tom Ryan

Found a camp spot that the derivative expert would love. A WPA project dam from the 1930s in Rucker Canyon in the SW side of the Chiracahua Mts. A concrete and masonry dam about 100 feet high built in an ephemeral stream that was completely filled with rock and dirt in 1983 from a flood and debris flow that was due to a combination of events. A fire in the head of the canyon the previous summer followed by a 100 year storm the next year which caused a collapse and large rock slide above the dam and which washed down into the lake completely filling it up. The dam did hold although it cracked on one side. interestingly, there is about 25% porosity I would guess to the debris of rocks and downed trees and dirt so the dam still holds tremendous amounts of water behind it and although the storage capacity is reduced the evaporation is substantially less.....resulting in a more constant outflow year round now below the dam. As a result the canyon below the dam has grown dense with trees of all sorts, all about 15-20 years old, cypresses, sycamores, hackberry, all crowding out and killing off the oaks which used to dominate the canyon when it underwent annual wet/dry periods. A classic change of cycles. Some unknown day in the distant future that concrete wall will finally break and the debris behind it will erode away and the stream will go back to its old self again and the trees below will change once again.

No bear sightings - it has been a wet winter so there is water up high and the browse and berries in full muster so we saw few animals. As it dries out up above the bears will descend to pick on the campers in the canyon bottom and we will go up to the high country on top to camp instead to avoid the bears.

In Vino Veritas, by Mark Mahorney

There are wineries in every state with 4,000 throughout the U.S. But I think they could still ban interstate so long as they also ban intrastate, discrimination being the key issue.

Small point, but it's doubtful there are any public companies that would be greatly impacted positively by this. Possibly, it could have a long-term negative impact on a few distributors. The various wineries get wine shop shelf space through several major distributors. Being able to order direct from wineries could be a negative for them.

If people visit a winery on vacation they will have a tendency to have an affinity for that wine and likely order more of it from home, give it as gifts, etc, even if there is nothing special about it.

Friends of mine went to Italy last year and brought back a couple of bottles of wine which they raved over. Knowing little about wine, it's likely they brought back what would be considered by connoisseurs to be low end, which includes the vast majority of Italy's 'everyday' wines.

Alas, being the uncouth domestic beer-swiller that I am, the wine was shared with other party guests. I was not offered a glass, little realizing that I knew quite a bit, having worked for a time in a wine shop where I had sampled many wines brought in by the distributors, coming to recognize and appreciate many of the subtle differences.

Most importantly I learned to identify which wines were good yet not overpriced, a skill having value in all of life and especially stock selection.

Back to the Futures, from Steve Wisdom

Every issue of Futures magazine has snippets from past issues. Among the "flashbacks" in the current, May '05 issue, these bits from Sep '83..

"'Has the wild ride in stocks really begun?' outlined how the Ell##tt W#ve principle suggested the Dow could go above 3,000 in the next few years followed by the worst financial collapse in U.S. history."

"In '####### ######: Turning a summer job into a legend', we interviewed the world's biggest futures trader at the time, who said all his profits came from 5% of his trades. ###### went from runner to floor trader to money manager and became one of the time's most successful futures traders worth near $100 million at the age of 34."

Well, the 'worst financial collapse' never came, and the 'world's biggest' soon became famous for his failed public fund and his 'persona', rather than his $100 million fortune. And I foresee this month's cover in a "flashback" 20 years hence.

Surf's Up, by Jim Sogi

In the big wave surf line up, being in the right spot is critical. The variation in the area in which the waves break is larger than the distance the surfer can paddle in the time before he sees the wave on the horizon and the time it breaks. Yet you have to be within the critical area to be able to paddle in on the steep part, but not so far in that you get crushed by the breaking wave. Positioning and timing are the keys.

How do you know where the right spot is to sit and wait: not so far out that you miss all the action, but not too far in that you get worked by a big breaker? The experienced surfers know their spot. We have secret line up points on the land from which to triangulate the position. For example, at Mahaiula, a famous big wave spot, I have a line up with a certain set of palm trees, and a formation of lava and grass on the mountain behind from which I can tell whether I am sitting 'deep' or still way far out. I can gauge my exact location in an otherwise featureless ocean. The goal is to increase the ratio of waves caught to times getting caught inside and worked. There is a triangle in which the waves are caught, and disaster on all sides. The 'kooks' don't have a clue and get wasted with regularity. The 'crew' catches wave after wave, barely getting their hair wet.

If you don't know where you are in the market, you get wasted and miss the waves. Ideally you want to set your orders right at the peak of the wave, and not too deep in so that the variations wipe you out, but not so far out that you don't even catch the wave. Line up with recent points, maxima and minima, or on cycles, pivots, variations, or whatever your methodology is that works. Often the variation in the moves is greater than the available equity or margin so positioning and timing is important. Its good to have a line up and know where you are, especially when big waves like today's come rolling in.

Dick Sears Weekly Update: One for the Seesaw

Victor Niederhoffer: A Good Research Project

IBM flirted with 72.50 the last two days and Intel flirted with 25.00. Both reminded me (especially the apparent erroneous market order to sell Intel on Thursday that dropped it from 25.00 to 24.01 in a minute with a yo-yo type reversal a few minutes later) of the convulsive and disruptive behavior of an animal trying to evade a predator, which in this case was to evade the all too strong grasp of the remaining bulls. I propose an index of Intel to IBM to quickly monitor new tech to old tech and wonder what the leading indicator properties of this are, and whether the Nasdaq up 0.6% percent as of 2:40 pm on Friday, with the old S&P 500 down 0.9% percent, a spread of 1.5%, is predictive of anything.

Bruno Ombreux responds:

I don't have anything predictive, but I have explanations. I think I would make a good journalist.

I don't know if it is sensible to apply classical statistics to something as clearly nonstationary as the Nasdaq. However, I looked at the correlation between USD/EUR and the ratio Nasdaq100/DJIA, a proxy for growth vs. value.

Using daily log returns since 1992, I find a -0.04 correlation. This is highly significant given that we have more than 3300 observations. This means part of N100 overperformance could be explained by currency effects. That is a stronger dollar.

Another thing is the flattening of the yield curve. In Damodaran's Investment Fables, it is mentioned that a flattening to inverting yield curve and growth relative performance are correlated. This must be a good book, because you wrote on the cover that it is a good book. So I'll trust the author on this one.

A third thing is ever changing cycles. The chart below shows the cumulative returns of Stoxx style indices. These are euro indices, but the US is correlated and should show the same picture. Large cap growth has been underperforming. badly. It only makes sense that it starts overperforming. At least for a while.

Victor Niederhoffer: A Little Table

A little table comes my way via a tennis buddy who runs a research and investment firm. It divides the stock market into periods of bull and bear moves as follows:


Several questions arise. Are the swings consistent with randomness? Are comparable swings in individual stocks consistent with same? Are there any predictive merits to such a typology? Can other typologies be developed which are predictive? Is such a descriptive typology useful or educatory? How could other rules be developed which are more useful? Is there any relation between local maxima and minima in markets? How could such a table be best extended forward or backward?

For many years, I have had a guest meeting with my tennis buddy's summer students and presumably this will continue in the future. This year, I will ask my summer people to answer some of these queries and share them with him. Perhaps our readers will wish to make their own contributions to these and related queries.

Professor Bud Conrad responds:

I put Vic's data into a spreadsheet, and added a few entries to interpret the latest five years.

The rallies were over 100% and the declines around 30%. The annualized rally and decline were about the same at around 30%. The average duration of the rallies was almost four years and the declines less than a year.

I added a decline to Oct 2002 and a rise to yesterday. As an alternative, I also added a line for considering the whole five years as a single decline. One of the biggest problems of this form of analysis, is that we never know if the last data point is potentially a turning point until way after the turn is taken. In my attempt to decide if we are in a long five year decline, or a decline to October 2002 and a rise since, I see the decision is arbitrary. As an additional example of the difficulty, I see that we are off highs now, that could mean we are in a third leg of decline, but we won't know until much later.

Duration% ChangeAnnualized

Aaron Koral replies:

Based on a cursory review of the rally/declines table, I noticed three things:

From the standpoint of randomness, where the same event happens with some probability distribution, I would say there is a low degree of randomness with the declines.

One could, for example, extrapolate forward what is the probability of declines lasting more than one year over the next 20 years from 2003 to 2023, based on the data given in the table.

Here is something to think about: since 1987, Alan Greenspan has been at the Fed as Chairman. Is there be a possibility that, during his tenure, monetary policy and low inflation contributed to the decrease in time for market declines to end?

As for the rallies, there is a degree of randomness. The length of time varies but generally rallies last approximately two years on average.

One way to extrapolate this rally theory backward would be to look at market movements from the Great Depression onward to 1962 and determine whether rallies during that period of time had the same "legs" as during the period of time given in the table.

If so, this could mean that there is some correlation with the length of time in declines and the length of time when rallies start to finish.

Victor Niederhoffer: Briefly Speaking

Two of the reasons given for the market's fall yesterday bring to mind the body snatchers. It went down because oil fell below $50 and the oil stocks account for 1/3 of the S&P index decline. But just a few days ago, the reason posited for the market decline was that oil was high and it would bring consumer spending down. Similarly for the decline attributed to retail sales twice as high as expected. "Well," as one manager said, "it's perverse. That's bearish because now the Fed will have to raise rates faster."  Finally, the dollar increase: the Euro was $1.36 at 2004 year-end and is $1.26 today. Wasn't the decline in the dollar last year one of the major planks for why the Buffetabelsons couldn't find any stocks they like?

Straws in the Wind, from Anonymous

Sage losing his shirt on the dollar, with very little media coverage.

Stockman resigns as president of buyout auto-parts company Collins & Aikman, amid cashflow shortage.

Vic's neighbor Jack Welch lowers price of his house to $9.5 million after not selling for two years. Surprising because it must have lots of built-in perks paid for by GE. And of course historical value, because it's where Welch and a court marshal served Jane with surprise divorce papers.

Ask the Specs

Q: I am considering leaving early to go home flat and ahead 20K on the day, as a prophylactic measure. -- California Daytrader

A: Yes, it's always good to practice safe specs. -- Specs

Historical S&P Performance Around Friday 13th, by Steve Wisdom

Looking forward from the S&P open on Friday the 13th since 1996, Change in points to:


12:05, by Victor Niederhoffer

At 12:05 yesterday the terrible news that a plane had been seen over Washington and that the evacuation of the White House and the Capitol was proceeding was announced. The market dropped from 1164 to 1158 (an eight day low) in three minutes, with about 1000 contracts traded at each price, 1164.00, 1163.75, 1163.50, et al. By 12:09 the price had bounced back to 1162. I must tip my hat to the market mistress's ability to unleash weak longs from their positions.

Backtesting When We Don't Know the Direction of the Expected Effect, by Dr. Alex Castaldo

A useful fact to know is that if a random variable is distributed as N(0, sigma) the expectation of its absolute value is sigma*sqrt(2/pi) or approximately 0.798*sigma.

The latest application I came across is as follows. Let R(i) be the daily returns (or daily changes) adjusted for long term drift. The R(i) have a zero mean by construction and a standard deviation sigma (approx 1% for the S&P 500 for example).

Suppose a decision rule selects N days as a subsample of interest. If the rule is no better than random, the average of the chosen R(i) will have expected value zero and standard deviation (approximately) sigma/sqrt(N). [I say approximately because I am neglecting a finite sample correction we might want to make]. In practice this sum S will not be exactly zero; if it turns out to be positive, we can say We have discovered a decision rule for going long that yields S, if it turns out to be negative we can say We have discovered a decision rule for going short that yields S. This is the way the result will inevitably be presented: in the most favorable light.

As a result, even for a random rule, we can expect to see a return 0.798*sigma/sqrt(N) and we should accept a rule as useful (nonrandom) only if it exceeds this value by a sufficient margin. (The margin being expressed as a certain number of standard deviations).

