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November 1-15, 2005
A Random Bearish Column Generator, by Victor Niederhoffer
In this day and age when so many bearish ideas are propagated daily, I need a way to keep on top of them. The best way I've found is to divide the bearish reasons into categories, and then pick bearish adjectives from another category, and then pick a impeccable source with a great track record to attribute them to. In using the computer to do this random exercise, I have been guided greatly by the financial weekly columnist who for 40 years, as far as we know, and by his own admission, has not once been bullish, and the columns on the site of two of the major bear funds. With the help of my colleagues, I compiled a list of 100 or so of the most frequently adduced bearish reasons.
One idea is to just do it the way the weekly does it: If the economy is in recession, predict a depression and a stock market decline. If a recession recently ended, predict a double-dip recession and a stock market decline. If the economy is expanding, predict Fed Funds rate increases and a stock market decline. Whatever you do, don't forget the Challenger layoff report and the Michigan sentiment index, which are always dismal, as well as the Employment numbers and other data releases by civil servants who are incented to increase the likelihood of government spending in their favored administration.
Another approach is to remember that the body snatchers use alliteration to insure that investors will have countless losses and insist that there are at least 10 such in anything that the computer comes up with.
However, I refuse to take the easy way, and want to come up with something really personal and customized, as only a computer can do, and not a banal apologia designed merely to protect against torts claims, or feather the nest of my boss who learned his financial analysis in the 1950s when Dow Theory was king.
Also too easy is a composite column: "I have dreamt that an evil entity, watching the Masters of the Universe, speculating against the US dollar, proposes to shave them smooth. It may be the same gang that keeps the US Dollar attractive for the foreigners sustaining the US economic boom, or the Plunge Protection Team itself."
There are four parts to every bearish piece:
The first part, the anecdotes that spark the bearish case, are as varied as life itself and can include such things as the weather in Maine, the growth of timber, disappointing sales or earnings of any of 30,000 public companies. A computer scan of who and what's being reported on any day will be sufficient to start the automatic process rolling. And if the scanner is broken, then choose weakness in the debt or stock of General Motors, Cisco or Intel, or pick the latest derivatives debacle.
Below are the classes and categories for parts 2, 3, and 4 of the process. Regrettably, I have to go to Vienna today to deliver a talk on the flow of the Blue Danube River and its relation to the first (the bullish) part of the Triumphal Trio's work, so I will not be able to generate a completely personalized, custom tailored computerized bearish column until I get back, but doubtless some of my readers will beat me to the punch and others will get the mojo.
The major categories of bearishness are weaknesses or catastrophes in the following:
The list of pessimistic descriptions for these categories might best be divided into two parts, based on whether the market is up or down but for the sake of simplicity we will combine them and program the computer to invert properly based on an artificial intelligence algorithm.
Bearish Descriptions (Pick one or more):
Well, that's it. I'll have to wait to get the computer programmed to do it until the boys and Minister come back, but I have to point out that there is a third part to any computer or actual article. That is the testimonial and appeal to authority. The weekly columnist is the grandmaster at this and here are just a few that one should choose from:
Ladies and gentlemen, please help me fill in the holes so that the computer can beat the human in this oh so important enterprise.Thanks to Steve Ellison, J. T. Holley, Jim Sogi and Jaime Klein for their contributions to this essay.
Andrew Moe Replies:
No bearish random column generator is complete without a "despite" module that instantly turns good news into bad:
McDonald's, by Ming Vandenberg
McDonald's apparently is responsible for destruction of the rainforest due to cattle rearing, but all kinds of restaurants serve meat products, so I can't place blame on McDonald's alone for the whole unsustainable meat-eating culture.
However, the business model of McDonald's and the other fast-food chains (Burger King, Wendy's, Roy Rogers) enables the working class to eat out in a safe family environment. Also, in Singapore (I'm not sure if this happens in America) McDonald's employs those who really need jobs but might not find employment elsewhere (the very elderly, some slightly mentally retarded people, those without English skills).
Overall, I feel strongly that McDonald's is a wonderful institution.
Market Inertia, by Dave Whitesel
Market Inertia is a phenomena tied to Intent. Many here wont like what I am about to say, but from where I sit, its as clear as can be. Inertia is a ledger of interest locked up, or is in the process of getting to that state where movement is a function of strength of one side of the ledger or the other.
As Vic describes in his profile of the organs of intent, clarity emerges from the consistency of the harking, but the harking is only the message as output by interests, its not the goal. Inertia is the collective stalemate that occurs when the momentum behind the harking begins to yield less product against the prospects of forward demand.
Our current economy is an economy facing radical discontinuity. Radical discontinuity is the wholesale shift of forward demand from sets of entrenched interests to solutions for the problems sustained by said interests.
Clearly GM is a good example, saddled with inflationary labor contracts, accrued pension and health care liability, set against a backdrop of demand shift for another class of transport, not tied to peak oil, the company and its wide range of owners stratified by class must somehow extricate themselves from this downward spiral linked to changing demand.
The interests, aligned as ownership classes, have already begun the process of positioning tactics which will preserve their positions to the greatest degree.This process is about risk subordination.
The goals sought by these combined tactics will provide an image to the broader public that the company can be saved, restructured and survive. This first wave of tactics will manifest as a static line where the smartest, within the risk subordination process, will exit incrementally. This will be accomplished under a state of apparent inertia.
Inertia has a primary goal and that goal is rotation to forward demand.
Within the market; classes of intent are stratified by their individual class of action as its related to duration. Traders function around the edges, buying the moves in progress, fulfilling objectives at the edges, where as investors own the entire process and use the traders to mask their rotations.
Knowledge in markets is distributed unevenly across classes of players, therefore some will interpret the Inertia as working towards a goal of surviving a rough patch, while others will evacuate to forward demand as quickly and quietly as possible.
Knowledge of forward demand is the prevailing metric of predicting the future, where the winners and losers will be aligned as intent on a ledger to be discriminated against as their wagers describe.
Inertia is the early adoption of Intent toward forward demand by classes of players whose knowledge is ranked above all others. Inertia is at once a signal of value and a warning about impending abandonment. The arrival of inertia with respect to any issue, is a tell about rotation and the intent of those who would be owners, postured against those whose ownership and conviction are not strong enough to meet the duration of this natural process.
Inertia is bought and paid for by interests whose superiority of knowledge permits the entry and exit of positions against the fat part of the curve.
Returns from the Sponsor's Gallery, by Rod Fitzsimmons Frey
Although there is a lot to enjoy in PracSpec, I especially liked the analysis of hubris. Not only does it ring true, but it gives me a chance to exercise my sense of righteous indignation -- always good fun.
Your section on stadiums brought to mind my time as a director of engineering with a small backwoods Internet start-up. The founders raised around $10M from local doctors and other aristocracy. Thinking (quite rightly) that professional management would improve their odds, they jetted to San Francisco for a series of interviews. They hired a gentleman whose white hair and measured tones completely masked his true nature as an incompetent boob.
While I was haunting local flea markets looking for a backup database server, our CEO was "marketing" the company using the aforementioned dollars. One of his more inspired moves was to rent the driver's side door on a NASCAR racing car. When we received the motivational photo of our leader in the sponsors' gallery, NASCAR sponsorship was forever etched in my brain as the pinnacle of pointless corporate largesse.
With that in mind, I gathered a list of publicly-traded companies that initiated NASCAR sponsorship between 1995 and 2003. I tabulated their 1-year and 2-year returns and compared them to the S&P 500. The companies showed an average 1 and 2 year return of -0.38% and 3.03% (-2.22% and -6.46% median: Time Warner did well in 1999). That was an under-performance compared to the S&P 500 of -9.07% (1 year) and -19.89% (-2 years). The table is pasted below for your viewing pleasure.
My study has several flaws: There is a significant survivor bias since some of the companies are no longer with us. A couple of companies (Sears and AOL) were acquired or reorganized and I didn't have historical records. Several companies were listed on OTC boards and were not included, since I got a bit lazy. My guess is that these flaws would worsen the case for NASCAR sponsorship, though.
A natural extension of this study would be to look at Formula-1 sponsorship, which I believe to be even more expensive than NASCAR advertising.
A Technical Analysis Confession, by RP
I realized at a young age that financial markets were an important element of our society and that it would benefit me to learn something about them. Unfortunately, my lack of education coupled with my desire for quick profit allowed myself to be seduced into the technical analysis community. I read it all...Magee, Elder, Pring, Pretcher, and especially Farley. I subscribed to TC2000, read the Worden reports, and even joined their online community in hopes of learning from 'the professionals'. I played the 'loyal student' role to those in the know and applauded their every move, all the while waiting for the day that their understanding and trading skill would become my own. This went on for (painfully) a few years. Luckily I never stopped reading and eventually came to the Niederhoffer selections and articles on CNBC. The first readings didn't trigger the realization of my TA error like they should have. I was much too focused on trying to understand how he turned a profit to understand the other side of the coin presented...that how not to turn a profit is just as valuable, if not more so. Time passed and doubts about the 'professionals' began to creep into my mind. Why did they need thirty different indicators if price patterns were so predictive? Why was there no consistency to the application of Fibbonaccis and with wave counts? Why could I never understand exactly what predictions were being made? (bullish unless bearish) If all these men were so talented, why did they devote their lives to herding members of the public and not making millions at private firms? Why didn't Wall Street want a piece of the 'valuable' information I received access too everyday? Frustration grew and I turned back to your published works, this time with a new agenda. And yes, as you have probably guessed by now, I was able to put the pieces together and realize that I had been fleeced. My doubts and frustration with the online TA community grew, and eventually resulted in me lashing out about the nonsense that was being sold. The main catalyst was my discovery that the TCNet software corporation had arranged compensation policies for the 'professional' traders who were 'teaching' others how to trade. While I have never been able to (or really cared to) confirm the specifics, I imagine that the relationship goes something like this. Newbies decide to try out real time software. Under normal conditions, they would quickly realize that they were in over their heads and end their subscription within a couple of months. But by having a 'community of professionals' available who are willing to 'teach' others the 'business' over a year or two (or more), subscriptions are drawn out for a much greater length of time. Also, the warm and helpful nature of the 'community' entices others to tell their friends and generate even more revenues. Yes, my own greed, lack of education, and unchecked self confidence resulted in the hardest lesson of my life (thus far). The sad truth is that had it not have been for the Neiderhoffer/Kenner works, this could have gone on indefinitely. I know this because when I left the TcNet group, there were grown men and women, with families, still chasing the 'professionals', always 'learning', always 'getting close to profitable' despite having been there for many years (some 10+). While I know nothing about psychology, it is almost as if the lie has progressed for so long and received so much investment (time, money, sacrificed relationships) that people are afraid to wake up.
Predicting the Dow, by Victor Niederhoffer
An analysis of sweeping moves in the Dow reveals a practical example of why analysis of ratios is very confusing, especially when the analyst is a chronic bear. Take for example the numerous studies that show that the average P/E of the Dow over the last five years is somewhat negatively correlated with future returns and moves in the Dow. (The studies of course are biased in the sense that they assume earnings were available as of year-end, and they tend to throw out the negative earnings. But put that aside for a moment.) If such a negative correlation exists (and the correlation between a ratio consisting of a 0 correlated bottom and a 0.30 correlated top with the variance of the bottom say five times the variance of the bottom is indeed problematic), the question is, what causes the correlation? The top or the bottom of the ratio?
It turns out that the correlation between the last five years' change in the Dow and the change the next year is -0.25. A good regression equation for the forward one-year Dow return is 11% - 1/10 x previous five-year Dow return, with an r-squared of about 0.08.
Thus, if the return on the Dow is -20% over the previous five years, the predicted return for the Dow next year is:
11% - 1/10 x -20% = 13%
The current Dow of 10,686 is about 1% below where it was five years ago, so a good regression prediction for the Dow one year later is 11%.
A good way to study regressions is to divide the independent variable into classes and note the mean of the dependent variable in each class. The slope of this relation between the means of the dependent is how the greats originally calculated and motivated the regression line. Until the last 30 years, when computer calculation made statistical work an exercise in the use of cans, this was still the way most investigators looked at linear relations.
Such an analysis shows the following:
Returns of DJI Number of Average return prev 5 years obs next year -100% - -50% 4 20% -50% - 0% 22 18% 0 - 50% 40 06% 50% - 100% 18 06% 100% - 150% 10 04% 150% and up 01 -20%
Note that the Dow on average is up 7.5% a year. The current five-year change of 0 is quite low on a relative basis -- in the bottom quartile. The prediction one year ahead is not encouraging to the chronic bears. But this is just when they are the most vociferous. Of course, this is ideal in the sense that they make the greatest contribution to the market and have the greatest capital and mojo at their disposal at such a time.
Note also how the numerator of the ratio under consideration is the key variable that truly is negatively correlated with the future and how hard the chronic bears and their supporters in the recycling-of-information business must work to obfuscate the true source.
Year DJIA 12/31/1980 963.98 12/31/1981 875.00 12/31/1982 1046.55 12/30/1983 1258.64 12/31/1984 1211.56 12/31/1985 1546.67 12/31/1986 1895.95 12/31/1987 1938.80 12/30/1988 2168.60 12/29/1989 2753.20 12/31/1990 2633.66 12/31/1991 3168.83 12/31/1992 3301.11 12/31/1993 3754.09 12/30/1994 3834.44 12/29/1995 5117.12 12/31/1996 6448.27 12/31/1997 7908.25 12/31/1998 9181.43 12/31/1999 11497.12 12/29/2000 10786.85 12/31/2001 10021.50 12/31/2002 8341.63 12/31/2003 10453.92 12/31/2004 10783.01 11/14/2005 10683.48Thanks to the Minister of Non-Predictive Studies for his calculations and regression.
Cliches, from GM Nigel Davies
From Aaron Nimzovich's book on the Carlsbad 1929 tournament:
Another of Rubinstein's characteristic features is his dislike for melodramatics. Empty rhetoric and pretentious moves shock him to the core! All of his moves are suffused with a natural elegance, bordering on severity. He abhors cliches. In 1912, while reading the annotations to a certain game, he chanced upon the expression, 'This move highlights the hopelessness of Black's position.' 'A cliche!' cried Rubinstein, and would read no further. It was necessary for me -- being the unfortunate author of the note that had so infuriated him -- to go to great lengths in order to convince Rubinstein that my note had, in fact, only reflected the actual state of affairs, and thus was not a cliche. Only then was Rubinstein persuaded to continue reading.
What the Oil Market Wants, by Dave Whitesel
Over the last year, we've been treated to a large number of appearances of Mr. Lee Raymond, president and CEO of Exxon Corp., on CNBC's shows. What is notable about these appearances is the consistent message Mr. Raymond has delivered against the theory of peak oil. Mr. Raymond has stated almost every time that there is no supply problem. In some cases, he did so subtly; in others he was more strident.
Mr. Raymond knows oil, and Mr. Raymond knows the markets for his commodity. These are mutually exclusive domains. Supply and demand underlay the market for commodity oil, just as they act as an underlay for all other markets. Mr. Raymond's persistence in reminding us of this is notable. Mr. Raymond knows oil.
We can take Mr. Raymond's enlightened opinion and compare it with what we see day to day as reflected in the market prices for oil, and we can come to but one conclusion. Prices are artifacts of prevailing systems' intent.