Alfred Cowles on Sequences and Reversals, from Dr. Alex Castaldo

Alfred Cowles (1944):
The author and the late Herbert E. Jones once made an investigation of the evidence as to the element of inertia in stock prices as follows : (6) In a penny-tossing series there is a probability of one-half that a reversal will occur. If the stock market rises for one hour, day, week, month, or year, is there a probability of one-half that it will decline in the succeeding comparable unit of time ? In a attempt to answer this question, sequences and reversals, as defined in footnote 5, were counted. A study of the ratio of sequences to reversals will probably disclose structure as previously defined, if it exists within the series, and the significance of this structure can be investigated by ordinary statistical methods. For instance, the probability can be determined that any ratio occurred by chance, from a random population of possible price series. Also, from the frequency distribution of these ratios one can estimate the probabilities of success in forecasting a rise or decline in stock prices. Samples of adequate length, were available, were examined, the intervals between observations being successively 20 minutes, 1 hour, 1 day, 1, 2, and 3 weeks, 1, 2, 3, ... , 11 months and 1, 2, 3, ... , 10 years. It was found that for every series with intervals between observations of from 20 minutes up to and including 3 years, the sequences outnumbered the reversals. As a result of various considerations it appeared that a unit of 1 month was the most promising from a forecasting viewpoint. In the case of the 100-year monthly series of common-stock prices from 1836 to 1935, a total of 1200 observations, there were 748 sequences and 450 reversals. That is, the estimated probability was 0.625 that, if the market had risen in any given month, it would rise in the succeeding month or, if it had fallen, that it would continue to decline for another month. The standard deviation for such a long series constructed by random penny tossing would be 17.3 ; therefore the deviation of 149 from the expected value 599 is in excess of 8 times the standard deviation. The probability of obtaining such a result in a penny-tossing series is infinitesimal. An investigation of the average amount the stock market moved in each month, a consideration of brokerage costs, and determination of the degree of consistency revealed by the data, were used to supplement the information as to the ratio of sequences to reversals. This further analysis indicated an average net gain of 6.7 per cent a year with a probability of a net loss in 1 year out of 3.
(5) The word "sequence" is used here to denote when a rise follows a rise, or a decline a decline. A "reversal" is when a decline follows a rise, or a rise a decline.
(6) "Some A Posteriori Probabilities in Stock Market Action," by Alfred Cowles and Herbert E. Jones, ECONOMETRICA, Vol. 5, July, 1937, pp. 280-294.

On Gasoline Prices and Car Sales, by George Zachar

Naively looking at year-over-year sales figures for March and April, gasoline stations saw a rise from 18.4% to 20.1%, while auto dealers saw a rise from 3.8% to 8.7%.

How this squares with the doomster headlines about gas prices killing consumer demand in general, and for autos in particular, eludes me.

Neurological Aspects of Trading, by John Kuhn

Last night on PBS Paul Solman ran a piece on neurological aspects of financial decision-making. Brett's study on the emotional psychological aspects of trading is also available now online for $5. Together these works explore emotionalism in financial decision-making, particularly germane to traders who are a bit loose on the rules side of their game. To reduce both stories to their purest essence i liked this example: subjects are given a choice to receive $25 today or $20 in a week. As they decide while hooked up to sensors, one can literally see the to-and-fro between the pre-frontal cortex understanding the 25% return in one week and the flashing agitation/illumination of the limbic system fighting to get that $20 NOW!

James Lackey responds:

In a lab, a trader would have the same cortex movement as an expert marksman on a gunnery range. However, in combat friendly/foe, kill no kill, go-no go it is a big battle even for the combat patch (in the army you wear a combat patch on right shoulder to signify what unit you were in combat with and wear it for life. No matter what unit you are assigned to in the future. Your current unit's insignia or patch goes on left shoulder.) Traders walk around with these combat injuries, fatigue and experience for life.

What seems to drive Ken Smith and perhaps even the Grandmaster nuts is the difference between clinical trials, the business world (mutual fund) fantasy world (hedge fund) the real world (streets of hard knocks) and the 20/25 dollar question. That sentence would drive Laurel or Dr Ross nuts. However, Laurel will laugh and Dr Ross may use this to explain to his students how to get the joke.

In the clinic I can trust Dr. Brett in paying me 25 next week so I walk. On the street, Ken Smith and I take the 20 dollars down immediately. It is not only the risk of losing 20/25 by not collecting next week. It is the risk of me doing 30 days in the County jail for having to go "collect" on the $25 just for the principle of collecting what is due. If you do not collect in the world of hard knocks, you are soft. You may never get paid again.

In the business world we would immediately by the futures, in due course we would then use a sell program out of futures into a basket of INTC on the next opportunity. The vigorish is too great to day trading INTC so we must in fact hold the common for a week. Then we pray that we receive mutual fund cash inflows by the next week. Therefore, we never, ever, ever, have to sell INTC common for tax reasons.

Next is the fantasy world. We take the future revenue of 25 dollars and get Morgan Stanly who is having client problems, to loan us the 25$ and buy 10 year bonds. Now 10 years bonds we can leverage to 20-1 then we take that and buy INTC common, sell the puts and we day trade NASDAQ futures against the position. Currently the bookies call NAZZ contracts VS S&P futures 40% (per contract on P&L) yet they are moving 1.1%-1% (all the bookies care about is margin requirements and fees) we notice that the risk manager hasn't changed the rules on the NAZZ futures in 3 years so we use the extra contracts "on down moves" to buy and sell SP futures until the end of the week.

Oh I forgot. A hedge fund that is "raising money" takes "measured risks" They would take the 25 dollars of future cash flows and "not make any directional bets." That means have zillions of derivative positions that are "hedged" in ways that no one understands meanwhile doing seminars on "volatility and uncertainty" and doing their very best to make people feel stupid. I laugh. Therefore no one asks any real questions on how in the world do you really expect to make any money? That is after the Wall Street's vig and those fund of fund fees after "I" the client, does not put all my eggs in one basket.

That is what a day trader does. We take on ridiculous risk, put all our eggs in one basket and watch it very closely. "where are the clients yachts?"

The joke of the past two weeks for day traders has been "have you heard about the Junk credit spreads and JGM fund's problems" Naaa, we are too silly to understand any of that. All we know how to do is buy when they go down and sell when they go up. A day trader is always wrong. We accept this like the weather on a daily basis, yet strive for the perfect game every day. To what degree we are wrong and at what time depends on whether we make the 100% annual return required to overcome the costs of doing business.

Rules, by Grandmaster Nigel Davies

Strong players find rules very useful in that they can explain to weak players what they've just done. They can also put these rules in books. Do they help the weaker player play better? Nope.

The problems start when next time round the strong player ignores the rule he applied previously and this is then noticed by the weak player. 'Oh, that's because of such and such - I never do this if there's such and such an exception.'

One particularly indignant novice once accused me of telling 'half-truths' because I changed what he perceived to be the rules just when he thought he was getting there. When this kind of situation arises I just smile kindly and say, 'You need more experience'.

Going back to the original question, there are times when you should take the $20 and other times when you should take the $25. Sub-rules won't always get it right either, and then there are cases when everything seems the same but the right thing to do is the opposite of what you did last time. Lizard brain vs neo-cortex? I think that's just another bit of intellectual irrelevance, about as useful as saying that most traders have a nose.

Elasticity, by Grandmaster Nigel Davies

An important thought from a colleague on maintaining flexibility when playing chess. There are analogous situations in ball games in which recovering a flexible posture is important after playing a shot.

After initial moves in the King's Indian Defense 1 d4 Nf6 2 c4 g6 3 Nc3 Bg7 4 e4 d6 5 Nf3 0-0 6 Be2 e5 7 0-0 Na6 8 Rb1 exd4 9 Nxd4, Black has a choice between 9...c6 or the direct 9...Nc5 attacking the pawn on e4. Which move is better? One should elect the more elastic move which gives more choices. So after 9...c6 if White continues with 10 b4, Black has a cheapo with 10...Nxb4! 11 Rxb4 c5 which gives him a good play, so 9...c6 is better and more elastic than direct and routine 9...Nc5.

On the Insurance Industry, by Mark Mahorney

Having been a business analyst for number of years in the insurance industry, I worked with all areas of a number of insurance companies such as actuarial, reinsurance and finance. I studied actuarial science in college for a time, but switched to economics as my interests shifted.

As a somewhat removed observer with a big picture perspective, fair understanding of the inner workings of the insurance industry, and being a perpetual student of the markets my observation was the investment / fixed income departments were significantly hindered and naive by a lack of balance in experience and education.

These departments are almost entirely staffed by highly trained actuarial specialists trying to serve as market generalists, while contending with the incredibly demanding rigors of advancing within their chosen careers. The actuarial career path has made significant advancements in the direction of investment study, but not towards being students of the markets themselves.

Being a very insular coterie, this is a fringe group of investors seldom open to a big picture perspective or building an educationally balanced team. Seldom does this group tap into Wall Street experience, economists, futures traders, etc...

But this is not unique to the insurance industry. There are many sub groups among market participants. Energy traders, pensions, commodities, the mutual fund industries CFA farm team, theoretical academics, etc... Each of these groups tend to keep to their own.

The end result of this lack of inter-industry mixing has been behind many historic debacles. There was Enron in energy trading. LTCM, which was academically and theoretically driven, had constant infighting with its minority Street wizened staff. The list really goes on and on and this is at the root of the issues being discussed with the EIA products. Hubris and extreme arrogance being found in all cases.

Annuities, by an Anonymous Spec

So-called annuity products are one of the largest investor frauds ever perpetrated on the unsuspecting masses. It is the finest way of separating the public from their money I have ever seen in 15 years in the brokerage business. Whether an index or regular variable annuity, the fees are so egregious that the investor has no hope of a decent return on his money. The trade-off is he gets his principal back when he dies. Dying to break even is worse than a turf handicapper's 9-way exotic bets. I recently let my insurance license of 25 years lapse lest I ever be tempted on a weak moment to foist one of these off on an unsuspecting investor

Ten Variations on Lessons from Tree Growth, by Victor Niederhoffer

The fundamental law of economics is that incentives matter -- that all actions people take are based on their choice of alternatives with different estimated benefits and costs. But who would have thought that the tree makes a million decisions of the same nature? And what is true for the tree and people, is also true for the invisible evil hand wielded by "they", "the mistress of markets", as manifested in the shape and path of prices, its growth and decay, stasis, its spurts, and its shading and competition with other markets and companies.

Consider the tree in its attempt to grow higher to get light and more food. But this must be counterbalanced by the offsetting difficulty of getting water to the top, and the mechanical instability that higher growth causes because of greater leverage and bending action of the wind against the bottom of the trunk, and greater force against it of gravity on the thicker branches needed to support more leaves. As Peter Thomas in his excellent book Trees: Their Natural History puts it " A tree needs to be tall to out-compete its neighbors, and big to hold as many leaves as it can, but there comes a point where the return is less than the investment (a tall tree must invest a disproportionately higher amount in wood ).

But the tree can't stop producing new wood, nor can a company stop its efforts to grow and "this is partly responsible for the death of the tree". In subsequent installments I'll consider the forces that affect the shape of trees and prices, and apply it to some specific aspects of movements of individual stocks and markets.

Mark Mahorney adds:

The bristlecone pine does not have to, nor can it, compete to be the tallest tree. It lives on the edge of the tree line higher up than any other plant its size and it can live more than a thousand years. They are as gnarly as the ground they take root in is craggy.

I would ask whether trees actually compete for height as popularly believed, or rather are a product of their environment. The richer and more stable the environment, the taller the tree may grow. In a dense forest, isn't the percentage of the tree protruding into the sunlight only a small percentage of the total?

Redwoods are one of the longest lived trees, yet one of the largest. Its root system can extend outward 200 ft. That means it's not competing for nutrients with its neighbors, but rather it is entangled and interwoven with its neighbors in such a way as to share equally in the available nutrients, while the overlapping root system serves as a collective support system reducing the load stress on each individual tree. Together they are able to grow so strong that their bark is thick enough to resist fire and parasites that destroy other trees. But isn't it the rich environment in which the redwood grows the primary factor that enables it to grow to such great heights and live such a long life?