I've adopted this original truism across all areas of my market endeavors. At least for now, I sense that this truism will emerge as the prevailing understanding of markets going forward.
Supply within most commodity markets are fungible, though sometimes scarce and sometimes abundant.
The breakthrough for market participants who choose to square off against the vagaries of market supply starts to change when you begin to see your capital as fungible against your self-constructed buffet of alternatives.
If you accept the premise that price is an artifact of prevailing systems' intent, your focus must be to begin to measure system behaviors; system behaviors are the accumulated interests of market participants aligned on one side of a ledger or the other. Clearly Mr. Raymond has known that oil products are not particularly scarce over this past year; his company is one of the largest buyers. Clearly Mr. Raymond's message to all of us is that geopolitical interests have fallen on the side of the markets ledger of intent, to drive prices higher.
Mr. Raymond is not apologizing, he's been very clear: systemic intent is driving price, not supply and demand. There are times when every person must calculate that someone has moved their cheese
During periods of recognition of this fundamental point of interest, we all must find a map to guide us to where our cheese has been moved. Systemic intent is the alternative offered as the active force, in place of supply and demand. Adaptation towards current methods and practice becomes the survival metric for all market participants. Systemic intent exists as the prevailing metric of disconnected supply and demand.
Supply and demand remain, but as an artifact of the accumulated intent of a ledger of interest.
From where I sit, I sense that the methods and practice installed have yet to be codified; they are evolving against limitation. The future greatest challenge will be the same challenge confronting every other practice instituted as trend, and that will be miscalculation of greed as the prevailing metric of accumulated interests, aligned to a ledger along a time line that ends.
Mark Benjamin Responds:
I was struck by how closely this statement resembles an old salesman's close. Many years ago a friend of mine worked for the notorious firm First Jersey Securities, they had a checkered history and were widely considered to be nothing more than thieves.
Salesmen at First Jersey were given rigorous training, and the organization was run like a military operation. All sales calls were scripted, and a list of ten responses to customer's objections was given to each salesman. The idea was every time a customer gave a reason why he could not make a purchase you would reply with one of the ten scripted closes.
The first on the list was: They know their markets, they have paid their dues
That's My Boy, by White Bred Ed
I tutored Mark when he was fourteen and seven-feet even. Today I looked up to him in the Kitchen for the first time in five years. We sat across the table from each other at the Blythe Kitchen for California s finest free chow. He and I wore competitive gleams over plates of heaped enchiladas.
Seven-and-a-half now? I asked, pleased that he looked passers-by straight in the eye while eating. More like seven-nine, he answered.
Well, you've filled out too. What s new in your life?
I'm raising a new pup, he exclaimed.
That's wonderful. What else?
My fiancee is pregnant.
I turned white. He was too young for that, and he cut me off. We met up in Missouri.
I went back in line for seconds, but not he. I returned for thirds, but he didn't. I grew petrified over time. His mom used to drive us after tutoring across the Colorado River to the nearest all-you-can-eat Pilot Truck Stop smorgasbord. He wolfed seven plates a sitting then.
Are you ill?
No, I feel like a new man! I just don't eat like then. I stopped growing too. It all started in Missouri.
A clamor shot up at the door. Two men shouted, approaching fisticuffs. Quickly, the Kitchen supervisor, a 300-lb. Mexican grandmother, inserted between the ruffians, raised her palms, and chided, I don t take sides. Sit down, both of you! Silence reigned except for the chews and swallows of thirty hard-bitten men and women back at their plates.
A siren screamed. Who called the squad car? A black man demanded. We don't need no cop, a Hispanic pronounced. White trash joined the general tongue lash when a giant of a policeman walked in.
Where's the pregnant lady?
At the end of the table, someone pointed.
The girl was a redhead with lily thighs and green flip-flops.
He strode to her and slapped out rubber gloves. Have you broken water miss? She moaned yes. The cop snapped the plastic fingers one-by-one in front of her nose.
The grandmother approached, gently rested a hand on her shoulder, and said, Honey, listen. Breathe in slow Exhale Breathe in
Everybody in the room look the other way and shut up! yelled a wop.
A siren wailed. It's about time for an ambulance! declared White Bred Ed. The paramedic replaced the cop at the groaning redhead s side and pulled out fresh plastic gloves. He snapped them before her unblinking eyes.
She's blind, cautioned the grandmother. They awkwardly pivoted her into a wheelchair. The girl who a week ago led the Kitchen revival fainted.
I swung back at Mark. The door slammed. The siren wailed onto a distant street. I watched him rise to full height, amble out, and almost bump his head at the door. He shyly glanced back over the crowd, and left too.
The cook yelled after him, I told you not to give her any enchiladas!
Article Review by Alex Castaldo
Make no mistake: the purpose of this article was to shoot down the Bush proposals for investing Social Security funds in the stock market, and to preserve the traditional FDR type Social[ist] Security. Nevertheless, leaving aside the partisan aspect, the article is sufficiently well done as to be worth summarizing and discussing. Keep in mind that when this article was written the S&P was approximately 1331.
The Chief Actuary of Social Security has assumed a 7% real return on stocks and a 3% real return on Treasury bonds over the next 75 years. The author argues that the 7% figure is unrealistically high; the main objective of the article is to shoot down the 7%.
The Historical Record
Compound annual real returns, by type of investment, 1802-1998 (in percent) Period Stocks Bonds Bills Gold Inflation 1802-1998 7.0 3.5 2.9 -0.1 1.3 1802-1870 7.0 4.8 5.1 0.2 0.1 1871-1925 6.6 3.7 3.2 -0.8 0.6 1926-1998 7.4 2.2 0.7 0.2 3.1 1946-1998 7.8 1.3 0.6 -0.7 4.2
The stock returns seem fairly stable, so as a starting point a 7% forecast for stocks (based on the full historical record) seems plausible. For Bonds, on the other hand, there seems to have been a steady decline in returns as the US changed from an emerging market to a superpower, so a figure from a more recent period (say 2.2% for the last 75 years) may be more appropriate as a forecast of future returns.
Why the Future May Differ from the Past
The author feels that the 'adjusted dividend yield' is probably 2.5% or at most 3%. For analysis purposes he will investigate four possibilities for adjusted dividends: 2%, 2.5%, 3% and 3.5%.
The author then applies the Gordon Model of equity valuation: k = D1/P0 + g In the steady state, the rate of growth of stock prices, g, must be equal to the rate of growth of real GDP, for which the author will use the Chief Actuary's estimate of 1.5%. Even assuming a 3.5% adjusted dividend rate, the rate of return on stocks k=3.5+1.5 = 5% would fall considerably short of the Chief Actuary's assumed 7%. Thus the Chief Actuary is being inconsistent.
In conclusion: "Either the stock market is overvalued and requires a correction to justify a 7% return thereafter, or it is correctly valued and the long-run return is substantially lower than 7%. (Some combination of the two is also possible)".
Assuming the former case, the author computes the decline in real stock prices that would have to occur over the next 10 years to bring about correct valuation and a 7% expected return forever after:
Required percentage decline in real stock prices over the next 10 years to justify a return of 7, 6.5 and 6 percent thereafter:
Percentage decline to justify a long run return of Adjusted dividend 7% 6.5% 6% yield -------------------------- 2.0 55 51 45 2.5 44 38 31 3.0 33 26 18 3.5 21 13 4Source: Author's calculations. Derived from Gordon formula.
The retirement of the baby boomers has the potential to bring stock prices crashing down, according to some. The author cites two papers that are skeptical of this view. Poterba "does not find a robust relationship between demographic structure and asset returns". "The connection between demography and returns is not simple and direct". [An article googled by Vic attributed to Poterba a forecast of a market crash: two very different readings of Poterba's views!!]. Another paper by Goyal also reaches the same conclusion: "demography is not likely to effect large changes in the long run rate of return".
Of the three main bases for criticizing the Chief Actuary's assumption, by far the most important one is the argument that a constant 7% stock return is not consistent with the valuation of today's market and the projected slow economic growth. The best remedy would be to assume a lower rate for the next 10 years and a return to a 7% rate for the following 65 years.
Today (Nov. 11, 2005) the market is valued about 15% lower in real terms than when this article was written six years ago. This figure is more benign than most of the entries in the author's Table 3 but is still within the limits of that table. Keeping in mind that these are just back of the envelope calculations, the author can pat himself on the back for being not too far from right.
Spirituality and Markets, by Sushil Kedia
Emotional Intelligence, without a debate today, is a pre-requisite for surviving markets. Doing well would need obviously beyond. What is that beyond? Overcoming fear and avoiding greed to put simply, is only the first milestone (though the trickiest one) of behavioural advancement on a road to a successful life in the markets.
Market is the final God, so many say. While, the God of Reflexivity does reveal his belief that markets are incorrect. How does then reflexivity add up? The individual perceiving the market when shifts its frame of reference to include himself in the definition of the market then the combined two self and the market are in unison and NEVER wrong but together in a state of perpetual change. So, it indeed is true then that Self and its God together are the totality if not a good definition of the truth.
One may not endeavour to change markets, but focus on the more achievable objective of changing oneself. Beginning from re-training cognitive skills to re-engineering one s response mechanisms to such cognition what then a life in the markets is other than a spiritual ecstasy?!
If, the training - that markets induce in one whereby one refrains from getting too happy at gains as well as refrains from getting anguished by losses - is not spirituality, then what is it? Which other profession focuses so much on understanding the self and manouvering it right? If one likes to use the word excellence in lieu of spirituality that is fine too, since the purpose of spirituality is to bring out the excellence from within each.
I am not sure, if my passion for markets makes me perceive them as the grand mechanism that induce the most complete and most expansive spiritual evolution of the entire mankind: directly for the involved & indirectly for the others. As a corroboration, I borrow from the Indian Saint Kabir who says, Bhookhe Pet Bhajan na hohi Goapala , which means "with an empty stomach one can t sing paeans of praise for you, oh Lord".
Broadly, the human mind loves to control, enjoy and prove its superiority. Spirituality in all its flavours and origins aims to address these shortcomings of the mind. If the market does humble one down the instant any of these three tendencies erupt in one then ain't it the ultimate spiritual engine that waits for nothing in its pursuit of making its devouts to be the best?
Does it not insist perfectly on making everyone acquire thorough abilities to live harmoniously with its imperfections?
GM Nigel Davies Responds:
One of the major insights I've gained from chess is that errors often appear to stem from a person's character, with technical aspects of someone's game appearing to mould itself around their personality. And with many people I've known it often seems that chess improvement and greater emotional maturity go hand in hand.
Adi Schnytzer Responds:
Whilst I accept the need for Emotional Intelligence when trading, I feel very uncomfortable with the deification of the market. There are more important things out there like life itself and one's family for a start. I prefer to view trading as gambling where information really matter. It is that like betting on sports and horses and unlike betting on the toss of a fair coin. Yes, one must learn not to be greedy (and how exactly might I measure that? 4%, 5%, $50,000, what?), not to get carried away by wins and not to fret over losses. Finally, not to regret inevitable mistakes! But I need spirituality even less here than I need it in interpretations of Wagner's Ring! Why not simply speak to yourself and brainwash yourself with what needs to be known? Simple behaviour modification therapy self-applied? Whether I bury $10,000 betting on a horse or lose it on a stock are the same thing. It's gone. For me, spirituality has to do with things beyond the realm of human and scientific understanding and not such man-made institutions as the market.
A Book Recommendation from Tim Melvin
Fortune's Formula by William Poundstone gets the coveted must-read rating. It's the story of Ed Thorpe and his forays into both the casino and the stock market using higher mathematics. There are gangsters, gamblers, traders, arbitrage, Kelly formulas, Monte Carlos (both casino and computation). It covers his Newport partners and their relationship to Boesky and Milken, the blackjack days. All in all, a well written easy read, fantastic book.
The Amazon page has a few reviews that mention the Kelly Formula, which was originally derived from an engineer's mathematical approach to optimizing data transmission flow over very early telephone lines. I believe that the Formula works by suggesting an optimal amount of equity to risk on each trade, given inputs based on expectation, average win size, and average loss size. The main problem that I see in taking the approach from the casino and into financial markets is that although we can know historic win/loss data for our portfolio, there is no way to know the current expectation of our trades based on immediate market conditions. (Ever-changing cycles?) By contrast, the Casino game expectations are well known and constant.
I am also skeptical given that I have heard of Kelly Formula proponents claim to have winning roulette strategies.
Does anyone have experience working or trading with the Kelly Formula?
Chris Cooper Responds:
I have used Kelly extensively in gambling, and use a more conservative form of it when trading. You are correct about the limitations in applying it to trading, but the real killer is the major penalty you pay if you overestimate your advantage. Even with an advantage, if you bet a higher proportion of your capital than is optimal according to Kelly, you can easily end up losing your stake. I learned this lesson the hard way many years ago -- one of those lessons you tend to remember.
And yes, there are winning (computer-aided) roulette strategies. Ed Thorp was the first that I know of to investigate them, but his success was limited. My senior project at university (30 years ago) was an investigation of the feasibility. When I wrote to Prof. Thorp about what I found, he confirmed that it was similar to what he discovered. Others, such as Doyne Farmer, came later, but probably made more money writing books about the experience than by gambling.
Phil McDonnell Replies:
The purported theme of this best selling investment book is the Kelly formula. This is the so called "Fortune Formula". However readers of the spec list may recall several discussions of the Kelly formula in which we discussed the fact that the formula is designed for two outcome (binomial) games only. In that sense it is arguably appropriate for use as a money management formula in a game such as coin flipping where there are only two outcomes with equal win loss amounts. That is where the Ed Thorpe (Beat The Dealer) connection comes in. Thorpe used the formula as his money management rule for blackjack betting. However even games such as blackjack and roulette have more than two outcomes. So strictly speaking the Kelly formula does not apply even to such simple games but it is pretty close.
However many widely publicized formulas attempt to generalize the Kelly formula for trading purposes and do so in an incorrect manner. In general such formulas usually simplify the Kelly formula by assuming that its binomial nature can be satisfied by using a simple average of the wins and average of the losses to replace the binomial win loss outcomes. In so doing such formulas make the mistake of applying the distributive law to logarithms. It's a simple mathematical mistake which can have disastrous consequences for one's investments.
We should also recall that no money management formula will make us rich by itself. A winning blackjack system or valid market timing system is also required. However it is true that a bad money management system can ruin us all by itself.
The following is excerpted from a post I sent some time ago regarding the maximum trade size which will compound your money at the fastest possible rate. This is a formula which I developed and have presented here several times over the last few years:
Optimal Trade Size
The maximum trade size f as a fraction of net worth is that f which will maximize the sum:
sum[ p(i) * ln( 1 + f * r(i) ) ]
where: r(i) is the return number i (expressed as a fraction and derived from backtesting or theory) p(i) is the probability of that return For counters the inputs to the above formula are relatively easy to obtain. Take each backtesting outcome as r(i) and set each p(i) = 1 / n where n is the number of outcomes in your sample. Then find the f which maximizes the sum.
Note that this f is only optimal in the sense that it maximizes the compounded return if one looks at this as a series of trades. In that sense it should be thought of as 'maximum f'. One should be especially cognizant of the fact that it assumes a utility function which is indifferent to risk.
One simple way to use the above formula is to calculate it as is and then back off from the maximum f. If we graph the above formula it looks like an upside down letter U. The peak of the graph is the point of maximum compounded return, but the graph is relatively flat around the top. So reducing one's f from the maximum will cost little in return but can often greatly reduce the oscillations, risk and drawdowns of trading. Ultimately the decision as to how much to back off is a personal one. If you are more a risk taker back off only a little, if more conservative reduce the f even more.
The above formula is preferred to the Senator's because it takes into account every outcome from backtesting and weights each appropriately by both probability and the natural log which represents that outcome's contribution to long term compounding. Note that the formula gives the largest drawdown the heaviest negative weighting because of how the log function works. It provides a more robust estimate of the compounded return than just using the largest loss. It's a bit like estimating the average size of a basketball team by only looking at the shortest player.
The Kelly formula is often touted as the ultimate scientific money management formula. Unfortunately it is only correct for two outcome games of chance such as coin flipping. For such games the maximum f and the Kelly formula will yield the same result. For multiple outcomes such as trading the Kelly formula is just plain wrong. It can literally lead to ruin as demonstrated by numerous simulations. Traders should avoid.
The max f formula directly deals with the question of how much to trade each time. If you are on a losing streak using a fraction will automatically reduce your trade size as your account size diminishes. If we recall Zeno's paradox - take 1, divide by 2 to get 1/2, then 1/4, 1/8 .... We never quite get to zero. In the same way using a fraction of net worth also avoids ever getting to zero and thus eliminates the gamblers ruin problem. Thus the formula directly deals with the issue of successive losses.
Selected Quotes from Fed transcript From Nov. 1999, by James Sogi
Streaks in Spot Crude Oil Prices, Last 2 years, by Russell Sears
Total Positives Days 271 or 54% Total Negative days 229 or 46% Pos Neg Lasted 1 day 137 136 Lasted 2 days 62 53 Lasted 3 days 35 24 Lasted 4 days 17 8 Lasted 5 days 10 4 Lasted 6 days 4 2 Lasted 7 days 2 2 Lasted 8 days 2 0 Lasted 9 days 2 0 Avg Avg Next Next Day Day Lasted 1 day -0.0855 0.1710 Lasted 2 days 0.0681 0.0374 Lasted 3 days -0.1117 0.3863 Lasted 4 days 0.1000 0.0925 Average increase per day $0.0581 Stdev $1.10
A good trade is to bet against streaks starting. Or negative streaks, but with a standard deviation of 1.10 not statistically significant. Still the lack of negative streaks last 3 year seems suspect. Do I feel a butterfly wing flapping?
Darwinistic Morality, from Dr. Kim Zussman
Darwinistic morality from Nietzsche is implied in this recent paper by Joshua Knobe and Brian Leiter:
In particular, it claims that differences in the degree to which different individuals behave morally can often be traced back to heritable differences between those individuals. We show that this third approach enjoys considerable empirical support - indeed that it is far better supported by the empirical data than are either the Aristotelian or Kantian traditions in moral psychology.
A New Indicator, from Hanny Saad
We devised a new indicator that might be of interest to the list.
While the new indicator will not tell you which way the stockmarket is headed tomorrow, there seems to be a correlation with the 60 day Dow's performance. The new indicator is based on thrift stores lineups and quality of the goods displayed.
The table looks something like this:
Long lineups Long lineups no lineups no lineups Dow'sperdormance 60 days later Low quality High quality low quality high quality
Hint: The long line ups, low quality showed a very high (negative) correlation with the dow 60 days later.
A View From the Old World, by Alexander Privalenkov
"A near object is better seen from the distance," says the Russian proverb. It seems to me that American traders do not see all the considerable changes that happened in their country at the end of the millennium. Nonetheless, those changes greatly influenced world markets, American included. The only American who felt those changes and described them in his book was George Soros (The Crisis of Global Capitalism: Open Society Endangered. )I offer you a different view -- a view of a person who spent almost half a century in the country that was for many decades and unfortunately still is your ideological opponent. The collapse of the USSR in the interpretation that was presented to the world by Gorbachev and that was accepted with great joy by the Reagan and subsequent administrations -- and, as far as I know, by the American business community -- never happened. Read the whole article.Editor's note: We are not experts on Russia and have no idea whether these assertions are true, nor how they might be tested.
Buyouts, by Alston Mabry
A recent NYT article on buyouts suggests that there may be a bubble in the private equity area. Given the numbers they throw around in the article - "the industry has more than $2 trillion in purchasing power" - and other juicy quotes - "in Britain buyout firms own so many companies that they now employ 18 percent of the private sector" - it makes one think it might be an important area of study.
Quotes like this:
"There's no question this is going to end badly for some," said Colin C. Blaydon, a professor at the Tuck School of Management at Dartmouth and the dean emeritus of its Center for Private Equity and Entrepreneurship. "It's almost a classic boom-bust cycle."
make it seem a legitimate issue to an amateur such as myself.
It is hard to quantify the issue though. IT seems that a big enough increase in rates would put a serious damper on the availability of leverage for buyouts, thus affecting stock prices and private-equity-based IPOs.
Antipredator Behavior, by Victor Niederhoffer
The moves of the market are designed by an invisible hand to foster the continued survival of the market itself. If such were not the case, then moves that would lead to its death or grave decline might occur. One example is the disruptive rally that occurred in silver and gold in 1980, after which rules were promulgated that allowed for liquidation only in the silver contracts. Such rules were good enough to stop a squeeze. But they also served to reduce volume and the price of seats by an average of 90% from the pre-rule level, over the next 10 or 15 years.
The unprecedented run of four trading days from November 3 to November 9, where not one close to close move was more than one point in S&P and the total change over the 4 days was exactly unchanged, is not consistent with maintenance of all the feeding relations among the major market groups and niches, as it would lead to a cessation of the frictional trading which is so necessary to provide an offset to the massive fixed costs of maintaining the system.
They play a similar role to the feigning of death that often occurs in the animal world. A good example, covered in books such as Perspectives on Animal Behavior by Judith Goodenough, is the feigning of death by birds such as the killdeer when a predator is spotted. The parent flies away from the nest, dragging its wing, luring the predator away from the nest. Then, as the parent is about to be attacked, it suddenly becomes energized and flies away.
Snakes are excellent at feigning death, secreting death fluids, writhing, and finally rolling belly up with open mouth and tongue wagging, but the classic example is the possum, which secretes death-like fluids, rolls up and wags its tongue. If such death-like displays don't work, many animals have a final escape act involving startling behavior. Insects display many of these behavior patterns when threatened, suddenly showing bold colors, enlarging body parts, secreting vile liquids, and making loud sounds. And we are all familiar with the curling up and erecting of fur of the cat when a dog is ready to attack.
The S&P futures on Thursday showed this startling behavior, with a range of 18 points from a low of 1217 to a high of 1235, and a net change of 10 points, its largest range since similar moves on October 28. The question emerges: do these startling behaviors lead to escape? We cannot answer such a question for the animal species without a controlled study of the kind reported in the literature, e.g. the response of a feral cat to simultaneous presentation of automatized tails (either thrashing or exhausted) and live tailless bodies of two species of lizards . But we can report what happens in the market after a series of very small days followed by a large rise . In a typical study we find a 0.5% average rise a few days later with a batting average considerably higher than the first place baseball teams'. Apparently in the case of the market the startling behavior is on average successful, a success perhaps hastened by the revulsion of the doomsdayists to give up the ghost.
Mike Desaulniers Adds:
In keeping with the animal theme, I might mention Rene ("Le Crocodil") LaCoste's feigning death after being hit by an opponent's passing shot.
The Stock Market Should be Closed Today, by Tim Melvin
That's What Makes a Horse Race, by Leonard Lerer
We derive a modicum of pleasure when the great stumble (and sometimes fall). So the Sage and his acolytes are wrong on the EUR/USD at the moment, but what is the time horizon of their speculation? I am reminded of the exasperated outburst of the CEO of a pharmaceutical giant who shouted at a room full of analysts who seemed not the least bit excited by all the promising facts that he had just shared about his companies future R&D pipeline. A brutal reply came from the back of the room: "That's very interesting, but all we care about is what is going to happen tomorrow."
My view on forex speculation is that for the vast majority of us "little speculators" our time horizon is hours to days. The value of economic data and the vague prognostications of a bevy of experts and analysts lies not in the opinions provided, but how this information can be processed to support a good short-term prediction. Prediction is at the heart of speculation; but it is "that of which we do not speak".
My most valuable current contribution to speculation is a horse racing predictive tool built on qualitative analytics. Feel free to start playing with it (it is not quite completed). This should warm Vic's heart, and make a small contribution to vindicating his view on the interrelationships between financial market speculation and horse racing.
Vital Signs, by Jim Sogi
The patient's objective vital signs seem strong despite malingering tendencies:
GM Nigel Replies:
Are any of these things objectively bullish? I must admit to having been considerably more positive a few weeks ago when the SP was breaking down and the Naz was getting hammered. As Tartakower was wont to say: 'Obvious therefore dubious, dubious therefore playable'.
Audacity, from Don Boudreaux
The Editor, The Christian Science Monitor:
Cartoonist Clay Bennett shows an oil-company executive sitting smugly in front of charts showing that "audacity" and "temerity" are rising along with profits (Nov. 10). Is it audacious to risk billions of dollars annually to explore for oil? Is it temerity to enjoy high profits in some years, knowing that other years will bring losses?
The truly audacious (and greedy) ones are the politicians who demagogue this issue. After all, since 1980 oil companies paid taxes of $2.2 trillion (in 2004 dollars) -- an amount more than three times higher than the profits these companies earned during the same period.
Donald J. Boudreaux
Chairman, Department of Economics
George Mason University
Buyback Study Update, by Tom Downing
Quiddities, by Victor Niederhoffer
By some measures, the last four days in the stock market are among the least volatile in history. Four days in a row without a one-point change occurred just once in the last eight years. The market couldn't function with such small changes because the public would not be induced to lose so much more than they have any right to lose (as Robert Bacon would say) with such stasis. Apparently the predictive properties of similar runs of nothingness are not overly grandiloquent.
A New Meme
This brings up some recent doomsday forecasts. Reading through all the demography papers, I see that the mojo behind them all is that demography is why we're heading for Dow 500 real soon. Almost every agrarian is riding this dismal bandwagon, with the two chronic bears S. & S. from Yale and Wharton leading the hoped-for debacle race. The story is that the proportion of middle-aged in the population is going to decline, and this is bearish because in some models the middle-aged buy stocks whereas the seniors and juniors consume more they earn.
Comparisons and attributions to the Japanese slump and the comparable demographics in Japan and Europe are legion. And the only way to pay for such a shortfall in benefits and entitlements is to raise taxes. But this lowers the incentive to have kids because the after tax cost of having them is so much greater.
Such hoped-for abysmals looking at supply and demand as if they are static flows, without taking into account prices, incentives and the prospective rate of return on holding the existing stock of assets, are behind the grievous errors that flow-of-funds crypto-accountants make when predicting the decline of prosperity in one field or another. Recall the accountant Henry Kaufman with his perpetually bearish fixed income forecasts.
In medicine, the CEA count is a blood test that could save millions of lives annually if performed regularly. Since elevated levels of CEA are only 75% predictive of disease, rather than 100%, insurers won't pay for the test. Individuals won't assume the cost either, because they are induced by our system to lethargy and the belief that others are responsible for their health. Regrettably, this cost-benefit analysis fails to account for the money saved by catching a disease in the early stage.
The foregoing is a preamble to a market study. Are there any tests like the CEA for the market that would tell whether it's in a sick or healthy state? Looking at the plethora of indicators out there -- new highs vs. new lows, advance-decline lines, moving averages, Fibonacci charts, Hursts, parabolics, money flows, oscillators, envelopes and stochastics -- I want to turn myself in at the nearest police station as Willie Sutton did when the Dodgers lost, just to get some peace. Too many of these measures are highly correlated with the market's past movements and don't take account of the moves of other markets.
I propose the following as indicators of market health: the extent of prices slightly below the round vs. those slightly above; the number of other stock markets that are outperforming or underperforming; or some of the other things that the Minister of Non-Predictive Studies likes to look at.
Sayonara to a Bearish Scenario
It was just a month or two ago that the analysts and the media were lionizing the Sage for his bearish dollar scenario based on the twin deficits motif that if you are borrowing constantly then eventually the idiots who hold your unwanted currency through no volition of their own will have a revulsion that will cause asset prices to fall to zero or below. But now that the dollar is at a two-year high, 1 euro = $1.175, the strongest dollar since mid-2003, the Sage is not quite as so lionized. Perhaps his surrogate son will take a good introductory economics course and learn that the current account deficit and long-term account balance are jointly determined by the incentives to hold balances and investments in the respective countries, their prospective growth rates and interest rates, and their comparative advantages in the provision of goods and services. And perhaps he'll be less willing next year in Davos to play "own man" in the game of "Your own man says it's bearish" to the immense cost of his stakeholders and reputation.
The two major reasons for stock market bearishness in the last few months have been the coming swoon of the dollar and the terrible impact of oil prices in the $65 a barrel-and-up range. Now that oil is in the $50s and the dollar in the teens, the chronic bears will have to turn their attention to something else, like demography. The new meme doubtlessly will be the slowing growth of earnings forecasted for next year as compared to such ever-growing assets as the tree and the vine.
Dr. Kim Zussman Responds:
The analogy of a tumor marker to detect occult disease is similar to the use of any set of objective measurements of the body in diagnosis. The analogy is even better in veterinary medicine, where the patient can't tell you he is sick. Taking the temperature of entrants before a horse race might find a febrile animal to bet against.
Early medicine was limited to feeling the forehead or looking in the throat. But temperature alone is not sufficient to diagnose all relevant illness, and medicine progressed to auscultation, blood tests, imaging, and other findings in physical examination. Because of the variability of findings, variations of normal between individuals, and myriad old and new diseases, diagnosis is very difficult. A "good doctor" is one who gets the diagnosis right, as result of objectivity, study, and experience.
In markets most such diagnosis takes the form of post-mortem: Nazzy was sick in '00 but the full extent of the illness awaited the course of the disease. Even more difficult, once effective diagnostics and treatments are found the disease mutates, old treatments don't work, and more patients die than they have a rite to.
We need evolving diagnostics to determine which stocks are sick, and which are healthy, to plan for when inevitable stress visits. In addition to features of stocks, certain stocks and their behaviour under stress might provide clues about the whole herd.
Jim Sogi Responds:
Viruses have the ability to adapt, mutate and change into new ecological niches. Humans are adaptable, and change. Markets and their human participants seem to mutate, adapt, change and manifest in interesting new ways, sometime mutating from one state to another in the middle of one form. Structures or mechanisms branch off, or continue longer than was previously thought to be the norm. The idea of diagnosing the current conditions with some scientific methodology might be a good way to 'diagnose' the market condition and most importantly give a prognosis.
Brief research of the area shows some promising work in this area. Computational prognostic models are increasingly used in medicine to predict the natural course of disease. In recent years several methods and techniques from the fields of artificial intelligence, decision theory and statistics have been introduced into models of the medical management of patients.
Ask The Chairman, a Continuing Series
Dear Dr. Niederhoffer,
I am an aspiring self-taught speculator and I write to learn from you by seeking a list of your top ten books on trading, speculating, investing. Here are my top ten books:
Sincerely, Simon Gordon
Dear Mr. Gordon,
You need many more quantitative books on your list, such as those of Thaler and Goetzmann and Dimson, and you should stop reading qualitative psychology books. Instead read technical books about ecology, behavioral psychology and cognitive biases. Also, read Atlas Shrugged.