The aspen takes the codependency of the redwood a step further. Clusters of aspen trees are actually a single organism. Each tree grows as a sucker from a single widespread root system. This enables them to survive in harsh conditions. Yet the individual aspen tree is not known for being a hardy, strong, or long lived tree. Rather the colony depends on a high turnover rate to ensure the longevity of the underlying organism.

There are positive analogies that can be drawn from this with regard to society in the way the redwood thrives codependently in its nutrient rich environment, or in the case of the bristlecone, being a highly specialized loner. Both are equally successful if longevity of life is the criterion. To me the lifecycle of the aspen seems similar to the relationship between the underlying security or commodity from which futures contracts are born.

David Higgs suggests:

The introduction of exotic species to a niche can be a disaster for the local landscape! I suppose new/changes in tax laws & Federal regulations could be considered exotics.

Credibility, by James Sogi

Success and failure, and even  life and death hinge on credibility. People are judged on their credibility and the ability to gauge credibility is critical.  What is it, and how is it judged?  Do you believe the analyst, broker, doctor, spec, wife, witness, client, salesman, advertisement, warranty, insurance company.  How can you avoid being conned?

Ask yourself:

  1. What are the person's motives?
  2. Are his statements consistent with prior and current statements and actions?
  3. What is his demeanor?
  4. What do you know about this person?
  5. What is this person's record?
  6. What opportunity has this person had for perceiving.
  7. What is your relationship with this person?
  8. Are the statements consistent with generally accepted expertise on the matter?
  9. What is the person's reputation in the community and for veracity?
  10. What are the person's credentials?
  11. What are the facts upon which he makes his conclusions? Are the facts correct?
  12. What are his assumptions? Are they correct?
  13. What are the person's prejudices?
  14. Is the person  able  to perceive, understand, and remember?
  15. Has your prior experience with this person been good or bad?

Negative or no answer to any one of these should be a red flag. Chair always warns of the big cons. This will help you avoid them.

Real or Onion? from Steve Wisdom

From the preface to the Expert's upcoming book The Black Swan

Talk is cheap. A word of warning. Someone who took too much philosophy classes in college (or perhaps not enough) might object that the sighting of a Black Swan might not invalidate the theory that all swans are white since such black bird is not technically a swan since whiteness to him may be the essential property of a swan. Indeed those who read too much Wittgenstein (and writings about comments about Wittgenstein) (.. )

Lessons in the Trade Deficit, from Donald Boudreaux

Dear Editor: (of the Washington Post)

The graphic that accompanies "Putting Pressure On China's Peg" (Business, May 11) has two flaws.

First, it reports the merchandise-trade deficit (which measures only trade in goods) rather than the current-account deficit (which measures trade in goods and services). Because the U.S. is predominantly a service economy, the merchandise-trade account underestimates American sales to foreigners.

Second, the very act of reporting the U.S. trade deficit with China suggests that there's something unnatural and worrisome about one country's running a persistent trade deficit with another. But in fact, it would be most extraordinary if any two countries ever had balanced trade with each other. Just as there's nothing unnatural or worrisome about my persistent trade deficit with Nordstrom, for I buy lots of clothes from Nordstrom while it buys zilch from me, there's nothing unnatural or worrisome about one country's running a persistent trade deficit with another country.

Thoughts on Currencies, by Dr. Philip McDonnell

Prompted by an essay on currencies from Tim Hewson, my thoughts turned to some comments by the Palindrome. In the initial pages of Alchemy he points out how efficient the stock market is. In the US and most advanced countries trading on insider information is illegal. Assuming reasonable enforcement this means that all participants enjoy relatively equal access to information.

The large volume of trading and liquidity of the markets translates into a fair market which is not dominated by any single player. All things considered the stock market is a remarkable fair and efficient market.

This stands in contrast to the currency markets. These markets are undeniably large and liquid, but are dominated by two significant groups. First, the large international banks dominate because of their huge transaction volumes. Secondly, the governments and their central banks have significant political and economic interests.

With respect to the question of information advantage the currency markets are again asymmetric. Big banks trade for their own accounts. Each has a disproportionate sample of the transaction volume and thus access to greatly superior information.

Add to this the fact that governments can do things individuals cannot. If an individual were to dissemble on his intentions or market activity some prosecutor with political ambitions would instantly indict him. When a government engages in deception there is no adverse consequence. Governments can suddenly move markets or set arbitrary trading limits on markets which would be called manipulation if performed by an individual. This creates an added risk which is generally not present in the stock market.

On the statistical side currencies have value which is only measured by other currencies. The value of a euro is defined by how many dollars it will buy today. The value of a dollar is determined by how many euros it will bring. The value is the exchange ratio.

If we pretend there is something called intrinsic value for a currency and that it behaves as a perfectly civilized normal variable. It is well known that the ratio of two normal variables follows a Cauchy distribution. Thus the ratio of two idealized normally distributed currencies would be a Cauchy distribution. The problem with the Cauchy distribution is that it has an infinite variance. Thus measures such as variance and standard deviation break down making statistical analysis quite difficult. This, combined with the big bank dominance and governmental intervention, make the foreign exchange market a most treacherous place to play.

A Few Interesting Numbers, by Mark Mahorney

These are the changes for stocks, commodities, and the CPI since 1956, the earliest data available from the Reuters-CRB Futures Index:

Dow Jones Industrial Average: 2000%
Reuters-CRB Futures Index: 180%
Consumer Price Index: 600%

The data behind Vic's oft reference to the economics of commodities. Technological advancement, substitution, and competition all pressure commodity prices to appreciate at a rate less than inflation. Effectively commodities prices have consistently fallen over time. Has there been some change to the fundamental laws of economics that I am unaware of?

Tim Rudderow comments:

All those who look for appreciation in commodity prices look to futures prices, since spot prices do not rise over time. The argument, going back to Keynes, is that "normal backwardation" in futures prices provides the additional return. This argument relies exclusively on a specific weighting of index results towards non-storable (livestock) or low inventory (milk, crude) markets. This is why the Goldman index is built the way it is (currently 70% energy). In the 1970's, when there were no oil markets in the index since there were no oil futures, the index was primarily livestock. You would be surprised how many users do not know the GSCI did no benefit from the OPEC embargos of the 1970's.

Wheat was $2.00 a bushel in 1960, and it is $3.15 today. The inflation adjusted price would be about $14.00. Rolling a long futures position in wheat would have been a big loser. Hence, very little wheat in the commodity indexes.

Justin Klosek adds:

Right, but you earn the carry on the cash (or, better, Treasuries). that you've posted against your position. So while the price of the futures contract hasn't changed, you've earned plenty in interest. The big commodities paper that came out of Yale is actually an active strategy that's rebalanced at the end of every month: you end up cutting your winners and adding to your losers as you rebalance to an equally-weighted index. This fact is often missed.

Incentives in the Commodities Market, by Steve Wisdom

Chair has remarked many times on the role of incentives as they pertain to the effect of high commodity prices on economic decisions and choices, and on lacunae in certain analyses thereof.

Today's straw-in-the-wind: Mining enterprises are expanding so fast, in response to high prices, that there's now a shortage of tires for huge dump-trucks:

Tuesday, May 10, 2005 Mining boom creates shortage of giant tires

By BRIAN FARKAS, The Associated Press

CHARLESTON, W.Va. - Steve Walker was ready to sell four massive, 200-ton dump trucks, with price tags as high as $3 million, when the orders were canceled.

The buyer, a coal company planning to open a new mine site, was ready to buy. It just couldn't find the 12-foot-tall tires to get the trucks rolling.

The mammoth tires, which can cost up to $30,000 apiece, are in short supply worldwide, leaving earth-moving industries, including coal, in a lurch. The shortage is due to a rise in equipment orders, an increase in worldwide mining because of increased mineral prices and growth in China and other Asian counties. (.. )

Tennessee-based Bridgestone/Firestone has a large-tire plant in Illinois and is spending millions to expand capacity at its Japanese plant to address the shortage in Asian markets. But that plant won't be operational until the end of next year.

Michelin, which has a large-tire plant in South Carolina, announced earlier this month it is building one in Brazil. The plant is expected to come on line in mid-2007, serving North and South American markets. (.. )

From the Grandmaster

The common perception of how to 'learn' an opening is to memorize many series of moves by rote, an activity that is guaranteed to make Jack a very dull boy. But good players know something about everything, achieving a broad perspective that allows them to hang their memories on hooks of understanding.

Chinese Reveal Non-Story, by Tim Hewson

Around 9.30 a.m. today a flurry of headlines ran across the screens saying China would revalue the yuan next week after a meeting with US officials. The article cited a state-owned news service.

Confusion, retractions, denials and clarifications ensued, but during the melee, the yen and the dollar strengthened and the euro weakened, returning soon after to preannouncement levels.

I cant help but wondering in my amateurish way (bearing in mind Spec writings on deception  how one should view such moves and their implications for how the market will react when the announcement is finally made?

Is this an example of active deception where the organism (market) attempts to trigger a specific behavior in another organism (participants) in order to get the other to lean the wrong way?

Morse is Back, by Victor Niederhoffer

Today after the close the West Virginian announces the results for his high tech company. And although as night follows day, the actual reported results always seem to be 3-5% above expectations, the stock has been down an average of 6% in the subsequent two days, after the last five earnings reports. Collab and I have written about the West Virginian, with his virtual closings, his Napoleonic portraits, his upbeat forecasts, and his tendency to buy companies at 10,000 times book that he may have an ownership interest in, as a case study in hubris. The reaction of the market to his statements reminds me of Morse, the great bull leader of Trolley and Fort Wayne a century ago. The mere fact that he's out there again brings back so many unpleasant memories even though the earnings per share are at an all time high, considerably above the levels that supported a price of 80'ish a few beautiful years ago.

Horses & Swans, by an Astute Handicapper

Pretty sure I saw Nassim Taleb standing by the rail at Churchill Downs, smiling.

The 2005 Run for the Roses will go down as one of the great Derbies because of the longshots. Giacomo won at 50-1 odds. Closing Argument placed at 72-1 and Afleet Alex showed at 4.5-1. Fourth place was Don't Get Mad at 30-1. It's the second biggest upset in the history of the Derby and certainly the biggest pay out. No one bet a $2 superfecta. It would've paid $1.7 million.

The Real Estate Beat: Word from Miami, by Yuri Skrilivetsky

Two weeks ago I was in Miami Beach. One could not have asked for a better day. Standing on the beach on a warm sunny Saturday afternoon in sunny isles I noticed something not right on an otherwise perfect day for the beach. Nobody was on the beach. Considering the rows of high-rise condos along the beach, I was expecting to see more people on Miami Beach than Brighton Beach in April. Such is not the case. I asked someone where all the people had gone. I was told they are all back home in the north, Europe and Latin America. "All those condos are owned by investors." To be an investor in a condo is to have a negative dividend attached to it given the maintenance and other fees.

I was trying to figure out what people saw that I did not. A friend says to me, "I thought this condo was expensive one year ago when I could have bought it for $400K. It recently sold for $2.2MM."

The town is real estate-crazed. Everyone has at least has four RE brokers at all times. The taxi cab driver on the way to airport told me about a condo he fliped in one week for a $10K profit. As far as investments go, if it's not RE it's a joke. If there is one popular slogan over there it's, "Buy real estate, it always go up."

From what I understand Miami is not the only city right now with a hot RE market. A month ago I spoke with the engineer who liquidated all his market holdings. I asked him when he will look to get back in. His answer was when RE prices start to come down. Could it be that RE is sucking so much liquidity out of the stock market? What makes RE vs Stocks so different now from where is has been historically?