Sincerely, Vic Niederhoffer
Justin Humbert Writes:
A bond sales guy just said to me, "you are very Niederhoffer-esque," not knowing that I actually know the Chairman. The impetus for comment was: I bottom-fished some cheap Treasuries. I took it as a compliment.
Accelerated Buybacks, by Prof. Gordon Haave
What is the next big scandal that will tarnish Wall Street? I predict it is "accelerated buybacks."
In a typical stock buyback a company will announce a program of, say, 1 million shares. The company will then proceed over some indeterminate or perhaps publicly stated timeframe to buy back and retire those shares, which improves that value of each remaining share, as reflected in per-share metrics, in the quarters following the retirement of shares.
An accelerated buyback is a transaction where a company buys the entire 1 million shares up front from a broker, who is borrowing the shares that is sells to the company, allowing the company to immediately retire those shares. The broker, short 1 million shares, proceeds to buy them in the marketplace to cover its short position. There's just one problem: The corporation and the broker have a deal whereby the corporation reimburses the broker if it loses any money while buying back the shares in the marketplace, and the broker reimburses the corporation if it gains any extra money in the marketplace.
The economic impact to the corporation is the same as if the corporation conducted a regular share buyback, however, the corporation gets to take the shares off of the books early. For example, let's say on January 1st a corporation announces that it is going to buy back 1 million shares in a regular share repurchase program.. The price of the stock is currently 100. Let's say that by March 31st, the corporation has bought back 500k of those shares at an average price of $90, and that in the second quarter, the corporation buys back the second 500k shares at an average price of $130. So, the buyback costs the firm a total of $110 million. As of March 31st, the corporation's books reflect a reduction of 500k shares outstanding, and on June 30th, they reflect a reduction of 1 million shares outstanding.
In the "accelerated buyback", the firm pays out $100 million up front to the broker, who is then short 1 million shares. The broker buys back, say, 500k in the first quarter at an average price of $90, and in the second quarter, the broker buys back the second 500k at an average price of $130. Now, however, the firm owes the broker a check for $10 million, which is the loss that the broker experienced on covering its short position.
On March 31st the corporation reports all 1 million shares retired. But the company winds up owing more money than the $100 million that the public thinks the buyback cost. There is only one word for this: scam. The corporation on March 31st still has an unknown financial obligation on the remaining 500k shares, yet from the books one would assume that the transaction has been completed.
There are many scenarios where between the time a corporation reports the shares as having been retired, and when the shares are repurchased, something dramatic happens in the stock market, and investors who bought based on per-share metrics are unaware that in fact the economic impact of the share repurchase has not yet hit the company. The entire transaction of the accelerated buyback is designed solely to fool the marketplace.
Just Say No, by Jim Sogi
We should not blame unhappiness, obesity, urban sprawl, prescription-drug addictions or declining morals on "the Market." Each must choose his own priorities of health, family and morals. The Market merely offers temptations. We have the power to decline the extra helping, to run the extra lap and design a life. "Just say no," we tell the teens. Traders have a strong sense of self. We must say no to market propaganda, say no to panic, no to analysts, no to brokers, no to greed, no to fear, no to uncertainty, no to CNN, no to the newspapers, no to fixed systems, no to randomness, no to uncritical thinking, no to the deceptions of the market, no to self-delusion, no to rationalization.. Why, then, is it hard to say no to TV, no to Hollywood immorality, no to excessive consumption, no to anger and no to frustration? Why not be kind to the ones closest to you every minute?
Remembering Oklahoma City, by Russell Sears
Early on a Sunday morning you can often find me in an open-air chapel at the heart of downtown Oklahoma City.
On a typical Sunday in early fall, I lace up my running shoes on the hewn oak pews and do a physical inventory while I stretch at the altar, giving thanks for the glorious chance to run 20 miles (32k) through the largely empty street of a thriving modern metropolis on the city's marathon course.
The chapel is built on the corner of the Methodist lot -- with money from Catholics, Jews and Muslims -- overlooking the memorial to the Oklahoma City bombing.
The swirling red mica dust glitters from the rising sun as the dark wall opens to the numbers "9:01". It's a time burned in every American worker's brain, whether blue collar or white collar.
I think about the spectacularly stupid act as I run through town. A non-productive terrorist conflagration is meant to spread in a chain reaction of workers killing more workers till the social structure collapses. Yet, the only hope of such a chain reaction rests on a political elitist's monopolizing the hate and fear of the workers.
A large and spectacular explosion, but senseless and pale beside the daily conflagrations and explosions caused by the worker a few streets down at the Kerr-McGee headquarters. Explosions that daily propel hundreds of thousands of productive workers home to their loved ones.
The banks and the state's financial center surrounds the site from the north, west and east, looking up at the tall building and down the fast hill.
In the first mile of the marathon course, I also pass the true gladiator arenas of the city: the Ford Center for Basketball, the "Brickyard" for baseball and rodeos, and a huge shopping complex for outdoors sportsmen. Quaint bars owned by country music celebrities are found here, and a river walk. Plenty of opportunity to prove your manliness, or become a legend, hero or immortal.
The course winds through the rich man's and the poor man's neighborhoods, each yard neat and trim; around park after park, community after community. It's clear that the pride of the city is what got residents through that dark time. It seems only natural to skip the solitude of the lake and stay near the people.
The 20-mile run ends two hours later, where I pass the "9:03" wall, and quietly walk up to the "Survivor Tree." This 90-year old tree, an American Elm, was badly scorched by the blast. It seedlings were given to the surviving family and friends of the bombing victims. I struggle to bend and pick up a silvery yellow leaf from the ground. Ah, the eternal beauty created by the fleeting individual lives on.
What Virtue in the Virtual Close? by Victor Niederhoffer
I am always on the lookout for hubris in myself and the fake kind in the Nebraskan and the overt kind in the West Virginian's company that reports today after the close with its famous virtual close that enables them to come up with a report just nine calendar days after the end of a quarter. Today's estimate is not the round 25 cents a share, but 24 cents. However, the company has beaten estimates in the last five quarters that I have ready data on and I would estimate it has done so for the previous eight in a row.
It used to be that when the company reported, the stock went on a tear. For example, the stock rose 24% after the May 7, 2002 report and 8% after the Aug. 6, 2002 report. But day-after performance has suffered since those glory days:
1-day 2-day 1 day 2-day date perf(%) perf(%) Naz(pts) Naz(pts) 11 06 02 -5 - 3 -40 -60 2 04 03 0 0.3 - 6 0 5 06 03 -3 - 4 -13 -34 8 05 03 -6 - 7 - 2 4 11 05 03 5 2 6 -8 2 3 04 -9 -10 -24 -20 5 11 04 -1 - 2 3 -7 8 10 04 -11 -13 -10 -28 11 09 04 -7 - 5 - 4 14 2 08 05 -3 - 4 -21 -23 5 10 05 2 3 7 4 8 09 05 -7 - 8 -12 -13 avg -4 - 4 - 9 -13
The tabulation shows clearly that "virtual closing time" has increased in recent years. Also, a general revulsion appears to have developed toward the reports and/or the verbiage accompanying the reports, especially the putting-in-perspective and anticipations for the future. Let us hope that a similar revulsion does not ensue after the close today.
However, a warning: To see this data, I asked the Minister of Non-Predictive Studies for his good work and data, and he was quite euphoric, even interrupting his tennis game to provide same.
A Former Wrestler Adds:
CSCO was recently down 2% after the company offered disappointing earnings guidance following a relatively upbeat first quarter that included a 10% revenue gain. After slipping 11 cents in regular trading Wednesday, it was down another 35 cents to $17.40 on Instinet.
Ethics on Wall Street, by Prof. Gordon Haave
Unethical practices on Wall Street exist because of what I call "ethical discrimination" and the fact that unethical behavior has negative externalities, thus resulting in its overproduction.
Theory dictates that financial markets should for the most part be ethical as most transactions of are a recurring nature and thus each party has an incentive to behave ethically lest one party finds that it is unable to conduct transactions in the future and therefore unable to stay in business. Those of us familiar with the ways of Wall Street know, however, that ethics is often in short supply, particularly when it comes to dealing with the investing public.
What explains this failure of ethics in the financial markets?
The recurring scandals on Wall Street are the result of "ethics discrimination" (defined later) and the fact that with regards to retail investors, Wall Street's reputation is largely a public good.
As an after-hours economics professor, I always look at the world from a price-discrimination viewpoint. Price discrimination is the desire by a company to capture all of the consumer surplus in a market by charging each consumer exactly the amount the consumer is willing to pay for a good. This is a difficult thing to do. Walmart doesn't know how much each individual is willing to pay for a snow-shovel, and thus charges the same price to all customers regardless of how much each is willing to pay. If I were willing to pay $10 for a snow-shovel, and paid only $7, then $3 of consumer surplus was generated by my buying the snow-shovel, and Walmart missed out on an opportunity to charge me $10.
There are some products, however, where consumers and their preferences can be differentiated and thus charged different prices. The best example of this is airline fares. Business travelers are willing to pay more than leisure travelers. Airlines bifurcate the two groups by reserving the lowest fares for those who are willing to stay a Saturday night (leisure travelers) and charge more to those who are not willing to stay a Saturday night (business travelers).
I theorize that firms not only seek to capture surplus through price discrimination, but also through ethics discrimination. That is, firms seek to behave just as unethically as each of their consumers is willing to tolerate. For example, a broker who calls a money manager will state that he has 10,000 shares of company XYZ for sale, while the money manager knows perfectly well that there is another 100,000 shares coming behind it. Meanwhile, a retail broker working for that same firm might call a retail customer and give him a cock and bull story about how that same stock is a "sure thing" and guaranteed to go up next week. In each case, the firm sizes up how much unethical behavior it can get away with with each consumer, and pushes the behavior to that limit.
All this can be viewed within the framework of price discrimination, i.e. unethical behavior is just another way of exacting a more favorable price, but I prefer to look at them separately for illustrative purposes. For, just as airlines don't have a single specific pricing policy, firms have different ethics policies for different customers. They might not state that, but in reality there is no question that a large brokerage firm such as Merrill Lynch will treat its institutional clients more ethically than it does its retail clients. The only explanation of that is ethics discrimination.
So knowing that the Street is going to size up its customers by their willingness to withstand unethical behavior, it is logical to assume that it is going to act on that knowledge. The problem with this theory is that sizing up the degree to which someone is willing to tolerate unethical behavior is difficult. It is worthwhile, however, for any given Wall Street firm to push the limits, because Wall Street's reputation is largely a public good, and unethical behavior has significant negative externalities.
The full price of unethical behavior towards retail clients, when exposed, is borne not just by the person or firm that behaved unethically, but also by the Street as a whole. Corporations and institutions have to be fully engaged in the financial markets. If they encounter unethical behavior by, say, Morgan Stanley, they can easily shift their business to Goldman Sachs. However, they will not pull their business from Wall Street entirely. The price of defrauding individuals, however, is borne to a great degree by Wall Street as a whole, as individuals that are defrauded largely become distrustful of Wall Street and are likely to pull their money from the Street entirely, or at least shift their business to the lowest cost provider. Basic economics suggests that goods with negative externalities are over-produced, and such, I believe is the case with unethical behavior. Wall Street's reputation is also a public good, that is enjoyed by the Street as a whole. It is rational for the players behaving unethically to take advantage of what little of that reputation exists before their competitors do.
Billions and Billions, from George Zachar
Old-timers remember Johnny Carson's mocking Carl Sagan's use of cosmos-sized figures, intoning "billions and billions" over and over. Now, from a newsletter:
Billions To Pour Into UBS Hedge Unit: UBS appears to have a one-track mind filled with lots of zeros. First came the news yesterday that the investment bank was filling a bonus pool with $1 billion to help attract and retain the hedge fund talent at Dillon Read Capital Management. The whole division was created to keep talent at UBS, and though the bank would not confirm it, a source told FN that it could be sending up to $10 billion to get CEO John Costas started when the Dillon opens its doors by mid-2006.
Adaptation, by GM Nigel Davies
It's not easy to pick the most important things Kasparov says, but these are two of the most significant sentences he has uttered. And this is not just important for chess players:
Topalov is better adapted to modern chess that requires constant work with computers, precision in all areas, incessant self-perfection. He seized the spirit of the time, whereas Anand and Leko did not quite catch it.
Strategy, by Jim Sogi
The Dalai Lama is said to have compassion. He says others feel the same as you. The Shadow knew what evil lurks in the heart of men. These are two sides of the same coin. Approached from strategy rather than ethics, to understand the weakness of others, you must see and know your own weaknesses. How few people can do this! Unless your own weaknesses are known, you are vulnerable. If you don't know your weaknesses, you don't know your strengths either nor how to best go in for the kill. With self-knowledge, you can anticipate others' reactions, their weaknesses and your own, and plan and act accordingly. This is the essence of strategy in the markets, war, business and combat.
What Shui Kage Loves to Search For
Long downtrend followed by a long flat, no price change move. 44% gain in the past 1.5 months for the longs I've initiated based on this pattern.
Valuing the Madison Avenue Bus Commute, by George Zachar
Dept of Trees & Markets: Dutch Elm Disease Among Retailers, by Russell Sears
Chains and franchises retail with admirable efficiency, but their vulnerability to weak links curbs my enthusiasm.
Consider the American Elm. There are two basic vascular strategies for tree structures: diffuse-porous and ring-porous. The vessels of ring-porous trees like elms are more efficient, but are more likely to become clogged. Dutch elm disease suffocates the trees by clogging low cells so that water cannot flow up from the roots to the leaves. (Leaves use water to dissolve minerals.) Moreover, because Dutch elm disease spreads through roots, it can destroy a whole grove at once.
This strikes me as being true of chains and franchises. Yes, they are efficient in branding a reputation and building a clientele. A good chain repeats its formula, ring after ring. The formula is noticed by customers as "the (insert chain) Way" of doing business. A good chain's philosophy permeates everything it does.
However, the chain's hard-earned reputation is vulnerable to the weakest link. Its reputation is often only as strong as its worst stores or products. A quality decline at the lower levels can be disastrous. It can kill individual stores, but it also spreads amongst the grove.
A "decline in quality" may be hard to "count." But I would suggest that when it's obvious to a client or an investor, it is time to get out. This has worked for me, a person inclined to optimistically stay in with my few "winners" too long, enough times that it clearly not random.
Dept. of Ever-Changing Cycles: What Peter Sellers Taught Us, from J. P. Highland
This is a dialogue from Peter Seller's "Being There." It helped me to understand the concept of ever-changing cycles.
President "Bobby": Mr. Gardner, do you agree with Ben,
or do you think that we can stimulate growth through
Chance the Gardener: As long as the roots are not severed, all is well. And all will be well in the garden.
President "Bobby": In the garden.
Chance the Gardener: Yes. In the garden, growth has it seasons. First comes spring and summer, but then we have fall and winter. And then we get spring and summer again.
President "Bobby": Spring and summer.
Chance the Gardener: Yes.
President "Bobby": Then fall and winter.
Chance the Gardener: Yes.
Benjamin Rand: I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature, but we're upset by the seasons of our economy.