Henry Gifford, Daily Speculations real estate expert, responds:

Things are different this time because a higher percentage of people get paid by check instead of cash. Only a few years ago there were many more smaller hardware stores taking in cash, now Home Depot pays people by check, making income tax shelters such as deductible mortgage payments on an expensive home relatively more important. Ditto for all the business that has moved from Main Street to the mall and the internet since the last real estate boom in the late 80's.

Things are different this time because many people lost money in stocks only a few years ago, and are thus more willing to put money into the other one of the two main investments they can think of: real estate.

Things are different this time because crime was much higher in US cities during the last boom, but has gone down nationwide since NY's Mayor Giuliani hired more police and changed policies. Lower crime makes cities more livable, thus less scary as investments.

Things are different this time because loans are even easier to get than at the peak of the last real estate boom, when the "Savings and Loan Scandal" was happening - anyone with enough money for a couple of desks and some carpeting could lend out US Govt. insured deposits and collect fees large enough to make the long term prospects for the business irrelevant. This time even easier loans are making buyers out of many people who used to be renters, driving up demand. The personal trainers in the gym who were planning to float IPOs a few years ago have become mortgage brokers now.

Things are different this time because people (I think) are less honest than they used to be, and therefore don't worry about claiming to live in six houses at once, and don't worry about walking from debts resulting from buying property with very little or no down payment. Owners simply mail the keys to the bank and sign a "deed in lieu of foreclosure." The chances of being sued for the outstanding balance are small. Different from putting up real money to buy stocks.

The last drop in the market was in the range of perhaps 30%, so people figure if it goes up 50% in a few months then drops 30% they will still be OK.

I was reading about James Bogardus, who invented cast-iron buildings. I noticed that he made good money and spent some of it buying a row house on 14th Street near Second Avenue in Manhattan for $15,000 or so in the mid 1800s. The same house could be bought for fewer dollars in the 1970s after 100+ years of inflation.

Allen Gillespie comments:

While Miami Beach is it own thing, I have thought a lot about the homebuilding/real estate situation. I admit to having made money being long the homebuilding stocks, and having made and lost some money being short them recently, as a hedge on my own home.

I am of the mind there are three major factors at work with real estate:

  1. Fed Funds below inflation rate - our work has suggested that homebuilding/real estate moves inversely with the Fed Funds rate, but the Fed has been below the inflation rate until recently, so real estate has remained hot despite the rate increases.
  2. Financing options have increased dramatically - thus buyers can shift between 30/15/10 yr fixed, ARMs of various lengths, they can refi, they can chose various points, etc.. thus they move along the yield curve more than in the past. This is important, particularly for investment and second home buyers, because it is the presence of the idea of a put option that encourages riskier behavior (remember the Greenspan Put?)
  3. Demographics - (I think I underestimated this effect) - I think we are witnessing many condo and second-home buyers who are planning for retirement. The rub here is what happens when they actually do retire. Do they try and sell their first home? From what I read, the demographic shift is concentrated in 2007 and the following years which may be another reason the healthcare, drug, hospital, and nursing home stocks have been leading the market this year.

Volatility: A Twilight Zone in Financial Markets, by Dr Ross Miller

Dr Miller writes that that for some time now, the financial markets have inhabited their own twilight zone of falling volatility, shrinking risk premia, and other (as Alan Greenspan would call them) conundrums. Read his brilliant explanation of what has been going on at the Miller Risk Advisors site [His commentary appears on page 2 of the May/June 2005 issue of Financial Engineering and is Copyright 2005 Financial Engineering News.]

Do You Have the Head for Trading?, by James Sogi

The Art of Speculation and the practice of other types of business engagement utilize different parts of the brain. In fact, the art of speculation itself requires use of different parts of the brain at different times, and hence its difficulty.

Speculation has kind of a meditative flavor of relaxed concentration, with a passive and receptive aspect to it. It requires being "in tune" and playing along with the market, and when a play is spotted, only then is affirmative action required. The receptive mode seems to use a different part of the mind and brain than the part when the bid or offer is made or the decision to sell. When the setup or overlay spot arises, a whole new part of the mind has to kick in to enter or exit the position. Once the position is in place a different part of the mind has to kick in, the active mind needs to kick back, and let the position ride.

When the trading day ends and the lights camera and phone get reconnected, and action starts, a whole new part of the brain, that has been dormant during the trading day, comes to life. After the market closes business demands require attention, and action. It requires a mental phase shift to make the transition, and those of you who engage in other activities in addition to speculation experience this.

This hypothesis would explain the barriers to transition skills from other jobs/professions/businesses into trading. It might also explain the difficulties and or training needed to jump from entering a position to monitoring the position. And the transition from the trading day to the business world or even the difficulties of day trading. In pondering these matters, as invariably happens, an article in Sunday's New York Times popped up. As with the Buddhist monks who with 10,000 hours of meditation have altered the physical structure of the brain to a relaxed consciousness, the trader with 10,000 hours of screen time may develop the neural pathways to quickly and smoothly jump from the entry mode to 'ride' mode. 10,000 hours of screen time is 5.7 years of market watching -- and as is the case with many vocational trades, professions, or sports, the approximate time to achieve a master's ticket. Perhaps there is a key here to market enlightenment.

Sushil Kedia adds:

Meditation that is known as Dhyan in Sanskrit on transliteration means observing one's thoughts from a position that is away from oneself.

Dhyan or meditation is one of the four key components of Spirituality (Eastern) which in Sanskrit is called Adhyatm. Adhyatm is a compound word composed of two other: Adhyayan (study) and Atma (self).

So Meditation is one of the four key components of studying the self. Focusing only on meditation here which is the string of this excellent post from Mr. Sogi, is then a key effort at knowing the self.

Coming back to the markets, at a price one buys and another sells. Both can get out at different prices profiting. So, no particular moment and no particular price is specifically good or bad for buying or selling; but it is in identifying with the rhythms of one's self a pair of open and close decisions that would lead to profit.

Inappropriate assessments of the self-rhythm identification with the rhythms of the markets would lead to out-of-phase trading extreme repetitions of which would bring one to a point when one should be vacationing.

So, in deciphering the different parts of the brain (the physical entity) that are more active than others in the different activities the key entity to overcome is the mind (the information entity) since the mind is a pattern of learned and acquired responses.

Meditation has as its objective seeking freedom from the mind (acquired and lengthening operating system) such that in each next moment that is unique a rational response be generated from the physical brain. In the absence of a better alternative available to me, I borrow from the computer and the operating system that dictates its capabilities as an example (assuming all the human engineering is an imitation of the ultimate engineer, nature!

When a computer has data overload and the hard-disk exerts, or when a string of commands in a program need to draw too many things at a time in the RAM or when the CPU itself is over-burdened with too many simultaneous operations, then in such circumstances the operating system generated flaws like the blue screens, the system hang-ups etc. would occur. Those are the moments that are anathema to a trading mind-brain combine.

So, the 10,000 hours of watching the screen or meditating both have a similar purpose of identifying the rhythms of the self that would match with the rhythms of the markets. For each player there is a suitable play. Practise, meditation, coaching or training it all adds up to identifying the suitable rhythm.

Once the rhythm is there the CPU, the RAM, the Hard disk; obviously without the viruses of emotions, the information overflows of adware and popups (did someone say CN*C?) and all other bugs would just be operating at their optimal mix of action.

The idea to me sounds more similar to freeing the brain from the shortcomings of the mind. Obvious that everyone who has traded and everyone who has meditated have aspired to reach that state and be there; but few reach that and still far fewer stay there.

NEW! SPEC OF THE DAY: Marion Dreyfus

Marion D.S. Dreyfus is a communications pro. She is often found in caffeine-like mode writing in a range of styles on subjects as far afield as safari hunting with a camera to knowing what to do with lightning when you're lost in the wild, prison reform in a dicey environment, to taking on routinely inaccurate international media on their own turfs.

She has gotten back from teaching 2003-2004 in the Far East in four universities in China; writes for weeklies, dailies and blogs; hosted a radio show in big ol' Wuhan, Hubei province, PRC; discusses and debates healthcare, medicine and new drug entities; is a Middle Eastern maven, activist and pundit; reviews film, theatre, TV, restaurants (a dozen reviews in 2006 ZAGAT's); calligraphs belles lettres, love notes from rock stars and plaques to Putin (always a godmother, somehow never a God); creates and publishes (and performs for audiences in 10 states) poetry; coaches speech makers; judges international documentary festivals; and millipedes medical documentation for the ever-hungry but reticent FDA. Journalistic endeavors in four continents. Major travel. Mensan.

Aside from those, she produced in the tri-state area a radio talk show that features parodistic high-fission skits, call-ins, political scathe and a mlange of melody for the not-yet-savvy-enough-to-opine listener. Had been a puts-and-call girl for a wild while; now a somewhat more sedate blue-chipper until the next bubble or victor comes along?

Will edit for chocolate.

From the Mouths of Babes, by Dr Mike Ott

I was playing with my three year old today. He was a tiger, and I was a gazelle, and he was trying to catch me to eat me. He said, "I'm a creditor! I'm going to chase you and you'll never get away!" I stopped to ask him what he meant, and he intended to say that he was a predator, not a creditor.. I hope it was unintentional.

Three Easy Pieces, by Kim Zussman

  1. Hot Dogs
  2. Driving recently pondering octogenarians Redstone, Captain Kirkorian, and the Green one who are still doin' it. Tussling with all the tassle-loafered sharpies, movin' markets, making markets. When they could be duffing with decrepit doctor sexagenarian retar'd colleagues on the links?

    Like most wisdom in California, the answer floated preternaturally from a bumper-sticker on a passing contractor's truck. Displaying an image of a Dachshund, the message read "I Love My Wiener", and in a flash of prededuction it struck: Progress in medicine has prolonged the lives of our doggies! Our precious pets, which studies expose prolong enthusiasm and expel depression, now live longer and run harder than years past. Who wants retardment at 80 in a perpetual supermarket of doggie-treats?

  3. Land of the Setting Son
  4. The centennial millennial stock-return paradigm, evidently based on intrinsic compensation for risk, has not worked well in Japan. One has worried that this exception might disprove necessity of long-term updrift. However, a recent WSJ article (5/6/05 A1) on a crime-con in Japan, read as a libertarian, may give a clue.

    The Oreore scam is when poseurs hysterically telephone, claiming that a son or daughter has been in a car accident causing extensive damage to another vehicle. To spare shame and humiliation, the family can just wire money and all will be kept quiet. Unlike the US, in Japan it is rare to hire a lawyer or go to authorities. Cultural differences create less suspicion of crime as well as a deep desire to make reparations to injured parties.

    Might such homogeneous cultural emotion help explain the long Japanese stock market decline? Would a generation facing shame over loss of family savings dissuade new speculations differently than America's culture of "try, try again"?

  5. Theta for Dummies
  6. Why are puts too expensive? Beyond geeks and greeks there is the appeal to fear of potentially unlimited upside with delimited loss. Brave souls with many dogs to walk sell this insurance to leash in the reverse.

    One recent bullish pattern decided to play with OTM long calls. It ended well, but during the enduring one noticed daily declines with flat to slightly increasing underlying. They weren't lying about time decay of a wasting asset. Motivated best by any education with steep tuition it becomes even more obvious that decay works in favor of option sellers.

    Unlimited down-risk on a timer? Perhaps the high returns of selling overpriced insurance are just another example of compensation for constructive training of those powerful pups to herd the flock of human emotion.


In Honor Of "Haiku Day" (5/7/5), by George Zachar

(BN ) Carly Fiorina Says She Has `No Regrets' After Ouster

Nine figure income,
publicist, lecture circuit.
No regrets, Carly!

Cumulative Sum Control Charts, by Victor Niederhoffer

The cumulative sum control chart is a standard quality control chart used to detect changes in the mean output of such things as the output of a machine, the thickness of the asphalt on a road, the amount of bacteria in an infection, the steadiness of heartbeats. It has been used in financial application to study changes in the enthusiasm for IPOs and to detect changes in price.