Chance the Gardener: Yes! There will be growth in the spring!
Benjamin Rand: Hmm!
Chance the Gardener: Hmm!
President "Bobby": Hmm. Well, Mr. Gardner, I must admit that is one of the most refreshing and optimistic statements I've heard in a very, very long time.
Benjamin Rand applauds
President "Bobby": I admire your good, solid sense. That's precisely what we lack on Capitol Hill.
Demographics and the Stock Market, by Victor Niederhoffer
It's exciting to see an effort to take a grand macroscopic look at the effect of an important variable like demographics on individual stock market returns. Professor Stefano DellaVigna of Berkeley makes such an effort in his paper Attention, Demographics, and the Stock Market. His startling conclusion is that portfolios with good demographics outperform those with poor demographics by about 8% a year for the 30 years ending in 2003. The key, according to DellaVigna, is that investors pay too much attention to short term trends in age factors in the 1- 5 year horizon but not enough to predictable changes in the age distribution in the 5- 10 year horizon.
But there are so many hurdles to leap over with such a grand motif that the author's conclusion that predicted age structure can lead to systematic outperformance seems highly tenuous. Some of these hurdles:
One of the key links of the paper is an attempt to show that the profitability of certain industries will be affected by the changing age distribution of the population. Among the affected industries:
The next step is to estimate the concentration ratio in each industry to come up with a theoretical sieve as to which industries would be expected to maintain high profitability. Another step is to calculate the time horizon that investors might react to the predicted changes in age structure. Finally, the companies' exposure to each of these variables is estimated using Compustat and SIC date. Each one of these steps requires a tremendous amount of data mining and retrospection, and implicitly contains the end result of a myriad of hurdles that would have led to negative results thrown out and good paths followed.
The paper cries out for an out-of-sample test, with the companies that are supposed to be helped or harmed clearly spelled out so the reader can make his own verifications, refutations and extensions. Failing that, since most academics have a certain reluctance to give away the skinny, a series of out-of-sample tests, perhaps starting at year-end 1999, using only contemporaneously-available data, would be most educational. A study that is statistically significant with past data is not necessarily likely to be predictive for the future. Indeed, the opposite is true.
The author believes his results show that "forecastable future demand changes (in the 5- 10 year horizon) due to demographic variables predict abnormal annual stock returns." I conclude that by overreaching and artful misuse of seemingly rigorous statistical procedures, that this paper belongs in the bailiwick of the Minister of Non-Predictive Studies. However, Professor DellaVigna is to be complimented for focusing attention on a key variable to consider with respect to the analysis of individual companies.
Dr. Kim Zussman Adds:
Adding to the frustration is how obvious such trends look in retrospect:
The harder questions are about what's coming:
Jason Ruspini Responds:
Demographics might also have an effect on rates. All things being equal, it seems that if both total population and the ratio population ex-retirees,children and the unemployed / total population are growing, the supply of credit should also grow.
Technology almost always has an effect on time, either by making things take less time (e.g. travel, communication, manufacturing processes), or in the case of medical technology, simply giving us more time. If legislation caused the average retirement age to suddenly jump higher, I wonder if that would have a material effect on rates. Numerous other factors should drown it out, thus my cheapish "all things being equal."
My Name Is Jim and I Am a Surf Addict, by Jim Sogi
Ben Franklin: America's Original Entrepreneur, by Ryan Carlson
As Ben Franklin is an inspiration for many of us, I think others might learn from and enjoy a recently published adaptation of his autobiography. The 250 page book is divided into 82 chapters and makes for easy reading with light commentary to help guide the reader. I'm one of many who've picked up the original autobiography but struggled with the 18th century language, so it's a treat to be able to breeze through this modern adaptation.
Laurence Glazier: Royalties Claimable, but by Whom ?
Recently Sky TV has been plugging a sci-fi show to start in a week, called Threshold. The visual basis of the trailer is especially interesting for me, being my all time favorite crop formation that I was one of the first people to enter. This particular pattern has become iconic over the years, reproduced countless times - presumably those budgeting this soap are confident the artist/s will not come forth to claim royalties. I wonder how much money it would amount to.
When this landscape art is depicted in movies, it is usually associated with aliens of doubtful character, and I guess the same is likely with Threshold, but I shall certainly watch episode one, and wonder if there will be any attribution or mention in the credits to the original design from 1996.
Decline and Fall, by Pitt Maner
Are the events in France an indication of the failure of socialism in general?
Can you continue to encourage immigration without integration in a system that relies on heavy taxation of productive workers? The socialist governments offer free education, generous sick and maternity leaves, long vacations, free medicine and so on, but how is the bill to be paid?
In Sweden there are cracks in the social welfare system and they are being manifested by cases of surprisingly poor eldercare. But with elections approaching, the party in power turns up the "promise" palaver and raises the fears of losing "your benefits" -- where have we heard this before? My goodness, how can we live without government support? Government as addiction. Socialism creating a passive and accepting flock.
The controversial Oriana Fallaci has upset many with her visions of "Eurabia", a title used by Bat Ye'or. And there are political extremists standing in the wings (e.g. Le Pen) to stir the pot. And France was worried about EuroDisney -- how absurd!
Change is coming. Choices must be made. To whose benefit, whose detriment?
Mr. E. Adds:
In France they're letting it go on and on and on. This is exactly the wrong thing to do. You can't condone this kind of systematic planned violence without irreversible damage being done.
Leaves and Prices, by Victor Niederhoffer
The shape of leaves is determined by many interrelated variables, including the relative effects of evaporation, transpiration, convection and photosynthesis, and the position of the leaf in the edge and the height on the canopy. A general principle is that the greater the amount of rain, the larger the leaf; and the warmer the temperature, the smoother the leaf. Paleontologists use these two classifications to date fossils according to contemporary climate.
A similar classification seems to determine the shape of prices in individual stocks during the year. The extent of teeth and the closely related variables of lobes correspond to my favorite variable: the ratio of absolute deviation to total algebraic change. The leaf size corresponds to total magnitude of the price move.
I have taken preliminary steps to quantify these variables, as their relation would seem to be the underlying dynamic of Value Line's "Technical Analysis" ranking system, said by esteemed forecaster Sam Eisenstadt to perform at least as well as the "Timeliness" ranking.
All these hypotheses on the shapes of leaves and the shapes of prices during the year have to be tested and predictive relations ascertained. We will be working on this at my shop, and I hope the Minister of Non-Predictive Studies will not have the last say.
No Pain, No Gain, by George Zachar
This is the pain trade. it's FMNA 30 year 5% mortgages against swaps. According to data I saw this morning, there's a ton of these "new production" puppies that are not prepaying, which is to say they were bought as 3.5 year pieces of paper and are now 5.5 years long and still extending, requiring selling more swaps at increasingly disadvantageous spreads. I can only imagine the vigor with which Mr. E. would pile into this kind of trade, forcing the Street even longer the dreck and shorter their stubbornly firm hedge.
Scholarly Review by Alex Castaldo
Hsu & Kuan: "Reexamining the Profitability of Technical Analysis with Data Snooping Checks," Journal of Financial Econometrics, 2005, Vol 3 #4, p 606-628.
The authors considered a universe of 39,832 trading rules applied to four stock indexes (DJIA, S&P 500, Nasdaq Comp, and Russell 2000) for the period 1990-2003.
Among the rules tested are 497 Alexander Filter Rules, 2049 Moving Average rules (using moving average periods of 2,5,10, ..., 250 days in both Simple and Double MA (crossover) formulae, with or without a protection band), 1220 support/resistance rules, 2040 channel breakout rules, and others. The full list is on page 611, but you get the idea. Some rules only use prices and some use volume as well.
With so many rules it is guaranteed that something will appear to work. The authors are aware of this problem and apply Hal White's methodology to compute a significance level that takes the multiple comparisons into account.
Briefly, White's method (the so called "reality check") is a Monte Carlo simulation method. The trading rules are applied both to the real price data and to 1000 artificial data series generated ("bootstrapped") from random reshuffling of the data. The performance of the best trading rule on the real data is compared to the bootstrapped distribution of best rule performance. For example if the best trading rule on real data outperforms 950 out of 1000 artificial runs we could conclude that "it works" at the 5% level.
Because White's method has been criticized by Hansen, they also apply Hansen's proposed method, SPA as an alternative. The difference between the two methods' results are fairly small.
The results of White's method are as follows:
Prob. DJIA 0.39 S&P500 0.22 NazComp <0.01 R2000 <0.01
The trading rules do not work for DJIA and S&P 500 but do work for Nasdaq Comp and Russell 2000. The authors attribute this to the fact that the latter two are "relatively young markets," whatever that means (!!).
The best rule is a simple two-day moving average with (for Naz) or without (for Russell) an 0.1% guard band. This produces annual returns of 38.2% for Naz Comp and 47.0% for the Russell 2000.
My conclusion: The paper is not outstanding from an academic or practical point of view.
From an academic point of view it is not very original; the key idea is lifted from White. It is also, in some ways, a remake of the Brock, Lakonishok and LeBaron paper of 1992 but with more recent data and more trading rules. On the plus side the authors did do an impressive amount of programming and calculation.
From a practical point of view: The equity curve for Naz shows that the rule worked terrifically from 1990 to 1999, after which it fluctuated erratically and then started to decline (after transactions costs). For Russell the returns were spectacular from 1997 to 2000, a peak was reached in 2001 and again the curve headed down. "It used to work" may be the best conclusion.
Prof. Pennington Remarks:
The rule that worked for the Nasdaq composite and Russell 2000 is based on very short term momentum. Ask any mutual fund timer and he'll tell you that what they're seeing is stale pricing. Stocks go up, but many components of the Russell 2000 don't even trade, and so they don't appear to go up until the next day, or maybe even a few days later. And isn't it interesting that the rules only work for the Russell 2000 and the Nasdaq Composite!
Jim Sogi Adds:
Same problem for the IWM/FVL "arbitrage". Testing seems to show an edge, but it's an artifact. The FVL bid-ask is so big you can't trade it. The purported edge is less than the vig. The difference between academic theory and real world.
Philip J. McDonnell Updates Hsu-Kuan:
Updating the Hsu & Kuan study with a tradeable Russell 2000 fund shows poor results. For the IWM fund a long only 2 day moving average crossover strategy showed the following results for one day look ahead periods compared to all days:
Avg --- Std Dev ---- % Right ---| All Avg --- Std Dev --- % Right -.00592 .98794 51.79856 | .04123 1.09069 53.60000
The average daily return is negative as compared to the +.04% return for the buy and hold. The probability of being right tomorrow for the moving average strategy is an inferior 51.8% contrasted with 53.6% for simple buy and hold. The study period consisted of the most recent 500 available days. The long only strategy was in the market 278 days of the 500. Trading costs were ignored and would only have served to further reduce the performance of the more active 2-day MA strategy.
The Trend is My Friend, by Shui Kage
When I was a busker selling audio tapes, I noticed that people are often convinced by the actions of others. Of course there were some who made buying decisions by themselves, but there were moments that mass psychology clearly overtook micro psychology.
Since I wanted to maximize my sales with the fewest minutes of work I had to focus on the mass behavior. I could change my talking style to suit the individual audience to sell the products, but best was to work when the majority was in a buying mode.
I suppose people in the financial markets behave pretty much the same way, which creates price trends in the markets and trend lines in the charts. I am quite an individualist and often like to question what the majority believes. As result I often went against the trend in the past, and sometimes got hurt. The lesson: it pays to watch the trend.
Should the past record indicate the future course? Maybe a bit, but prices are decided by market participants, so focus on the participants. Maybe it's time for me to revisit busking in London's Covent Garden, for its reminder of mass psychology and how it can affect my market performance.
Retail Magic: Expendable Products, Reproducible Concepts, by Victor Niederhoffer
A major qualitative regulatory that I discovered in the course of my extensive experience in operating businesses is that the best and most profitable businesses sell expendable products like razor blades, ink cartridges, welding rods, drill bits and inks. It would be interesting to develop an investment screen that classifies companies according to the extent of repeat business that they gain relative to their initial sales.
A second regularity recently hit home as my significant others made inordinate profits many times my own with their holdings of Whole Foods. In their initial phases of expansion, retail businesses have the ability to replicate their success by copying the initial success, much like an epidemic is propagated or evolution proceeds. The information cost of replication is relatively low relative to other costs for building a business. In the case of a good retailing concept like Starbucks or Krispy Kreme or McDonalds, or a hundred others that my friend the master retail investor Larry Leeds holds, the stock benefits not only from expansion into regional areas and niches but also patrons of the stores who become investors, as is the case in my family.
Larry is always partial to New Age concepts like Chico's and the Guitar Center that are ready to go rapidly from ten stores to a thousand. In addition to his success with his hedge fund and his research firm, he carries one other distinction with me. He's the youngest-hearted person above 60 I've ever met, and it's likely he's playing tennis at least twice each weekend day.
Dan Grossman comments:
May I suggest an addition to Victor's analysis of successful retail chains: the advantage of low cost of capital. Initially hot, successful retailers go public at and continue to sell at high multiples. Opening additional retail stores is very capital intensive. I suspect that availability of capital at very low cost (i.e., from high multiple stock) gives a significant continuing advantage over competitors who must borrow or otherwise raise capital at normal prices.
Charles Kin comments:
Am I the only one quibbling with the definition of the cost of equity capital? The standard definition employed in the Capital Asset Pricing Model is a function only of beta, expected return, and the risk-free rate. Ought there to be a term to take into account the current share price that is not contingent on a change in expected return?
For instance, a company that announces a large secondary offering might see its shares decline by a particular percentage, but if that firm's beta does not change, and the expected return remains constant (for simplicity sake) then the CAPM-derived cost of equity isn't altered, despite the fact that the new shares will be issued at a lower price. This was the case for a large secondary offering of AT&T shares in August 2002, in which the stock fell by 30% or so between the announcement of the secondary and its closing, yet the hypothetical cost of capital remained little changed.
Ibbotson Associates is apparently coming to grips with the need to refine the cost of capital methodologies. The firm has published some calculations that take into account small-company outperformance tendencies and a time series multiple regression model that incorporates a firm's monthly excess share price returns over T-Bills.
I recall when I first entered the semiconductor sales business in a territory where the competition was stronger than my own firm (though looking back I didn't know it), I would lose orders at the buyers' desk. For about six months I struggled with it; the buyers were in the grips of a strong personality, relationships that preceded my arrival. I solved the problem by moving the game; I went to engineering, where I spent my annual entertainment budget on the engineers who designed the products into their own products, and essentially left the buyers alone. Within a year, as all these new designs hit production, I was taking over the trade, because I knew well enough to use companies. The competition could only second-source. In the process, I made a lot of friends in engineering departments. Those friendships lasted and produced continuing success. The competition eventually folded. From strength to weakness, the path is always the same. Open the door less traveled, because in all organizations, jealousy and decision-making are channels divided. Seek the path of least resistance, no matter the odds. Power corrupts, and those who wield it frivolously are always vulnerable, despite their seeming security by way of current popularity.
Speaking of History, by Dr. Kim Zussman
In "History and the Equity Risk Premium," a working paper he co-authored with Roger Ibbotson, Yale professor William Goetzmann includes data on US stocks back to the late 1700s. He finds that though equity has relatively consistently out-performed risk-free assets (whatever those are), there still looms the all-important question of whether stand-out US experience is unusual and could have been anticipated ex-ante.