It turns out that a cumulative sum chart is almost identical to the filter techniques popularized by Alexander and Cootner in the 1960's , a point well covered and analyzed on SmartQuant. Acheson Duncan, in his classic work "Qualtity Control and Industrial Statistics," summarizes the advantages of CUSUMs as the "possibility of picking a sudden and persistent change in the process average more rapidly than a comparable (nondynamic Shewhart chart) especially if the change is not large. The key variable in a CUSUM chart is to compare the last point obtained with the lowest (or highest) point previously obtained. Thus, if you go from well below the mean to above or vice versa, the CUSUM is more sensitive than the standards that just look for a breakout from a fixed base. Yes, the CUSUM chart is like a Bollinger Band. The way it's used in practice is to compute the standard deviation from the past observations. Then to note how the current observation compares to the standard, like 0 mean. Next to plot the sum of the amounts above the standard and compare it to a cutoff point, Finally, to use a nomograph to see if the cumulative deviation from the past standard deviation is large enough to give your cutoff point the proper sensitivity without exposing it too much to false alarms.

The process cries out for simulation and direct applications to stock prices. One purpose would be to find out when a trend has been established in the minds of the believers and stoppers with a view to accommodating their visualizations and also finding an early way of detecting a shift in regime in some markets with subsequent testing of whether the subsequent distribution of prices can be forecast. Consider for example, the last 14 changes in S&P futures as of May 6:

-4, -0.5, +9, +3, +5, +15, -14, +4, -10, +7, -4, +22, -16, +9.

Simulating such a process with the artful simulator Tom Downing (using the last 50 changes) gives us an idea of how much the variation from a low to high, or high to low, might be for the next 1, 2, 5, 10, and 20 days, as follows:

Days Ahead Lowest 5%Highest 5%

Such bands around the present would be CUSUM control that a change above and beyond the 5% false-alarm level on either side had occurred. The applications of this to other intervals, other markets, and other areas are intriguing and alluring.

Acheson J. Duncan, "Quality Control and Industrial Statistics": Homewood, IL: Richard D. Irwin, Inc., 1965


Q: After reading your article on Cumulative Sum charts and giving it some thought I decided for a short term trend follower like me the practical thing to do is use the CUSUM to determine when the average of a price series changes. The benefit is to augment my current information and to determine the placement of the most recent short-term pivot with the daily pivot and compare both of these with the most recent change of mean.

Now , whether it is worth the money to actually buy this product to keep track of such changes is a decision for the analyst in all of us.

In closing you might find my recent post to my blog to be mildly interesting. Hopefully, tomorrow I'll be able to post a few trades to further illustrate the utility of Volatility Spikes.

Bruce Dixon

The Chair responds:Might you not test first whether following or going against the cutoff points is good or bad?

Dept. of Doomsday: The Chairman Poses 10 Questions to the Bears

We are bombarded each day with special pleadings from chronic bears about the excesses of corporations, the coming Armageddon because of wholesale liquidations of fixed income, junk bond or dollar holdings, the slowdown in our economy because of oil, and the excessively favorable reaction that everyone else had except the sender to the latest economic number because of faulty seasonal, hedonistic, or now birth/death adjustments, or the people with great track record with whom they are friends, in common with Abelson, who are truly bearish right now. To these people we would ask the following questions, and suggest that everyone do likewise who is about to push the button on an email to provide us with another anecdote about numbers that appear overly favorable. P.S. I have a relatively bearish position in stocks right now.

  1. Are there more such numbers today than before?
  2. Are the too-favorable numbers counterbalanced by too-unfavorable numbers?
  3. Is there a proper degree of skepticism concerning these numbers already and have they been discounted either before or after by people who are quite sophisticated at the margin?
  4. if there are many too favorably evaluated numbers than the past, is this bullish or bearish for the future?
  5. How has the market gone up 1.5 million percent a century in light of all the undue optimism and excessively expansive financial statements, analyst behavior, and corporate wrongdoing?
  6. Is the degree of risk aversion greater or less than the past and is this bearish or bullish?
  7. Are the people you know like Abelson and the proprietors of bear funds more or less successful than the average? (Hint: Neither Soros nor Victor have ever known a short-seller who made money over a reasonable period of time, and in 1999, the last bear fund out of 100 closed down right before the big fall.)
  8. Are there other factors besides the ones you adduce that are more important to the value of the market than such things as hedonistic adjustments and birth/death processes, and are these counterbalanced by biases against favorable numbers by the provider-oriented civil service agrarian reformer operatives who provide the numbers?
  9. What would it take you to convince you that we are not in a bear market and that the persistent bearish posts that you have sent us ever since 1987 of 2001 or since you put on your short position are wrong?

Word from the Bearish Camp, via Derek Gard

Despite the "1.5 million %" return of the market over the course of a century, we must accept that not everyone's investing lifetime is 100 years long. I know mine certainly is not, so arguing for the 100 year return may be a bit of a stretch for most of us.

The reality is, during those 100 years, there are many long stretches where the market does not offer a positive return. As such, one must be mindful of when to put money into the market.

I recently received the following data to illustrate this point:

PeriodDJIA Return# Years
AUG 1886 to NOV 1903-16%17
SEP 1899 to JUL 1932-27%33
JAN 1906 to AUG 1921-15%15
NOV 1919 to APR 1942-22%23
SEP 1929 to JAN 1950-50%21
AUG 1959 to DEC 1974-17%15
FEB 1966 to AUG 1982-23%16

Since 1903, there have been 26 different years where at some point that year the DJIA was lower than at some point 15 or more years earlier. In other words, 25% of the total number of years falls into this category. If you are an investor who believes 10% returns are a right, then I am afraid you will be disappointed. For many people, 15 years is a bulk of their investing lifetimes. You must make the most of those years, and it is possible stocks are not the place to put your money.

The Chair comments:

Many who write us point out such things as "There have been 26 years where at some point that year the DJIA was lower than at some point 15 or more years earlier." But these are guaranteed to happen with a series that has a 10% a year mean and a 20% annual range between high and low.

For those not privy to simulation software, or who don't like throwing a coin 100 times to simulate one year with a head coming up 6/10 of the time, and the tally during the year corresponding to the highs and lows et al., and repeating this once for each year of the 20th century , and then coming up with comparable statistics to see the accord with randomness, consider the following:

You have so many ways of coming up with a decline here because each time you go back "15 or more years," so you have like an average of 50 shots to find a decline, and then you have during the year, 250 prices to compare with those 50 shots, so 12,500 times to come up with that one beautiful decline each year. Is it any wonder that with 12,500 comparisons to make each year, you can come up with a 25% chance that one of them gives you the bingo?

What kind of mind uses this specious kind of reasoning to carry its flimflam points? And how much better could such minds have been occupied than by trying to find the needle in the haystack that supports their current bearish position, or doomsday service?

The deception of the DJIA comparison is exacerbated by the fact that dividends in the last 100 years accounted for some one-half of the total return for stocks. When you look at the DJIA itself, you're parceling out half of the returns, thereby leaving you with a 5% annual drift with a 20% average annual range, making the comparison even more biased and guaranteed to support the seeming point that it's possible to be down even while it's up.

Attempting to answer my question abut the kind of mind that comes up with this, one notes that the incentive to profit from a doomsday scenario is very great because people will always pay more for doomsday than optimism. It seems more cynical and restrained. But I would put it more to the kind of leveling that these people want to see--- a society with no one standing out from any other, where secondhand distributors of information are king, where anyone's insecurities are overcome by a view that no one will have what everyone else doesn't have, i.e., an "agrarian reform."

Yuri Skrilivetsky comments:

The data supplied by Derek Gard show the DJIA during bear markets on average returning -1.24% a year. Considering the risk one takes on by going short, the reward is hardly justified over going into cash or bonds.

It is also important to note that most of those bear years had high interest rates, so even if one was to time those moves and capture -1.24%, the margin interest and other fees certainly exceeded 1.24%. Thanks to those high interest rates, investors would have been able to buy investment-grade bonds yielding 10% during those years.

Laurence Glazier wonders:

On the flip side, I often wonder how quickly the DOW will rise to 100000, by 2050 perhaps? I just see endless development in the Net, robotics, space shipping lines, VR, and as yet unforseen technologies. Would love to see it all happen.

Nebraska Chronicles, by George Zachar

As demonstrated by the National Journal item from Friday, the Sage has successfully positioned himself as the press's perfect businessman: honest and folksy and altruistic and not at all puttin' on airs.

What's the difference between the Sage's enormous tax code arbitrage and the Loch Ness Monster?
-- The latter is sometimes mentioned in the press.
What's the difference between the Sage's ownership of one fifth of the Washington Post and the Protocols of the Elders of Zion?
-- The latter is sometimes cited, albeit soto voce, by nutters. The former is subject to a total journalistic omerta.

Give the man credit. He's successfully ingratiated himself with his "natural enemies" - the soak-the-rich crowd - while turning the machinery of the modern State to his advantage.

Reasons to Be Bearish: Plus a Change, from Steve Ellison

One of my prized possessions is a chart of stock market returns in Venita Van Caspel's book "The Power of Money Dynamics." Each year is annotated with a reason to have been bearish that year:

1934: Depression
1935: Civil war in Spain
1936: Economy still struggling
1937: Recession
1938: War clouds gather
1939: War in Europe
1940: France falls
1941: Pearl Harbor
1942: Wartime price controls
1943: Industry mobilizes
1944: Consumer goods shortages
1945: Post-war recession predicted
1946: Dow tops 200 - market "too high"
1947: Cold war begins
1948: Berlin blockade
1949: Russia explodes A-bomb
1950: Korean war
1951: Excess profits tax
1952: U.S. seizes steel mills
1953: Russia explodes H-bomb
1954: Dow tops 300 - market "too high"
1955: Eisenhower illness
1956: Suez crisis
1957: Russia launches Sputnik
1958: Recession
1959: Castro seizes power in Cuba
1960: Russians down U-2 plane
1961: Berlin Wall erected
1962: Cuban missile crisis
1963: Kennedy assassinated
1964: Gulf of Tonkin
1965: Civil rights marches
1966: Vietnam war escalates
1967: Newark race riots
1968: USS Pueblo seized
1969: Money tightens; market falls
1970: Cambodia invaded; war spreads
1971: Wage-price freeze
1972: Largest U.S. trade deficit in history
1973: Energy crisis
1974: Steepest market drop in four decades
1975: Clouded economic prospects
1976: Economic recover slows
1977: Market slumps
1978: Interest rates rise
1979: Oil prices skyrocket
1980: Interest rates at all-time highs
1981: Steep recession begins

(Van Caspel, 1983, pp. 124-125)

Unfortunately, I have the 1983 edition. A modest attempt to bring the record up to date:

1982: Double-digit unemployment
1983: Record budget deficit
1984: Technology new issues bubble bursts
1985: Dollar too strong
1986: Dow at 1800 - "too high"
1987: Stock market crash
1988: Worst drought in 50 years
1989: Savings & loan scandal
1990: Iraq invades Kuwait
1991: Recession
1992: Record budget deficit
1993: Clinton health care plan
1994: Rising interest rates
1995: Dollar at historic lows
1996: Greenspan "irrational exuberance" speech
1997: Asian markets collapse
1998: Long Term Capital collapses
1999: Y2K problem
2000: Dot-com stocks plunge
2001: Terrorist attacks
2002: Corporate scandals
2003: Gulf War II
2004: High oil prices
2005: Trade deficit

The Assistant Webmaster notes:

Charlie Minter and Marty Weiner have steadfastly maintained that the reinflation of the past 2 1/2 years has been a classic post-bubble bounce, destined to fail.

Their latest missive sums up some of the more egregious longer term problems they perceive. (.. )

Hany Saad says the Triumphal Trio had it right

Dr. Niederhoffer considers Ben Graham the most mythical personage in the market. I tend to disagree; I believe Livermore is by far the ultimate mythical con.