I wonder how Ayn Rand would have answered that question.
Listening to the Lord, by Pitt Maner
Listening to John Browne of BP, I might be tempted to go ahead and buy one of those Hummers after all.
Given that in the past there has usually been an unquantifiable amount of "cheating" (oil production over target quotas) by certain OPEC member states and that the Saudis have expressed interest in keeping a sustainable, less volatile price of oil (say $40 to $45 per bbl range), Lord Browne's prediction could be quite accurate. Sometimes overreaction to news of lower oil prices leads to nice buying opportunities in the drill bit sector--drillers and oil service stocks and natural gas stocks. Of course one must be very wary of true boom/bust cycles in this sector.
Mr. Buffet likes the idea of waking up in the morning to the thought of all the millions of shavers using Gillette products but how about all those ceramic proppants used for hydrofracturing hydrocarbon-bearing strata to go with your Rice Crispies. Unusual "tools" made by small number of companies with monopolistic overtones and high barriers to entry.
Jaime Klein Comments:
Proppants would be difficult to monopolize. Ordinary sand as well as engineered sand works quite well as proppant, and there are dozens of different silica, ceramic, plastic, resin coated etc. products.
Before Rockefeller oil oscillated between boom and bust cycles. He was the first to stabilize the market, using his control of transportation to impose order. Current disequilibrium between production and demand means that times are mature for a new re-organization of the industry. Who is going to be the Rockefeller of the 21st century? Who controls transportation?
Pitt Maner Responds:
You are correct that these are common products. Reminds me of a geology professor, however, who once said he would rather own a sand mine with optical-grade silica than a gold mine. So sometimes we overlook value in the commonplace. Certainly without prolific aquifers and an abundant water supply we would not have experienced the growth of the past 30 years here in South Florida.
At any rate the fact is that CarboCeramics has managed to grab about 50% of the global market for ceramic proppants. It appears to be an example of a company that has separated itself from competitors through its ability to make large quantities of and deliver in a timely fashion (transport) a quality product that is in high demand. And then further combine it with specialized know-how to enhance the recovery of hydrocarbons and add value for the client. They claim that not all proppants are equal in ability and suggest that there is a method to using them to full advantage. So it is the principle of taking something common and distinguishing it that is intriguing.
The fact that they are developing plants in Russia and China and are looking to get into the shallow well market also is very interesting--certainly an aggressive capture of market share and perhaps one indicator of where things are headed in the oil biz. Drill bits, drill pipe, drilling mud--how boring, how necessary.
Of course everything is positive in the projections. Please regard as an example not a stock selection,
Reality Check: TA, by Jeff Sasmor
I recently found an old book by the Senator entitled "The Secret of Selecting Stocks for Immediate And Substantial Gains", Copyright 1986 (this is a second edition, it appears to have been written about 15 years earlier, I guess 1970-71).
The first few pages of the book debunk a lot of charting assumptions; and specifically about moving averages:
"...promoters of the moving average methods selected stocks for which their system worked best in the past. They did not bother to show stocks the method did not work on. ... What they did do was find a stock or two that had a big up move and a big down move. The moving averages were placed on this trend and captured a large part of both moves. "
"Using the 100 day average with no filter produced a 57% loss of capital. Using a 200 day moving average produced a drop of 34% in starting capital." The period in the study he quoted was 1960-66.
So folks were saying that the moving average trading system was dumb back in prehistoric times; you know, when Fred Flintstone was foot-pedaling his rock-treaded auto around the town of Bedrock (and having a yabba-dabba-doo time of it, I might add).
Why do people believe, to this day, that future performance has anything to do with moving averages? I can see denoting the current price as above or below a moving average (a digital filter of price) as an interesting data point in an overall picture, but not much else.
Perhaps it's because the concept is simple; perhaps because people believe that history repeats itself. Perhaps it's because media outlets will always say things like, "IBM is way above its 200-day moving average." Or because of the "find the chart that proves the concept" scheme which Larry alludes to, in what I assume is one of his earliest books.
The other thing that comes to mind is that so many people thinks it works creates a self-fulfilling prophecy, at least sometimes.
I don't grok the fullness; I am only an egg.
Dr. Kim Zussman responds:
Paper by Hansen uses fancy stats* to control for data-snooping, and finds significant calendar anomalies in US and international markets (though now extinct):
This paper finds calendar effects to be statistically significant in almost all of the 25 stock indices from the ten countries we study. Some of the strongest evidence we have is for calendar effects small- and mid-cap indices. End-of-the-year, week-of-the-month-of-the-year, and week-day-of-the-month effects stand out as being responsible for the largest (in absolute value) anomalies. The Monday effect drives abnormally negative returns on the Dow-Jones Industrial Average on 106 years of daily returns, but not on the standardized returns of this index or on any other index we consider. A subsample analysis shows that the significance of calendar effects is not an economically important phenomenon because in many cases the last instance of significant calendar effects occurred in the late 1980s and early 1990s. Subsequent to this period, we find no evidence of significant calendar effects in any of 25 stock return (or standardized return) indices. This suggests there is an element of time variation in calendar effects that is not consistent with systematic seasonal variation in stock returns. An interesting task for future research is to examine the connection between measured calendar effects and conditional time-variation in the second moment of returns associated with Garch-in-mean return generating functions.
*A simpler kind of math is the correlation between the number of sophistocated statistical studies of markets "read" and one's asymptotic affinity for indexing. Or as Robert Young used to say, "I'm not a doctor but I play one on television".
Dr. Alex Castaldo comments:
"Moving average: they'll have used a retrospectively profitable number of days." Yes, absolutely. The usual trick.
But the reason Dr. Zussman brings this paper to our attention is that it contains an interesting methodological advance. They use a statistical procedure (the "White Reality Check" invented a few years ago by Halbert White) to attempt to adjust for the fact that a great number of parameter combinations have been tried; is the result statistically significant even after taking this optimization into account? That is what they claim to be doing.
I would not not want to underestimate Prof. Hal White. Not only is he a leading econometrics professor, but he trades futures for his own account using statistical methodologies. This is someone we should respect and try to learn from.
His reality check paper is a very difficult one, unfortunately.
As usual I am somewhat indignant that Dr. Zussman has brought to my attention a paper that I didn't know about (even though it is my job to look for such things) and that I haven't had time to look at carefully. But now that I realize the significance of this find, I'll try to read it carefully and report on it.
The Grandmaster Reveals: Why I Like Crazy Folks
What I don't like about the title Extraordinary Popular Delusions and the Madness of Crowds is the implication that contrarian individuals might therefore be right. I must admit to having seen some deluded crowds in my time, but usually they're quite sensible compared to the completely crazy individuals one finds on the planet.
If it's down to a choice, I'll pick the crazy individuals any day of the week. Why? Because they'll be so busy fighting amongst themselves that they won't gang up against you. Which I guess is why I like chess players and traders.
James Fee Comments:
I concur with the Grandmaster that there is something inherently sensible about those who refuse to join the crowd. Even those excluded from the crowd, the Outsiders, are appealing, aren't they?
Crowd behavior may seem innocuous on a Saturday afternoon watching a
local college football game but the steady state of the crowd can be
easily tipped, becoming a mob. Predicting that nonlinear
event, the Attractor (Chaos
Crowds and Power, by Elias Canetti, won him the Nobel Prize for Literature (it couldn't have been for any of his other books!). In it he describes with great accuracy the phenomenon of individuals' giving up their own rational determination as they join in the crowd. His thesis is that individuals give up fear to join the crowd. And that is where madness may lie. An excerpt from Canetti:
The Attributes of the Crowd
Before I try to undertake a classification of crowds it may be useful to summarize briefly their main attributes. The following four traits are important:
- The crowd always wants to grow. There are no natural boundaries to its growth. Where such boundaries have been artificially created - e.g. in all institutions which are used for the preservation of closed crowds - an eruption of the crowd is always possible and will, in fact, happen from time to time. There are no institutions which can be absolutely relied on to prevent the growth of the crowd once and for all.
- Within the crowd there is equality. This is absolute and indisputable and never questioned by the crowd itself. It is of fundamental importance and one might even define a crowd as a state of absolute equality. A head is a head, an arm is an arm, and differences between individual heads and arms are irrelevant. It is for the sake of this equality that people become a crowd and they tend to overlook anything which might detract from it. All demands for justice and all theories of equality ultimately derive their energy from the actual experience of equality familiar to anyone who has been part of a crowd.
- The crowd loves density. It can never feel too dense. Nothing must stand between its parts or divide them; everything must be the crowd itself. The feeling of density is strongest in the moment of discharge [Ed: This is the moment when, in Canetti's theory, a crowd actually coheres into a crowd. Once there was nothing, now there is a crowd. "Discharge" is the moment when that happens.] One day it may be possible to determine this density more accurately and even to measure it.
- The crowd needs a direction. It is in movement and it moves towards a goal. The direction, which is common to all its members, strengthens the feeling of equality. A goal outside the individual members and common to all of them drives underground all the private differing goals which are fatal to the crowd as such. Direction is essential for the continuing existence of the crowd. Its constant fear of disintegration means that it will accept any goal. A crowd exists so long as it has an unattained goal.
A Strange and Sensitive Situation, by Victor Niederhoffer
It is curious that one such as I, who has written extensively on the dangers, nay, the disastrous consequences, of grinding for the speculator, should be associated with one of the chief instruments for same: the Fund of Funds. The grinding of the FoF comes in many ways. They pay fees to the winners but don't get an offset from the losers. They often have positions going both ways, and thus are implicitly exposed to double bid-ask spreads, commissions, and slippage costs.
The idée fixe of the FoF is that there are tradeoffs between risk and return, and that by sacrificing a bit of return in exchange for reduced risk, the customers are better off. Part and parcel of this idea is that the FoF will invest in funds that have a higher base return than random selection, and that judicious selection by the FoF will give the investor a better net risk reward structure than a mixture of stocks and Treasury bills. Another advantage is that the FoF acts to certify the propriety, consistency, stability, honesty and integrity of the managers it selects, a function which the investor would not be equipped to perform. They must be doing something right because FoFs apparently account for some 60% of the capital invested in the $1 trillion and growing hedge fund field.
The sensitivity of this subject for me is that I am a fund manager. Many of my investors come to me directly or indirectly through FoFs. Who could blame these customers, with my record of blowing up in 1997 and the inordinate variations that my critics far and wide love to point to as why an investor must have ample diversification to even meet with me, let alone invest. As my friends and associates can guess, I exacerbate this situation by telling investors that they are absolutely right to question a million times when the next great negative variation associated with me will occur.
As if all these sensitivities weren't enough, many of my best friends and relatives are in similar situations, managing funds that have similar customers, although to their credit they do not have to overcome such a disaster as I suffered in 1997. This sensitivity is time-sensitive because I am speaking at a conference of similarly situated purveyors and customers in Europe in two weeks. To create a peaceable atmosphere in such a situation, I will be giving a musical talk, accompanied by the Collab playing the harmonious Blue Danube Waltz (in a transcription of supreme difficulty and beauty by Schulz-Evler) to soothe the savage emotions that might be lurking in an audience confronted by someone such as I.
It turns out that a certain firm has been offering an investable managed futures index* (investable in the sense that the funds that constitute the index are still open to new investors ). The index consists of the combined returns achieved by 14 selected funds of high reputation and excellent past track record. The index began December 31, 2002 with a value of 1000 and it currently stands at 1060, a return of 6 percent in almost three years. Without further ado, I report some correlations of daily returns of the index as follows. The one day serial correlations of daily returns are as follows:
YEAR S&P MgdFut 2003 0.02 2004 0.00 2005 0.06 2003:2005 0.02
Concurrent cross correlation of index returns with continuous futures of selected commodities the same day:
YEAR S&P CRUDE EURO/$ 2003 -0.20 0.37 0.49 2004 -0.02 0.42 0.52 2005 0.00 0.48 -0.01 2003:2005 -0.08 0.42 0.37
Note that these cross correlations measure the degree of co-movement between the index and the various commodities. A 40% correlation would correspond to approximately a 70% chance of the fund's moving in the same direction as the commodity. Thus, its about 70% that the index moved in the same direction as oil during these thee years (using a point bi-serial correlation approximation) . On the surface this would seem pretty good, as oil has about doubled during the period and these fund of funds apparently were on the right side of this move. The subject is so sensitive that I will not go further.
*The S&P Managed Futures Index is an investable index designed to be representative of investments in managed futures hedge funds/programs. Specifically, the index aims to track systematic managers employing mainly technical trend-following and pattern-recognition trading methodologies. The S&P MFI includes the four Managed Futures funds represented in the flagship S&P Hedge Fund Index, as well as ten managed futures programs added to create a broader, more representative single strategy index.Thanks to artful simulator Tom Downing for his calculations and work on the above.
An Irony, by Victor Niederhoffer
Some of my closest lady friends, whom I revere, but who presumably don't have my fine analytical sensibilities, have invested in stocks of products they admire and enjoy, a la Mrs. Lynch or the Beardstown Ladies, such as Whole Foods where they always enjoy the fresh and natural products, or in index funds when the market has a crash as it did in April and October (the latter not wholly unassociated with my persona), or the September 1 floods in Nola or January 1 tsunami in Indonesia. They tend to suffer a bit as the market thrashes around searching for weak hands. They snore a lot and ask me from time to time how I'm doing. I'm usually hanging on by the skin of my teeth. Then a few days later I ask them how they're doing, whether they still own this or that. "Do you still own those S&P futures for your retirement account?" "Oh no, I sold them at 1225 yesterday!" The irony is that all of these women are doing a Hades of a lot better than I this year. Perhaps Snoring as a Fine Art by Albert Jay Nock should be required reading for all would be players in the market, right after the triumphal trio or Fisher and Lorie.
A Cultural Note from George Zachar
Below is Bloomberg listing of top TV show DVD sales for last week.
This Last # weeks week week on list 1 New 1 Alias: Season 4 2 4 8 Lost: Season 1 3 New 1 The Munsters: Season 2 4 2 3 South Park: Season 6 5 3 3 Arrested Development: Season 2 6 1 2 The Adventures Of Superman: Season 7 6 7 Firefly: Complete Series 8 5 6 Desperate Housewives: Season 1 9 7 4 Stargate SG-1: Season 8 10 New 1 The L Word: Season 2
How should we interpret the fact that among "new" just-released to DVD items, The Munsters (a very old show remembered as a knock-off of the far cleverer Addams Family) far out-ranked the very recent lesbian-themed "L Word"?
Something to contemplate while observing the new-lows-for- the-move in debt.
Will-You-Give-Us-A-Break? Oil Companies Look for Profits in Public Relations, by Greg Remke
Will foolish public relations campaigns by Chevron and British Petroleum (BP) demoralize employees and damage stock prices? Or will millions respond to these advertising campaigns by rushing to buy more gas from caring oil companies? Continue Reading...
Strategy Part III*, by James Sogi
Bruce Lee, The Tao of Jeet Kune Do
*Text: Bruce Lee. (Market Parentheticals: Sogi)
Allen Gillespie Asks:
How do you measure in the present when an indicator has lost its future forecasting ability?
George Zachar Responds:
The decades-long erosion of the utility of the yield curve as a macroeconomic forecasting variable is exactly analagous to the way cycles change in markets.
An array of metrics such as the ISM surveys, credit market spreads, equity prices, etc., must be monitored, the way market tacticians examine the internals of their area of interest.
The Discreet Symmetry of the Market, by Victor Niederhoffer
There is a certain beauty to the symmetry of the market action in October and the reasons stocks went down. It all started on the second day of October; the market dropped from 1235 to 1216 when the first Fed stooge was let out of his box to jawbone about inflation and create the semblance of a justification for intervention. But then again, perhaps it all started at the previous Fed Open Market meeting on Tuesday, Sept. 20 , 2005, where inflation loomed larger than Katrina and the market went from a 1243 high on the Friday before the announcement to 1216 at Wednesday's close. The Refco news brought it down to 1172 by Oct. 13. Now it's back to 1218 on deflationary news from the October 2 meeting. What will the next catalyst be? The Shadow knows only that an organization will act to ensure its survival and increase its power.
James Sogi Responds:
News and public perceptions are a real part of politics, business investing and public life. It is the divergence between the news, perception and reality that presents the most interesting conundrums and opportunities. Assuming current low levels of journalism and high reader acceptance, the weakness of the news media to be exploited is their need for a "story" which outweighs their quest for accuracy. This allowed the administration and the hidden Refco parties to game the media for what they thought was their benefit.
I am involved in some headline matters now which present a similar situation. Hungry news sensationalized a 'story' from an unauthorized consultant with a hidden agenda speaking erroneously without authorization inflaming public sentiment. The affected government officials and principals meet, agree and shake heads and wonder, "what is the problem here". Rather than address the 'issues' in an analytical manner which common sense might dictate, the cure is to re-spin the story to satisfy media and public hunger for controversy, clearly defined roles and a simple digestible line. While we are dealing with interesting and important issues of cultural and historical interest, the media misses the matters of true interest and importance for the superficial. There must a great pressure on journalists to report in short order, and make a story from random facts. Just as traders make lines out of random points, the public wants simple answers from the media to help them make order out of apparent chaos. In this they both become doubly misled. There is a process of public digestion, acceptance, and consensus at work. The process has to be carried out no matter what the logic of the situation dictates. Stories take on a life of their own. Resonance describes part of the process. The market itself it integral to the process as a reflexive mechanism. These are the memes. Often the outcome is not what is expected. Here lies the edge.
Media is better understood by considering these three factors:
Given the important relationship of the market to recent events, there are important lessons for speculators to study.
S&P 500 Index opened the year at 1212; closes at 1214; 212 days.
23.36 sd 1193.3 mean 1245.0 max 1137.5 min
The ranges are increasing, compared to earlier in the year. VIX is up in higher range.
Trader Performance and Epistemology, by Dr. Brett Steenbarger
I recently had the misfortune of visiting a health care unit for patients with Alzheimer's Disease. As I walked the unit, I was struck less by the expected memory deficits of the patients than by the essential randomness of their behavior. The term that is commonly used for this behavior is "agitation", but that suggests an anxiety that isn't necessarily there. Rather, as the disease deteriorates the brain's frontal cortex-and those executive functions of reasoning, judging, and planning-behavior becomes more stimulus-dependent, impulsive, and range-of-the-moment. What I was observing was what happens when behavior is divorced from purpose.
I mentioned at the time, only half in jest, that some of the patients reminded me of traders. What I meant by that was that many of the traders I've worked with become so engrossed in the price action of the moment that they lose sight of their purpose. Like the Alzheimer's patient, they generate much activity with little aim.
This is interesting, because I've often felt as though many traders behave like children with attention deficit hyperactivity disorder (ADHD), and the Alzheimer's patients certainly resembled individuals with severe attention deficits. Russell Barkley's research on ADHD, suggesting that it is fundamentally a deficiency of rule-governance of behavior, is most relevant here. When the brain's frontal activity is compromised-either situationally because of emotional arousal (in the case of my traders) or more intrinsically because of disease-the capacity to generate and act upon rules diminishes. The result is a high degree of randomness to behavior.
In many situations, concepts form the basis for the rules that guide our behavior: concepts of fairness and justice (which prevent us from stealing and mistreating others for immediate gratification), concepts of duty and honor (which keep us acting toward an overriding purpose), etc. As Ayn Rand noted in her epistemology, concepts integrate a range of concretes by isolating their common features. Similarly, concepts integrate our behaviors by organizing them according to our values. When the brain's frontal lobe functioning is impaired, we-like the Alzheimer's patients-lose a bit of our humanness: our capacity for conceptual awareness and value-guided action.
Research in trading (counting) provides us with the perceptual concretes by which we can form market concepts. This serves an obvious epistemological function-separating random market action from significant, predictable behavior-but it also serves a psychological end. The research-grounded trader who formulates market concepts now possesses a natural brake on his or her impulses. The imposition of rule-governance (for example, extended declines are followed by increased probabilities of market rises) serves as a counterweight to our emotional tendencies (capitulating at market lows).
On my website, I use the example of feeling a desire to sell the recent bounce in the S&P. My impulse to short the market into the rise was checked by a market concept that has been reinforced by a variety of research: Very strong and broad upside momentum tends to be followed by price strength in the near-term. Sure enough, when I queried my database to look at the number of operating company stocks trading above a volatility envelope surrounding their 20 day moving average, I found that a high number of such issues was associated with superior price outcomes four days out. Specifically, from October 2002 to October 2005 (N=774), when we had 650 or more issues trading above their envelopes (N=33), the market's performance four days out was +.85% (26 occasions up, 7 down). That compares with +.17% (427 occasions up, 347 down) for the broad sample.
The market concept imposed rule governance on my trading, and I avoided a horrendous trade.
There are sound logical reasons for market research, and there are equally valid psychological ones. Markets exhibit inherent randomness, but we need not do the same.
Titanic Profits, by Fred Crossman
In a Wall Street Journal editorial yesterday, the "Political Windfall" article mentioned that in 16 of last 20 years, returns on investment in oil companies were below average of S&P industrials. Also, between 1977 and 2004, total taxes on gasoline sales (40 cents per gallon on average) at $1.34 trillion were over twice the $640 billion in oil company profits (which doesn't include taxes oil companies already paid on their profits).
Those "titanic profits" are still in the 10% range. P&G makes about 14%, thrifts about 20%, and MSFT over 30%.
Brownian Motion and Size, by George Zachar
Researchers have known for some time that when a particle is much larger than the surrounding fluid molecules, it will not experience the completely random motion that Einstein predicted. As the particle gains momentum from colliding with surrounding particles, it will displace fluid in its immediate vicinity. This will alter the flow field, which will then act back on the particle due to fluid inertia. At this time scale the particle's own inertia will also come into play.
I was struck by potential parallels to large/small market cap stocks and megacap corporate dynamics vs. small company characteristics.
The Dangers of Romance in Games & Markets, from the Grandmaster
From an interview in 1995:
Leontxo Garcia: "Many chess players have a difficult feeling, something like 'I must win today!' when they play a woman."
Victor Korchnoi: "I don't have that problem, but I had another one with Pia Cramling when I played here on an extremely warm day in Biel (Switzerland). I thought I couldn't play with my normal dress against such a pretty woman. So I was very well dressed, couldn't breathe and lost. A few days later I saw Robert Hubner, who played in shorts, beat Pia easily. That was a lesson for me. If you play a woman, just be yourself."
Retha Roux Responds:
Easier said than done, it seems... if the patriarchal Turkey Lurkey could choose to start doing just that right now, this world would be a great place! What exactly would it take?
Maybe Chicken Little will realize that the sky is within our reach but still hasn't fallen (7,000 years later) and that the earth is not rising either. Maybe we will realize that Ms. Little did not "gather her skirts" (rather unlikely in 4,800 BC) but more likely got herself organized and started working towards a balance.
Humility, by Victor Niederhoffer
"Making Money on the Stock Exchange," by Charles Gifford and J. A. Stevens, has a nice discussion of what to do when the market is too high. The book is in the form of Q&A, and the author answers: "If you think the market is too high, you are assuming that the people whose purchases made it too high were mistaken, and if you think it is going higher, that they are in error.
Q. Doesn't that mean that I should get out of equities [when they're too high]?
A. Natural humility. In making the assessment that the market is too high, and that people who have pushed it there are wrong, you will have sat in judgment on such subjects as the future course of interest rates, and the relative number of good and bad years to be expected in the future."
Such a foundation of natural humility is something we recognize often in our friends and heroes. Johnny Unitas had it in sports, Issac Newton and Albert Einstein had it in science, J. S. Bach had it in music, Horatio Hornblower and Jean Valjean had it among the great characters of literature, Helen Keller had it in real life, Jim Lorie had it among my professors, and my father, Artie, had it in my family. None of them ever said a good word about themselves but every other word was about some hero like Michael or Tiger in Jim's case, and Moey and Ralphie Adelman (two great handball players), or me, in my father's case. He must have told me a million times that he was "the world's worst" at this or that activity. And unlike the Sage, he really meant it.
He'd always tell me not to be too sure of my positions, and that he knew many bums on the Bowery who had more numbers and relations to support their speculations that I had and they died broke.
Somebody is going to say, "Vic should have had more humility when he sold all those naked puts in 1997." I agree. It's something I work on every day.
I find companies with natural humility do much better than those that have the opposite character. Occasionally you see that in the down-to-earth, self-deprecating sensibility shown when executives for companies like Wal-Mart sleep two in a room on a trip or travel a few hundred miles for their famous Saturday meetings.
Forgetting a natural humility is the reason that so many of the financial weekly commentator's forecasts and hopes -- dare I say all of them since 1964? -- have been so erroneous. And it's the major reason so many bearish funds and pessimistic books about the stock market find the limelight at stock market lows, even though a buy-and-hold strategy in almost every market returned some 10,000-fold in the last century.
Bessemer Venture Partners instructively lists its misjudgments and all speculators might do well to adopt the practice. For my own part, passing on, or selling out of, early-stage investments in Audiovisual Associates, E*Trade, Indiana Precision, and NavTeq were among the 9- or 10-figure mistakes I have made. In the market, I have allowed myself to be squeezed out of enormous profits for the sake of a token gain so often that it lays me low to think of it.
Greg Rehmke Adds:
Your post on humility reminded me of a place where humility is
unknown: state and federal governments. Politicians complain that
gasoline prices are too high, and oil company profits are too high.
How do they know this? I think BMW prices are "too high," but apart
from appealing to people who would prefer lower prices, how could
politicians know what the price gasoline should be? Of course they don't know that, or much of anything else. So
I wrote the article below as one I would like to see in the New York Times
Greg Rehmke directs Economic Thinking, a nonprofit economic education program for high school, homeschool, and college students. This "news report" is from his blog.
Secret Post-Hurricane Plan Taps Into 1.4 billion Gallon Reservoir,
by Not-New York Times reporter Greg Rehmke
Congressmen and journalists nationwide were upset to be upstaged by a secret oil industry plan to respond to hurricane Katrina (secret only because journalists were unable to comprehend it and report upon it). The oil industry plan drew upon the distributed knowledge and incentives of all Americans with automobiles and tapped into a vast 1.4 billion gallon gasoline reservoir.
The oil industry was unable to predict exactly how much gasoline refining capacity would be knocked out by Katrina, nor how long it would be out. Nor could they predict exactly how much gasoline would be available in regions near Katrina and supplied directly by Katrina- hit refineries. Working through a network of thousands of gasoline- distribution agents, oil industry experts unveiled a complex plan to enlist cooperation not only employees, but also of firms they sell gasoline to, and, astonishingly, all their customers.
Customers were called upon to individually examine driving patterns and make their own decisions on ways to reduce gasoline purchases. Customers had no way of knowing how easy or hard it would be for their neighbors to conserve scarce gasoline supplies. Somehow, an entire nation of automobile drivers had to arrange their response to Katrina with the also unknown details of just how much refinery supply was knocked out. And they had to somehow continue this coordinated response day-by-day through the entire duration of supply constraints.
Wealthy investor Don Smith (not his real name), on his way Saturday from Pittsburgh to Houston, revealed his part in this nationwide Katrina-response plan: "Not since high school had I bought just $5 or $10 of gas at a gas station." When asked, Mr. Smith confirmed that he could afford a full tank of gas. But since he expected the price to fall once refineries were repaired, he chose not to fill up. He added, "I couldn't easily switch to a smaller car, but I'm careful now to accelerate more slowly onto the freeway, and to brake less." As the crisis passed in the Pittsburgh area, and gasoline prices dropped to $2.19 a gallon (as of October 29), Mr. Smith said he expects to replenish his automobile's private reservoir the next time he visits an area gas station.
Central to the nationwide response, now seen by most as amazingly successful, was consumers' ability to tap into their own individual gasoline reservoirs during the supply emergency. Instead of filling- up, millions more Americans filled their tanks just to half or three- quarters full. High prices led millions not only to reduce gasoline consumption in their own preferred ways but also to draw down their own private gas tank reserves.
Unfortunately, since this oil industry response plan involved market concepts and demand-management through price changes, it was beyond the comprehension of most legislators and journalists. Legislators responded by calling for a "windfall tax" on profits generated by higher gasoline prices. They plan hearings where academics will testify that oil companies could have sold gas at lower prices. Interestingly, TV news viewership, as well as sales of newspapers and magazines, jumped significantly in response to hurricane Katrina. No word yet whether Congress plans to similarly tax "windfall" media profits.
Notes on numbers: 200 million cars in U.S. with average tank size of 14 gallons (at least my Volkswagon has a 14 gallon tank, which, pre- Katrina, averaged one-half full and post-Katrina averaged one-quarter full). With these numbers, the nationwide private gas-tank reservoir capacity is 2.8 billion gallons. If it averaged one-half full when Katrina hit, there were 1.4 billion gallons available for individual consumers to draw upon. 700 million of these gallons could be used before the average driver's tank hit one-quarter full. I can only speak for myself and wealthy investor Don Smith (not his real name): We both drew our tanks down and kept them down as long as prices stayed up.
-- Greg Rehmke, reporting from Pittsburgh and Seattle
Kim Zussman comments:
The reason to be humble is that the final score is not in until the game is over. One villainous act or grievous error, at any time, could end the career and reputation, as well as stamp the final judgment. In addition, heroism is subject to survivorship bias, which is not much reason to brag (think of all the tech stock jockeys 95-00).
There was a discussion of the dynamics of betrayal here during some unscheduled quality time. Betrayal is an important issue in teen life - a period when altruistic determinism of childhood gives way to weighing hormones vs. morals. The teacher was Mr. Clean, the family pet tarantula. He seems very peaceful as he crawls harmlessly over you. Even though as yet he has not, he could deliver a painful bite, and we hope and trust he will continue harmlessly. Like a friend or loved one, we can't know if he will ever betray until either he or we are gone.
Assumptions about markets are like pets which have always been friendly but could, at any time, deliver a venomous bite.
Adi Schnytzer Responds:
I like this very much and believe it to be true. But how does one identify the relevant Mr. Clean? I recall, when we moved to Brisbane in 1981 from Melbourne, seeing ever so many spiders in the garden. Melbourne has few. I went to the environment studies department at my university and asked to meet an expert on local spiders. I asked a trivial question: "Which of the spiders in my garden and/or home can kill me?" He replied that there were literally thousands of different types of spiders in Brisbane and that no one had even tested ten percent of them! He merely advised me to leave them alone, in which case they would probably leave me alone! It seems that the only really aggressive spider in Australia is the funnel web, which can attack you unprovoked. And most of them or in Sydney anyway! Can the market really be as complex as this? Maybe.