The all-time best-seller "Reminiscences of a Stock Operator" is full of such myths as "Never buy on a down day," "Never sell on an up day," "If a stock hits a new 52-week high, it's very safe to buy," "Never catch a falling knife," "A speculator should always be willing to be long as well as short the market," "I always preferred trading commodities over stocks", "Never use limit orders, only market orders" and an abundance of other lessons that, if followed religiously, would invariably lead you to the bankruptcy courts.

Unlike Benjamin Graham, Livermore's maxims became clichs in all brokerage houses and contributed countless billions to the market upkeep, because his methodology involved more activity than Ben Graham's.

Deep inside the pages of "Reminiscences of a Stock Operator," there is one buried gem, which was misinterpreted.

Livermore describes a man he called Old Partridge, nicknamed turkey, who never asked for tips and never gave any. Old Partridge was not donating much to the firm in the way of commissions. If a customer would tell Old Turkey a story of a stock that he's long or short of, once the customer would finish the tale of his perplexity and then ask : "What do you think I ought to do Old Partridge?" Old Turkey would cock his head to one side, contemplate his fellow customer with a fatherly smile, and finally would say very impressively, "You know, it's a bull market." Time and again, Livermore heard him say the same exact thing: "You know, it's a bull market."

This is where the gem is hidden. Partridge always called it a bull market. According to Wycoff, Old Partridge man never shorted the market. Partridge never said, "You know, it's a bear market." To him, It was always a bull market.

Livermore took that to mean that the big money was not in the individual fluctuations but in the main movements. But Partridge message was much simpler than that. "It is a bull market", the man said. It's always a bull market. Livermore had it wrong but the Triumphant Trio carried the same message with their magnificent book that says again and again, a century later: "You know, it's a bull market ... everywhere."

It is a bull market, my fellow Specs. Look at the charts in "Triumph of the Optimists" and tell me if you still want to short the stock market.

Ever-Changing Cycles: Concerts and Markets, by Jim Sogi

At the second very enjoyable Johnny Lang concert since seeing him open for the Stones on the Babylon tour, there was a great demonstration of the law of ever changing cycles. In festival seating, everyone could have enjoyed themselves seated comfortably and enjoyed his acoustic blues set. but a few stood up to see better. Soon, others seeing the advantage, stood up too. When everyone was standing, no one had an advantage. Then some discovered by standing on their chairs they could have an advantage of seeing better. Soon everyone was standing precariously on their chairs and none were better off than before when they were sitting comfortably in their chairs.

It reminds me of the hedgies and banks using bigger and bigger leverage to gain a smaller and smaller advantage. Soon all will be precariously leveraged out with the eventual effect on spreads and liquidity at the worst possible moment.

Steve Wisdom notes:

Thomas Schelling used almost exactly that example: fans standing at a football game, in his lectures at Harvard on tipping points and related themes. Schelling is/was the real deal; he had all of this figured out long before poseurs such as M#lcolm Gl#dwell took an interest in the subject

Modern Benoni Economics, by Nigel Davies

The Modern Benoni (1.d4 Nf6 2.c4 e6 3.Nf3 c5 4.d5 exd5 5.cxd5 d6) is one of the classic examples of 'dynamic chess' in which Black takes on a 'weak' pawn on d6 and gives White a central pawn majority in return for a semi-open e-file and Queenside pawn majority. Often sneered at by more classical players it has been a terrible weapon in the hands of 3 World Champions - Mikhail Tal, Bobby Fischer and Garry Kasparov.

It struck me today that much the same debate about the Modern Benoni exists in financial circles when debt is balanced against GDP and strong employment. Traditionalist are sure that the Modern Benoni 'disadvantages' are a certain recipe for disaster whilst more dynamic players think otherwise. Who is right? It all depends on the specific features of the position.

I find it difficult to assess Modern Benonis on the chess board, whilst in economics they are completely beyond me. All I know is that the Modern Benoni MUST be played with great energy, using every tempo as effectively as possible. The problem is that Black's initiative dwindles he will be left with nothing but weaknesses, so White's strategy is often to neutralise the initiative before proceeding with a demolition.

If I were to liken the US to the mother of all Modern Benonis (balancing strong growth and employment against debt), I'd say that George Bush is certainly playing it consistently (if Bush played chess I bet his style would be similar to that of the Swedish IM, Tom Wedberg). With the UK, on the other hand, I have my doubts; the position looks Benoniesque (serious debt vs strong employment and GDP) but with resources being used ineffectively I am concerned that Black's initiative may wane.

Disclaimers: a) I have played the Modern Benoni but generally feel more comfortable playing against it. b) I am very uncomfortable with personal debt, which probably explains any bias in my perspective. My saving grace may be that I'm at least partially aware of this bias.Be

The Sage, Petro China and the Yuan, by Aaron Koral

An article in the May 7 edition of The New York Times makes an assumption that the yuan will appreciate against the dollar and other currencies when China ultimately revalues its peg to the dollar.

The article, in my opinion, was a little alarmist and got me thinking about The Sage (i.e., Warren Buffett). After re-reading Berkshire Hathaway's annual report, the Sage has 3% of his equity portfolio in PetroChina (as of 12/31/2004). The Sage is also betting on foreign currency forward contracts to goose profits.

(Note: when reviewing Berkshire's 2004 annual report, he more than quintupled profits in currency trading between the end of 2002 (fair asset value was $297 million) and the end of 2004 (fair asset value at $1839 million. Recently in the 1st quarter, however, he has lost $310 million on these type of contracts, according to Berkshire's 8K).

Why do I mention all of this? Simply because you (and your writers) are right to question with skepticism the Sage's true investment motives. The Sage, in my opinion, is not only betting that other currencies like the yuan will rise against the dollar, but that oil prices will remain above $50 for the foreseeable future.

What I think the Sage forgets is:

A) Higher commodity prices for oil don't stimulate growth in future demand by commodity users (i.e., chemical companies, auto manufacturers, transportation providers, etc). Rather, the higher price of oil may sharply curtail future demand simply by forcing users to hedge by building and maintaining a supply of oil reserves for future use. This would ultimately hurt an oil exporter like PertoChina.

B) The press is so amazingly bullish on the yuan rising that no one seems to consider the opposite view: i.e., what happens if China devalues the yuan? By doing so, the yuan makes the costs of producing its oil exports cheaper, stimulating domestic demand and thereby boosting economic growth. But if the yuan depreciates against the dollar, the loss in foreign currency forward contracts could come back to haunt the Sage.

Anyway, that's just my two cents - I'm really glad to have come across your Web site. Now I'm trying to figure out a way to learn more about statistics and how to use it in speculations. Thanks again.

Dick Sears Weekly Update: Oh Behave!

A Month Without a Fed Meeting Is Like...by Kim

Months without FOMC meetings occur eight months per year. I noticed that in 2005, months in which there was no FOMC meeting (January and April) were bad for stocks.

SPY monthly return going back to January 1999:
Mean 0.989391308(-1.1%)1.007452222(+0.75%)
Variance0.002338604     0.001760149
Pooled Variance0.001955573 
Hypothesized Mean Difference0 
t Stat-1.689147611 
P(T<=t) one-tail  0.047700375 
 t Critical one-tail 1.665706893 

So FOMC-meeting month returns were higher (and positive) than non-FOMC months, which is just significant for this small sample. However this test was only during the Green period, and other pending timespans may not be as balming.

Ask the Chair

Received from a young-at-heart gentleman who is prone to using a cane on land: "After a long three-week hobble, resting in stately mansion in bosom of family. Fed ducks yesterday morning."

Vic's response: "We all feel that way. Went through Hades. Now threw it away also and retired until it goes down again. Amazing that one can buy on downs and sell on ups and still be scratching a rich man's back in this market. Guaranteed to happen."

Ask the Senator, a Continuing Series

Q: Do you agree with Richebacher that the current U.S. "recovery" is not a recovery in any economically meaningful sense, but rather a statistical hoax?

A: I have heard of the demise of America, the economy and the stock market. I blew one heck of an opportunity on this bearish meme for way too many years. That's not to say stocks can't or don't go down.. but that's why we have timing tools and selection strategies. Please do not mortgage your future on the nightmare dreams of this camp. They are long term wrong and that will not change. Their path does not lead to prosperity. The world will be better in 25 years than it is today. Shakespeare was wrong; don't shoot the lawyers, shoot the Cassandras.

But Gibbons Burke demurs: Cassandra was correct in her vision of Troy's destruction at the hands of the Greeks; she was cursed, however, in that no one believed her. She is to be pitied as a tragic figure, not scorned.

Bacon's Classic on Turf Betting

Robert Bacon's Secrets of Professional Turf Betting (Brattleboro, Vermont: Amerpub, 1956) contains some of the best insights for traders we've found. Unfortunately, the book is long out of print and difficult to find. Two of our readers pass along links to booksellers who have copies: Abebooks and Amazon.

Aesop's Fables for Traders, by Jim Sogi

The Town Mouse and the Country Mouse

Now you must know that a Town Mouse once upon a time went on a visit to his cousin in the country. He was rough and ready, this cousin, but he loved his town friend and made him heady welcome. Beans and bacon, cheese and bread, were all he had to offer, but he offered them freely. The Town Mouse rather turned up his long nose at this country fare, and said: "I cannot understand, Cousin, how you can put up with such poor food as this, but of course you cannot expect anything better in the country; come you with me and I will show you how to live. When you have been in town a week you will wonder how you ever have stood a county life." No sooner said than done: the two mice set out for the town and arrived at the Town Mouse's residence late at night. "You will want some refreshment after our long journey,'' said the polite Town Mouse, and took his friend into the grand dining room. There they found the remains of a fine feast, and soon the two mice were eating up jellies and cakes and all that was nice Suddenly they heard growling and barking. "What is that?" said the Country Mouse. "It is only the dogs of the house,'' answered the other. "Only!" said the Country Mouse. "I do not like that music at my dinner: Just at that moment the door flew open, in came two huge mastiffs, and the two mice had to scamper down and run off. "Good-bye, Cousin," said the Country Mouse, "What, going so soon?" said the other. "Yes," he replied; "BETTER BUNS AND BACON IN PEACE THAN CAKES AND ALE IN FEAR"

For the Trader: Use appropriate leverage and make a decent return without fear.

The Dog and the Shadow

It happened that a Dog had got a piece of meat and was carrying it home in his mouth to eat it in pace. Now on his way home he had to cross a plank lying across a running stream. As he crossed, he looked down and saw his own shadow reflected in the water beneath. Thinking it was another dog with another piece of meat, he made up his mind to have that also. So he made a snap at the shadow in the water, but as he opened his mouth the piece of meat fell out, dropped into the water and was never seen more. ''BEWARE LEST YOU LOSE THE SUBSTANCE BY GRASPING AT THE SHADOW"

Traders: When you have a nice profit of 2% and your work calls for a decline or the move is extended, don't get greedy and try for 4% and lose what you have. Take your profit and wait for the next overlay. The afternoon of Thursday, May 5, was a good example of this maxim.

A Connecticut Yankee in King Arthur's Court, by Steve Wisdom

Last night I watched a couple of hours of BBC's UK election-night broadcast. Quite entertaining, especially seen with fresh eyes, having watched only US coverage in the past.

In general, the MP candidates are much less spit 'n polish than US Congressionals. Less grooming, makeup, blow-drying. Perhaps politics is less TV-driven in the UK.

In each constituency, all the candidates line up, spelling-bee style, while an announcer reads off the totals and declares a winner. In Tony Blair's home constituency there were several independents running as ad-hoc anti-Blair parties, so during the lineup the PM had to endure a reading of "Blair Must Go Party, 943; We Hate Blair Party, 471; ..."

Surprisingly high turnover; big percent swings versus prior results in many constituencies, so the aggregate can change materially in a single election. A contrast to US Congressmen, who generally serve Papal terms in office because of gerrymandering and special-interest money.

Beeb coverage was openly lefty in tone. At every opportunity, presenters peppered Labour MP's with "isn't it true you lost much support because of the Iraq war!" After a while Jack Straw was reduced to pretending his earpiece didn't work in order to shut off the flow. And the commentators gleefully described Blair's expression as "a rictus, not a smile".

But when all's said and done, Labour won a third term with a big majority, despite the government's being long-in-the-tooth, and despite Iraq. It's a beautiful bit of triangulation, that Cigarman would die for. The Tories chip away from the right, and the Liberal Democrats from the left, but Labour has staked out a comfy spot in the "center."

Tim Hewson adds:

Don't know if you have silly election candidates in the US such as the UK's Monster Raving Looney Party, whose manifesto includes:

Things I like about the S&P 500, by Jim Sogi

  1. All 500 companies won't go bankrupt at once, so it's safe and diversified.
  2. All the presidents won't get indicted at once.
  3. Spitzer won't subpoena all of them at once.
  4. If some go bust, they'll add another good one on the bottom -- free management.
  5. Someone always is willing to buy them in quantity at a reasonable price.
  6. If you figure out a good play, you can leverage it up 14:1 or more and they're good collateral.
  7. It pays a dividend or it's figured in the price.
  8. All 500 of them don't have cooked books.
  9. They've all been checked out by S&P so its easy to keep an eye on them.
  10. All of their businesses won't go obsolete all at once.
  11. You don't have to worry about 30 little stocks running all around.
  12. Unlikely you'll lose all your money as long as you keep enough margin.
  13. Market is open 23 hours a day. What peace of mind that brings.
  14. Fast clean honest computerized fills and confirmation.
  15. Easy shorts.
  16. Alternate trading vehicles: ETFs, futures, baskets, options, mutual funds.

Deja Entendu, by Ken Smith

"The mob has been enjoying credit expansion in extremes, with the results of installment selling, mass education with frills, broad highways, two automobiles to a garage, political graft, real estate booms, efficiency experts, international trade en masse, "blue-chip" stocks, false economic teaching, and other well-known false gods which feed the senses."

Robert L. Smitley, 1933

See Our Monthly Buyback Study Update

Bill Gross' Investment Outlook, by Mr Bulldog

The chair has repeatedly pointed out that the two factors that determine the present price of an asset are the expectation of its future cash flows and the relevant rate of discount. As investors we ought not to "expect" price appreciation but from a change in these two variables.

Bill Gross' April investment outlook provides an interesting argument as to why his call for Dow 5000 was fundamentally flawed. I note that the argument relies precisely on these two factors, cash flow expansion and a fall in the real rate of interest. This argument appears similar to the one laid out by Mr. Paul Derosa as excerpted from Vic. Mr. Gross then goes on to conclude what is quoted below.

"Since the PIMCO forecast is for real yields to stay low, absent a policy mistake by the Fed, we may well whimper along rather slowly as all asset classes compress to provide 2-3 percent real and 5+ percent nominal returns over long periods of time. We remain mindful, however, of not only potential central bank errors of judgment, but of oil, currency and geopolitical sparks that could produce a calamitous Big Bang in a highly levered, finance-based economy. High quality bonds, and especially those with inflationary protection, remain the bond market's best bet absent a wormhole to a warmer and more inviting universe."

Disregarding all the nuances of salesmanship that Vic has often warned of, I am truly puzzled as to the statement above. If the price of an asset is the expectation of its cash flows discounted by the relevant rate of interest, how are we to believe that all asset classes must converge in return? I know of no 'long period of time" where the rate of growth in cash flows of equities equaled the return on bonds let alone the return to holding commodities or currency. The statement leads me to believe that Mr. Gross, a man I respect greatly and for whose company I am familiar with, continues to see the stock market as an overpriced bond of long duration.

The Semantics of Job Cuts, by A Natural Philosopher

The "standard job roles, processes, and tools" may refer to benchmarking. At the large corporation in which I work, the role of benchmarking in management decisions is increasing rapidly. For example, the company may commission a survey of the ratio of middle managers to employees or revenue at other companies, using the results to fire a sufficient number of middle managers to bring the company's own ratio in line with industry averages or "best in class" averages.

The "local consultation bodies" are obstacles--unions and government regulators with the power to restrict IBM from firing the desired number of people.

On your larger point, a colleague of mine draws an analogy between cost cutting and a wrestler trying to qualify for a lower weight class. It is one thing for a wrestler to starve himself to lose two pounds before a meet, but my colleague sees some cost-cutting efforts as the equivalent of a 225-pounder trying to qualify for the 150-pound class by amputating limbs.

The Sage: 'Your Other Own Man,' from George Zachar

In his recent appearance on Lou Dobbs' CNN show, the Sage hit all the right talking points: raising Social Security taxes and means testing, explicit class warfare, expanding the estate tax... even creating a new system of import certificates to control the trade deficit.

All in all, a "your own man" tour de force.

[Editor's note: For Charlie Munger's 'Your Own Man' Act, see George Zachar's May 1 post]

For the "Nobody Wants to Say It" Department, by Russell Sears

I know it's political incorrect to say so, but it appears that Mr. G has succumbed to age. Perhaps he's simply  not as capable, mentally. Or, in Freudian terms, perhaps he has no interest in seeing a successful transition and therefore is subconsciously undermining the institution. It's similar to Soros saying, "America is headed down," or the Sage saying, as he recently did, "We are at the apex of civilization." Such chronocentric statements and attitudes appear to me to be close kin to the apocalyptic forecasts of the chronic bear.

Perhaps this is what makes these prophets of doom so profitable. Not every self-made, wealthy old trader hobbles down Wall Street during stock market panics, cane in hand. Plenty, preferring stasis, are cheering, "I told you that the young generation would never amount to much." For them, the success of others threatens their records. Many end up handing their money over to these charlatans because they are leading these cheers.

I would think that such obvious chronocentric statements for leaders could be counted, as the Chair and Laurel counted arrogant, egomaniac statements by CEOs in "Practical Speculation" and in one of the many memorable CNBC Money articles. Further, as Social Security's troubles show, leaders retiring badly is most likely a growth industry.

Art Imitates Life, by Abe Dunkelheit

Victor: "Actually, the issue is the fees. They pay fees on about 10 different levels."

There is an analogy here to the art market - My dad is an art dealer and probably the last time he talked with me was after losing me an outrageous amount of money in so called 'art investments' which made me calculate the 'fees' and realize the following market realities:

There is an art object in New York at auction. Estimate is USD 10,000 - 15,000. You bid it up and get it for USD 20,000. You pay 22% commission. You pay shipping to Europe [USD 1000]. You pay 7% VAT in Germany. You will let the painting be restored and reframed [USD 1000]. All in all you pay USD 28,000. Ete: EURUSD.85, that is, you end up paying Euro 33,000. Then you go and offer it to your customer for Euro 66,000 [which is a very reasonable 100% profit margin for an art dealer - some take up to 400% plus]. When the heirs of the deceased costumer want to sell the object they will have to ship it back to New York [-1000 USD] to sell it there. The auction house wants them to pay catalogue fees [-500 USD] and insurance for the painting [1.5% on lower estimate is USD 225]. They will estimate it USD 15,000 - 20,000 but it will not sell because you are not bidding and without you the painting had been sold for USD 10,000 in the first place. They will get an after sale bid of USD 10,000. The painting is in New York shipping it back to Europe is too much to take and the customer's heirs surrender and accept the bid and pay another 12% commission fee to the auction house. All in all they receive a check about US 7150 and when you bought the painting the USD was at a peak towards the Euro while it is trading now somewhat lower. Exchange rate is now EURUSD 1.30, that is, Euro 5,500 will be the final payout to the heirs of the customer. But wait - subtract another Euro 20 for clearing the check at the bank and not to forget the art insurance the customer paid for years on his 'valuable' painting [some Euro 100s over the years].

Can it get worse?

Yes, the heirs will have to pay for their father's coffin, buy a place on the cemetery, pay yearly fees and have to organize a goodbye dinner, all in all, some Euro 5,500 - thank you very much.

But, of course, if your father's father had bought a van Gogh in 1885 for a few dollars while doing vacation in France and your family had hold on till today [2005] the painting could probably fetch something between USD 20 - 80 million.

The former is everyday art market reality the latter is the sales pitch.

Two Brief Bond Points, by George Zachar

1) The treasury isn't going to flood the markets with long bonds. Far from it. They're talking $30b/year no sooner than 2006, split into two semi-annual auctions. That's bupkus relative to any metric I've seen of demand/turnover for long paper. Note too that supply of the "other" long-dated (but far shorter duration) paper, fixed-coupon mortgages, has been net shrinking.

2) The reason bond futures closed little changed is that the new paper will be so "rich" relative to contract deliverable specs, that it should have next-to-no effect on futures valuation.

Don't Be Crude, by Victor Niederhoffer

Someone is going to say that the five most recent days in spot crude, where its high and low have been respectively above and below $50/barrel by an average of $1 each day, is random. But I say that it has within it a nice little reversal system.

4-May 49.50 50.95 48.80 50.15
3-May 50.30 50.60 49.30 49.50
2-May 49.30 51.05 49.17 50.92
29-Apr 51.25 51.60 49.50 49.72
28-Apr 50.70 51.85 49.80 51.77

Briefly Speaking, by Victor Niederhoffer

It's getting a little ridiculous that the main way big companies have to improve their stock price these days is by cost cutting. It happened in two of the companies I owned, right after or in conjunction with my selling: IBM and Pfizer. Such efforts strike me as Sage-like, Scrooge-like, short-sighted activities whereby accounting changes -- "We'll write off $5 billion now to save $4 billion a year in three years" -- similar to acquisition write-offs, can mask the intrinsic rate of profit increase.

But like the machinations of the Sage, such as his selling ABC to Disney without a brokerage fee (ain't Disney happy) and similar cost savings and knockdowns in all his other transactions and serial acquisition fees (apparently it was common to boast in the old days that through shrewd accounting, in the Caribbean, an acquisition could boost the reported earnings of the acquirer by 25%), such maneuvers are finite and do nothing for the long-term prospects of the companies, which are embodied in the expected future growth rate, and discount rate-adjusted for risk.

Please understand that one has nothing against economism, or the great Scrooge McDuck®, or Carl Barks, his heroic creator, and never should the Sage or the Palindrome be compared to them

Love and Markets on the Tennis Court, by Hany Saad

I watch a lot of tennis matches, and occasionally play. Interestingly, I learn more observing than playing; partly because I am in no way a good player. In my defense, I always try to play against excellent players with the inevitable defeat after a short match.

One particular shot that got me to put the pencil to the back of the envelope for some counting is "wrong-footing." Here is how it works for the non tennis players. Hit to your opponent's "side pocket," the outside corner of the service box, then as your opponent hurries back toward the center of the court, hit behind him (wrong-footing him). This is a classic shot combination that can be started with a slice serve, a sharp crosscourt topspin groundstroke, or a delicately angled slice groundstroke, usually a backhand. One hazard though: if your opponent gets to your widely angled shot in time to set up a good reply, he'll be able to create an even sharper angle than you did, because of his wide position on the court. This means this shot is in no way a desperation shot.

Upon counting, I figured that the players who are ahead in the game tend to use this shot more often than the player who's behind on the scoreboard as it is considered a risky shot if returned.

What does that have to do with markets?

After the market has been going down for few days in a row, the unsatisfied mistress starts wrong-footing market participants by another down open where longs look for the exits and overnight stops get hit. Once all the weak hands, a.k.a. the mistress's lovers or market participants, are out of the market, out of breath and licking their wounds, the market turns around and compensates the strong confident Casanovas with the large bank rolls, a.k.a. the strong hands. Didn't we all watch a lot of wrong-footing yesterday after Greenspan's speech?

Oh, the mistress. She did it to me so many times that I am starting to think that may be I should realize I am not a Casanova and stay faithful to my money market fund.