Dean Parisian Replies:
One of the books I refer to when my account balances grow far too fast relative to the market is Karen Horney's great work Neurosis and Human Growth. I was deeply humbled in the fall of 1998 by overstaying my welcome in small cap growth and found her work to be a great addendum to understanding/checking my ego when things overheat.
On the Senator's Bookshelf: Lovesick Blues: The Life of Hank Williams
Ethos, pathos, music, history... lots of material in this one, and what a story!
The All-Seeing Eye, by Victor Niederhoffer
This is the kind of day, the kind of month that only a writer with an all-seeing eye could do justice to. For a third month in a row, a rally of a few percentage points in the final three days moved stocks from the depths of despair to hoped-for glory. This is guaranteed to happen most months, most years, but it is apparently even more guaranteed when the mutual funds are closing out their fiscal years as was the case over the last few days.
It was nice to see the universal law of gravitation upheld, with four separate swings from a daily S&P 500 futures close of 1200 or above to a daily close below 1200 and then above. This makes the ninth such excursion back and forth in the last year. And it's getting to the point where I'm beginning to believe that even though retrospection can find any number of prices that are in the middle of a range for a year that is about unchanged, that have many swings above and below, this one seems a bit non-random.
Also seemingly non-random was the beautiful consilience of so many markets. Oil closed just below $60 a barrel at $59.76, the Euro was worth just under $1.20 at 1.198 and corn closed just below $2 at $1.96 a bushel. I hear from a Texas pilot fish that gasoline in Texas is retailing at $2.26 a gallon and I wonder, considering that taxes take up, how that compares to the $5.00 a gallon we pay for a reasonably clean bottle of water.
The Goldman Sachs commodity index fell 10% in October, from its Sept. 30 close of 469.6 to its close of 422.9 on Oct. 31, one of the biggest drops ever. This is a low since the beginning of August. But isn't this guaranteed to happen in conjunction with the Federal Reserve's staged program of speeches stating they're near the breaking point with their tolerance for inflation? Did it ever occur to these officials that the competitive situation around the world and within the US, the increased production unleashed with the breakdown of collectivist thoughts except at certain NGOs and certain Centrals, the innovative ways we have of producing, the dissemination of information on pricing, are such that inflation can't get going?
Of course, someone's going to attribute the decline to the debacle at Refco. But it had as much to do with them as the S&L crisis had to do with the fake doctor, soon to retire, who wrote a letter of recommendation for Charles Keating back in 1985.
The last hour of trading in the month is always a time for great trepidation. In the glory days for the bears, the always chronically bearish hedge funds were rumored to knock the stuffings out of the market in the last half-hour of trading. And indeed, as of a few months ago, the average decline during that period over the previous 4 1/2 years was a nice -0.2%. But it hasn't worked the last few times. Today's decline of 1% in the last half hour of trading will make up for that. Once again, an earnings warning from one company, Dell, was sufficient to trigger the weakness. When will the public learn that one sparrow doesn't make a spring? Especially when the average earnings increase this quarter has been 18%.
Like most speculators, I like to buy near the end of the month, and with the egregious declines that occurred during the corresponding periods last month, I could not refrain from wading into the breach.
The Minister of Non-Predictive Studies here at Daily Speculations is incredibly busy these days as he has access to a million data files with which to generate random results. One that he presented to me showed that with bullish GDP numbers, the market and certain key retailers tend to go up sharply in the weeks subsequent to the report. The t-score of 3 that he showed me for one typical study with a 2% or 3% expectation one month later got me shaking my hands in a lament, "This isn't non-predictive, Minister," until I realized that there were at least 25 indicators that similar studies could be focused around, either up or down, and he was exonerated at once.
George Zachar Notes:
In 1985, Charles Keating hired Alan Greenspan as an economic consultant, in an effort to convince an oversight agency to exempt Lincoln Savings from certain regulations. Greenspan delivered a favorable report, writing that Lincoln Savings was "a financially strong institution that presents no foreseeable risk to depositors or the government."
Niederhoffer Coverage in Media: Final Error Count for October, by Laurel Kenner
As a former journalist, I wouldn't have believed this possible. Not one major news establishment got everything right. Even if a reporter got it right, his editor would write a bad headline or introductory note. I'm starting to think there's something in the water that journalists drink.
Victor didn't even belong in any of these stories. An anonymous source was telling reporters that Refco had debts dating back to "at least" 1998. The only person who had been mentioned in connection with Refco around that time was Victor. While there were no debts involved in Victor's transactions with Refco, either on his part or Refco's part, reporters and editors could not resist the temptation of using a sexy name to cook up a story. Nobody really knew the facts, so they needed a story peg...any story peg. Now the lumbering herd has headed for the greener pastures of Malaysian currency speculation, and Victor is left to convince clients and casual readers that he didn't cause the collapse of Refco.
None of these publications had an interest in writing an accurate story. They were interested in avoiding libel suits and in maintaining a veneer of magisterial journalistic propriety.
But the worst part is that none -- except CNBC Money and thestreet.com, thanks to our former editor Jon Markman -- deigned to mention that Victor has achieved one of the greatest comebacks in financial history. Can someone tell me why?
A few publications -- thestreet.com, CNN.com and FinFacts -- immediately corrected errors, to their credit. The NYT and the WSJ were horrible to deal with. I was met with sneers, foot-dragging. Bloomberg requested a letter that I ended up sending to more than half a dozen reporters and editors, with the end result that the original story was run again with all but one of the flaws we complained about. It was a complete waste of time. Ron Henkoff, Bloomberg's executive editor, suggested that we write a letter to the editor -- but since they would edit it "for length and clarity," I think we'll pass.
Symmetries, by Jay Pasch
A good-looking example of symmetry in motion, with multiple symmetries color-coded:
Trading range% on day-1 after consolidation breakout exactly equal. Both post-consolidation breakout moves nearly identical thus far. One must endeavor to seek non-visual methods of finding symmetry of this sort, and to test such -- not an easy task by any means.
The Skyscraper Indicator in Full Effect
The following is excerpted from the Real Money.com site:
EnCana Tempts Fate, By William Gabrielski
RealMoney.com Contributor 10/28/2005
A New CEO, and the Building Phenomenon
CEO Gwyn Morgan, who ran Alberta Energy from 1994 through 2002 before assuming the top-spot at EnCana, said on Wednesday he will be leaving the company, effective Jan. 1. The board has said that Chief Operating Officer Randall Eresman will take over. Given EnCana's execution problems in 2005, Eresman may feel it incumbent upon him to make large changes to improve the company's consistency, so there is transition risk looming in the first few quarters of 2006.
Finally, it might bear noting that EnCana committed what often turns out to be a fatal act of hubris on Oct. 23 when it announced plans to build a new headquarters that will be the tallest office building erected in Calgary since 1988. According to data compiled by Victor Niederhoffer in his book Practical Speculation, there are plenty of modern-day examples of companies building tall before a large fall.
For example, the Petronas Towers in Kuala Lumpur were completed in 1997, the same year the Malaysian stock market collapsed by 50%. And in 1999, Nasdaq built its $37 million MarketSite tower in Times Square right before the tech bubble burst. For the more biblical readers, the book of Genesis tells the story of Nimrod's attempt to build a great tower to make a name for his people, only to have the Lord throw the builders into a state of confusion that put a halt to building. Lastly, how could anyone forget the famous Enron building that housed the Big "E" that, maybe not so ironically, was built in 2002?Many thanks to Paul O'Leary for bringing this article to our attention.
The Million Mind March, by Kim Zussman
Say one won $100 million in the lotto (appropriately known as a tax on people who are bad at math), and sought to exponentiate so as to cure malaria.
So ran ad in the math departments of the top SAT universities, which promised a position at a new fund running statistical patterns. After screening a large number of candidates, hired 100 traders. They were put in a large office, with 100 cubicles containing identical computers loaded with several statistical packages and complete data series for all widely traded markets.
All traders were required to read certain books on markets, and after a week's training on the system there was a big meeting. Each trader was charged with coming up with profitable patterns and checking them for statistical significance. Every day, they would be allowed to send their studies in, but only if they had significance better than p=0.05. For each study accepted, they would be paid $100 in the near future (note that no dental hygienists applied for the job).
After a short while, and hundreds of significant results and thousands in principal reduction, the intrepid entrepreneur has a revelation. With p of 5%, there is 1/20 chance that trader's studies will show significance even if the pattern has no predictive value. And if the 8000 hedge funds average 10 such traders each, and for each of those are several prop traders and privates, there are a million minds poring over the same data for pockets of profits.
The real information sought is not historically repeating patterns, but insight into the collective reactivity of the multi-cellular mind of the market. Perhaps the guy should shell out for a functional PET scanner, and study labeled-glucose uptake in the limbic system of traders faced with statistical patterns in trading real money.
A Reader Writes Regarding Negative Correlation
This weekend I read a chapter out of a portfolio management book similar to your chapter on scatter plots and correlations. Where the two diverge is the chapter that goes on to Markowitz portfolio theory. Assuming all assets in the portfolio have the same expected return, there would be no additional benefit of diversification into two assets with +1 correlation, some benefit into two assets with no correlation, and the ultimate benefit or a risk-free return if the assets are perfectly negatively correlated. It seems counterintuitive, because if two assets are perfectly negatively correlated then any positive move in one will be offset by a negative move in the other, leading to an indeed risk-free return, but also no return. According to Markowitz it will show a positive return with no risk.
In EdSpec you talk about diversification, but more as way to reduce the blow of an unforeseen event. In PracSpec you talk about the need to take risk. Is there a conflict in methodology between you and Markowitz, or have I misinterpreted the theory? I decided to write you because in EdSpec you talk about diversification, but more as way to reduce the blow of an unforeseen event. In PracSpec you talk about the need to take risk.
Dr. Alex Castaldo Responds:
Yes, Dr. Niederhoffer is right. The variances, standard deviations, correlations, are measured about the mean, which need not be zero. (You seem to be incorrectly assuming that the means are zero).
In Markowitz's theory there are two assets A and B, A with mean rA and variance vA B with mean rB and variance vB the correlation beween them rho
then when you invest in a portfolio of A and B you get the return w*rA+(1-w)*rB with the variance w^2*vA^2+2*w*(1-w)*rho*vA*vB+(1-w)^2*vB^2
when rho is -1 (perfect negative correlation) we can make it so that the variance is zero but the return is (generally) not. [I'll skip the math unless you ask]
Perhaps what makes it difficult to imagine is that realistically there are no assets that are different but perfectly negatively correlated. It is a theoretical notion. Some people might cite IBM shares as asset A and a short position in IBM shares as asset B. These ARE negatively correlated BUT have rA = -rB. So it is a special case that gives a zero return. But in the general case above, no. rA and rB can be anything.
Perturbation and Trading, by Alexander Privalenkov
After I graduated from the technical university I started working in a research institute where I studied transitional processes in electrical circuits. The goal of the project was to create a device that would maintain stability in electrical circuits during transitional processes. The interesting fact is that in transitional processes there are harmonic as well as non-harmonic oscillations of voltage and current. It is a known fact that oscillations of currencies have a non-harmonic behavior. Many analytics compare these oscillations to noise and believe that it is impossible to study them by standard mathematical means. This assertion is true in many respects but not in every one. The thing is that on the market, just as in electrical circuit, exist two periods. The first one is the period when currencies move in the steady range. This period is difficult to analyze by mathematical tools. The second one is a transitional period, i.e. there is a price shift and the market moves from one price range to another. This transition is in many ways similar to transitional processes in electrical circuits. Transitional processes are caused by so called perturbation. Perturbation can occur suddenly and its power can be compared to the parameters of the circuit. Or it can be gradual and small but at the same time it is able to swing the circuit due to resonance. It seems that there are similar processes on the market. Traders usually have at least three questions:
My observations and analogies answered some of the questions and these answers can be used for making decisions during trading. For example the transitional period can be considered finished if after a certain level has been reached the chart shows attenuating oscillations similar to attenuating oscillations in electrical circuit.
Old Menus and Abalones (Vic's favorite food), submitted by Kevin Depew
November 1, 2005
Old Menus Provide Clues About Shifting Seafood Tastes and Harvests
By Andrew C. Revkin
In 1899, the New York Public Library received a query from a Miss Frank E. Buttolph, who wanted to know if it would add restaurant menus to its growing collections.
The answer was yes, and Miss Buttolph, then 49, began spending 25 years visiting restaurants in the city and writing hoteliers and other correspondents abroad, eventually amassing more than 25,000.
They have periodically been dusted off and put on display, providing visitors with a view of the changing tastes and spending habits of everyone from Park Avenue power brokers to South Street stevedores.
Now, those menus, and thousands of others in collections around the country, are being sifted by oceanographers seeking hints of changes in fish and shellfish populations and popularity before good records were kept. "A menu was a piece of ephemera, it wasn't meant to be saved, but thankfully some people collected them," said Glenn A. Jones, an oceanographer at the Galveston campus of Texas A&M University and a leader of the research.
Only by knowing how bountiful the ocean was can one determine the potential for restoring important marine fisheries, he said. Before fisheries agencies routinely collected data on landings and prices, he added, there was not a lot of information to go on. Menus also are one of the only tools for tracking shifting consumer demand for various species.
Dr. Jones presented initial findings last week at a meeting of marine biologists in Kolding, Denmark, that are part of an international project, the Census of Marine Life, which is an effort to create a detailed picture of past and current stocks of marine species by 2010 (www.coml.org).
On menus, seafood types were seen to come and go as various species grew in popularity, were fished out and were then replaced by something else.
New England and New York menus showed how Atlantic halibut was replaced by cod, which was replaced by haddock, which was followed by the mix of juvenile haddock and cod called by the market name scrod.
Dr. Jones said he first examined the 400 boxes of menus in the New York library's Buttolph collection three years ago. Hundreds of them provide precise snapshots of species and price.
Altogether, 200,000 menus have been uncovered in the research, mainly in New England, the New York collection and San Francisco. About 10,000 show prices and dates.
Such menus provide an indirect measure of scarcity when the price is adjusted for inflation, Dr. Jones said. They also show the resilience of species.
For example, oysters have been a steady resource. In New York and Massachusetts, their price held constant from the 1850's through the 1950's at 50 cents to $1 apiece in 2004 dollars. The price doubled in the next decade but then held steady for 40 years.
Abalone, the mango-size Pacific Ocean mollusks with tender scalloplike flesh, has an entirely different history. They were once so abundant in California that old photographs show shell heaps rising to the rooflines of fishermen's shacks.
The delicacy started appearing on San Francisco menus in the 1920's, and the price of an entree stayed steady through the 1930's at about the equivalent of $7 in 2004 dollars.
Since the 1950's, Dr. Jones said, the price of abalone has shot up at 7 to 10 times the rate of inflation. Abalone served in the city now comes from places as far away as Australia.
Training in Chess, from GM Nigel Davies
Equilibrium, by Andrew Moe
4th of July:
Returning to equilibrium, we seem to have developed an improved outlook on the future, though one that gives us heartburn. With the planets aligned for a second time, we begin the turn for home.