Wrong-footing is not for the faint of heart or the player who's behind on that scoreboard. That's precisely why it is the mistress's favorite shot. After all, she's the strongest player around. Last I heard, she did so good wrong footing that she now owns the most popular casino. She still wrong foots the players back and forth before she invariably sends the killer shot in the opposite direction.

Of Human Bond-age, by George Zachar

I assume the pit cheered when the Treasury announced they were formally looking into re-issuing The Bond starting next February. The CBOT has been lobbying for a return of their favorite plaything for years.

For conspiracy theorists, there's this: The sudden re-steepening of the curve, and upward spike in long-end yields, means the Fed has a lot more room to raise rates before threatening to invert the curve. The general yield rise along the curve also helps the Fed, by taking some of the strain off short rates as an economic brake.

Finally, in what is now old news bordering on trivia, I recalled that in his Fed memoirs, ex-FOMC governor Meyer said that Greenspan actually presents the Board with a pre-written statement for release at each meeting. This makes the "transcription error" for Tuesday's debacle seem less and less plausible.

Steven Lambert adds:

I cannot think it coincidence that the Fed omitted the sentence regarding long term inflation containment, "corrected" it an hour and 40 minutes later, and this morning we learn that the Treasury is "considering" reissuing the 30 year bond.

More plausible is the scenario that the Treasury phoned the Fed, reminded them of the upcoming reissuance in this time of unequaled indebtedness, and asked: what were they thinking?

George Zachar replies:

None of it makes sense as an integrated conspiracy. The rigid schedules of massive institutions like the Fed and the Treasury can make for uncomfortable coincidences. The Treasury refunding statement date, and the FOMC meeting calendar, are fixed many months in advance, and it's not as if there's a financial crisis or anything that would make for such unusual public exertions. Altogether weird, and it's probably to my advantage that I wasn't lured into making a hasty rebalance, or other unforced error.

Stops and Aikido, by Essan Soobratty

There are many similarities between aikido and using stops to defend a market position or capital.

Zanshin is a state of relaxed awareness/readiness that you remain in even after your opponent's energy has been neutralized (or dissipated as Chair described yesterday). In the case of life-and-death combat, being ready to re-defend or defend against other attackers. In more general budo speak I think it's remaining in constant harmony with your surroundings. Your own energy continues to flow even after the attack is over. There is no beginning or end.

In the lexicon of speculators I think zanshin refers not only being ready to defend again if necessary but also being ready such that I don't miss the inevitable opportunity that comes soon after being stopped out.

I'm hearing echoes of Chair's post yesterday about using stops to "go against" as I write that advanced aikido techniques (kaishi waza) allow the previously neutralized attacker (aggressive speculator?) to use the defender's energy to apply a counter-technique. Thus attacker becomes defender and defender becomes attacker as both attacker and defender use their opponent's energy. There is no beginning or end.

For those who may have trouble visualizing aikido.

The Yo-Yo Effect, by Dr Philip McDonnell

It is often amazing to watch the market gyrations on Fed meeting days. Today's moves were no less entertaining than usual. To review, the S&P opened quietly and traded in a 1-point range for several hours. It seemed like a powerful spring was being coiled with all of its energy saved up for some sort of explosive release. The spring metaphor proved accurate as the Fed news was released.

The initial reaction to the news was a small move upward out of the narrow range. Then the market decided that was a mistake and dropped about 4 points to a new low for the day. That lasted 10 minutes. The next move was a powerful 8-point spring-like thrust upward, making new highs for the day. The highs lasted less than 20 minutes and were immediately followed by a 10-point plunge which carved out new lows for the day. One might think that after all of these oscillations of increasing amplitude that the market had finally found its level. Such was not the case.

As we neared the close, Fed officials announced a "correction" to their statement which apparently was interpreted as bullish by the market. It seems they omitted a line saying long-term inflation expectations are "contained."

Victor Niederhoffer comments:

And the futures closed up 2.5 points on the day, showing the usual Fisher effect of the lagged response of the index to the news and thereby emphasizing once again the inexhaustible number of biases in "academic" studies of markets, the supreme efficiency of the market, and doubtless webs of deception on all sides.

1166 Revisited, by James Sogi

(composed circa 14:35): The Fed shuffle kung fu finally poked through 1166, the number the amateurs have been watching).  Statistically 1166 is the mean, technically resistance la Wyckoff, mechanically the number that broke Globex, but it's been struggling to get though the last three weeks and now a crack in the door. Updating mean of Cash SP the last 1800 days is just 1166.

I'll be darned if it didn't close right at 1166 today. Hmmmm.

Autocorrelation, by Bruno Ombreux

There is some autocorrelation is some smallcap indexes. For instance, there was a French smallcap index called "Second Marche". It got discontinued this year due to Euronext's new market organisation.

Here are the first 10 ACF coefficients, with their standard errors:

1 30.6% 1.7%
1 30.6% 1.7%
2 17.4% 1.8%
3 13.6% 1.9%
4 14.6% 1.9%
5 10.3% 1.9%
6 6.8% 1.9%
7 9.4% 1.9%
8 10.2% 2.0%
9 9.4% 2.0%
10 4.5% 2.0%

Number of observations: 3609

This is quite strong. It can't be explained by non-synchronous trading of illiquid stocks, because the vast majority of these stocks trade every day. In order to exploit this type of phenomenon, you need to be a small investor, else your market impact will probably kill the edge arising from trading favorable odds.

Hope Springs Eternal, by Victor Niederhoffer

Old men are just as hopeful as young men when they see a pretty young nurse, and on Fed day that hope is manifested with a t-score of 5.5 for the open-to-2pm move. The problem is what happens once they make the move. But it's so much easier to describe than predict. The beautiful symmetry of the decline, which started with the S&P at 1193 on 3/22 at 2 p.m. with the Fed's warning on inflation, ending with a whimper as even the Fed realized that markets, with their 7% decline in commodity futures since that date -- a deflationary move in the top percentile -- are more important than pig-iron statistics read in the bathtub.

Two-Month Declines, by Victor Niederhoffer

April's decline created a run of exactly two S&P declines from month-end to month-end. This has happened 12  times since year-end 1994, with subsequent results as follows: 

End Date of RunLevel at End of RunMove Next Month (points)

All told, a pretty random assemblage (famous last words), with a mean of 8 points the next month. Note the inordinate cluster in 2000 and 2002.

Such a study might be generalized to other back intervals and markets, inter-market effects, magnitudes and durations vis-a-vis subsequent distributions of prices with a reasonable chance of useful lessons. 

Ask the Senator, a Continuing Series

Q: Do you use stops in your trading?

A: I think stops, for short term traders, are mandatory. It's simple math; without a stop a trade with a risk reward of 3 to 1 can change to 3 to 5 or 3 to 12! As a short term trader, my goal is to be out, not in, a position. I want to hit and run, not be holding and hoping.

Send queries to: senator -at- dailyspeculations -dot- com

Ask the Chair

Q: According to books I have read, you state that you never use stops and this on the surface would seem to be opposite the guidance of the former Montana rancher above?

A: This is what makes the day and the fray. I do not have the ability to use stops either mental or physical on the floor, or electronic in cyberspace, without the market unerringly receding against me to my stop price, effectuating a big loss, and then exacerbating it with an erratic fill, and then humiliatingly moving right back to what would have been a beautiful profitable trade. I try to use stops, however, to go against, the way I believe an expert Asian martial artist such as Mr Sogi might use a direct frontal assault on him with an attempted headlock or right cross to the face, i.e. I back away to let the opponent dissipate his energy, thereby allowing him to seemingly "hit and run", and then when the adversary is most extended, to move back to the offensive. All of this must be tested after different past moves of varying consistency and duration, as goes without saying.

Send queries to: chair -at- dailyspeculations -dot- com

Yuri Skrilivetsky comments:

The Chair's use of stops reminds me of the martial arts form of aikido.

From Wikipedia:

Aikido incorporates a wide range of techniques which use principles of energy and motion to redirect, neutralize and control attackers. Because aikido techniques allow practitioners to move considerably during their execution, as well as for other reasons, some believe aikido is particularly suited to multiple-attacker circumstances. However, like all martial arts claims, this is debated. At its highest level, aikido can be used to defend oneself without causing serious injury to either the aggressor or the defender. If performed correctly, size and strength are not important for efficiency in the techniques. Aikido is considered one of the most difficult of the Japanese martial arts to gain proficiency in.

Googology, by Gibbons Burke

In an ever-growing ecology of Google sucker-fish, this site does a wonderful Tuftean job of assigning visual rank to news stories featured on Google News, reminiscent of SmartMoney's map of the market:

It is fascinating to click along the top of the graph and see at a click how various stories rank in the various news markets around the world - this site gives you an immediate appreciation.

This link came from an article in the Wall Street Journal about sites that stand on the shoulders of the Mountain View search giant:

Tweaking Google: Fans and Critics Build Search Tools That Add Features or Remove Ads

The Internet has turned up a spate of new Web sites that strip advertisements from Google's pages, attach snapshots of sites to search results and plot online real-estate listings on Google maps -- and Google Inc. has had little to do with any of them.
The services were developed not by the search giant's engineers in Mountain View, Calif., but by enterprising Web users with a bit of programming moxie. Many are hobbyists who design the tools for fun, then realize others might find them handy and give them away. Some are companies looking to make a buck by riding on Google's coattails. Still others are critics trying to draw traffic from the search giant's site. Officially, Google frowns on the services, but it rarely goes after the people behind them...

Fearless Forecast, by George Zachar

I will be out all day tomorrow...a major heresy, as it is a FOMC meeting day. Nonetheless, I fearlessly forecast a 25 bp hike, the retention of the word "measured" in the post-meeting statement, and no material change in the committee's language.

The upcoming inter-meeting interregnum will set a record for the longest such span in modern FOMC history. They'll have two full sets of employment and inflation data before they sit down for their mid-year two day confab at the end of June, to lay the groundwork for Greenspan's final monetary policy testimony in mid-July. (Remember, he is expected to retire at the end of Jan 2006).

The Fed has every reason to maximize its flexibility going into June, by doing exactly what's expected tomorrow. What could possibly tear me away from the screens on a Fed day? The once-in-a-lifetime chance to accompany my kindergartener and her class to the Aquarium in Brooklyn!

'Your Own Man': Textbook Example, by George Zachar

Socialist Berkeley prof and former Clintonite Brad DeLong showcases Sage & Co's anti property rights broadside:

"The Republicans are out of their cotton-picking minds on this issue," said Munger, a self-described right-wing Republican. Social Security is "one of the most successful things that the government has ever done."

DeLong's blog is one of the most popular lefty/academic/econ sites.

[Editor's note: Read an analysis of SSI by aerospace systems analyst William Haynes]

Fading Yourself, by Ross Miller

There is an episode of Seinfeld where George does the opposite of everything he would normally do and immediately his life turns around.

Like some others on this list, I mentally track the predictions of the more vociferous members on the list, including myself, and see how well they perform. Oil has been a topic on particular concern, as some on this list think that we are "running out" and others, including myself, place faith (possibly misguided) in the law of supply and demand to sort things out, which in my case is supplemented by a longstanding observation that so-called analysts systematically underestimate the elasticity of demand for petroleum products over periods of time exceeding six months.

Also, while it is too early to declare victory, it is worthy of note that oil has now slipped below Goldman's target range of $50-$105 on a closing basis. The interesting thing about oil is that because the industry has so few moving parts, one can explicitly model the critical paths of the industry down to the individual refinery level. (The neat thing about a refinery is that it requires almost no labor to run -- some guy flips a switch and it just does its stuff -- until it explodes and even then only a few people are around to get killed.) As far as I can tell, Goldman works from a back-of-the-envelope modeling methodology rather than a detailed micromodeling approach in order to save money (and because they appear to lack the specialized expertise needed to do things right). Back in the 1980s, when I did a brief stint as a petroeconometrician, the group that I worked with was the only one that drilled down far enough and our competition (mainly DRI) were basically faking it by projecting down from a macromodel rather than up from a micromodel.

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