Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner


Nov. 1-15, 2006


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Health and Sickness, by Victor Niederhoffer

I wrote on Nov 9 about a most unsettling day in the market with all commodity futures up 2% right after the election. It was followed by a most healthy day with commodities down an average of 3% and some down much more.

It brings up the immediate thought that after cardinal events like elections there is a tendency to back and fill, trying to get you to get on the wrong foot like a good competitor in any game including the favorites here of chess and checkers, martial arts, and racket sports ( the defunct game of hard ball squash being the only thing I am expert about ).

The general question of healthy and unhealthy days in the market is a very pungent one that deserves study. Today, bonds are at a new 10 month high, and the dollar is low, and the Saudi Arabian market is pushing 8,000 again -- down 60% for the year. How should healthy days be defined and what predictive properties do they have?

Along those lines, another aspect of wellness is the health of the market for the big players -- the ability of the market to survive, recirculate the energy, carry away the wastes, providing food and hope for all the niches in its community -- is the movement in markets during the day. It must be sufficient to get the public to do the wrong thing and to create frictional costs to cover the costs of the infrastructure and the profits of the larger feeders in the chain. Tuesday's 16-point range in S&P futures (high 1399, low 1383) is the biggest since the 04 Oct 19-point range (high 1359, low 1340). It was very nice because it went down 9 points from the open at the low and up 7 points from the open at the high -- enough to get everybody leaning the wrong way, selling at the bottom and buying at the top, with a thousand other emotional trigger and chart points to do the wrong thing also. A most healthy day for the market for sure. But what does it portend for the future? Slightly bearish in the large, but in particular slightly bullish is a reasonable counting answer, but how can one generalize such health for the infrastructure days. One might suggest studying days of running maximum ranges as to their predictive properties. One believes that some meals for a lifetime are contained within the above lines of inquiry that might be used to answer such questions of strength.

P.S. Try graphing the consecutive points (a, b) on the S&P chart of Nov 13th and draw the points (a,-b) for a hypothetical chart of Nov 14th, and then query whether the degree of overlap between the hypothetical Nov. 14th chart and the actual Nov. 14th chart is random, and if you conclude it isn't, under what conditions is such a non-randomness predictive and/or useful? Alternately, flip the 13 Nov chart upside down and enjoy the Adam Theoretic aspects.

Whaling and Speculation, by J.T. Holley

I was in my garage late last night changing oil in my car and I came across an old beat up paperback of Moby Dick that was stashed in a box next to the oil filter wrench. One thing led to another and I was 30 chapters deep. I came to the realization that chapter 24 titled "The Advocate" could easily be retitled "The Speculator" and have the word/words "speculator" "wall street" substituted. I will share some samples with the ya'll:

In the first place, it may be deemed almost superfluous to establish the fact, that among people at large, the business of "speculating" is not accounted on a level with what are called the liberal professions. If a stranger were introduced into any miscellaneous metropolitan society, it would but slightly advance the general opinion of his merits, were he presented to the company as a "speculator", say; and if in emulation of the "Corporate Presidents (C.E.O.'s)" he should append the initials "C.S (Chief Speculator)" to his visiting card, such a procedure would be deemed pre-eminently presuming and ridiculous. Doubtless one leading reason why the world declines honoring us "speculators", is this: they think that, at best, our vocation amounts to a butchering sort of business; and that when actively engaged therein, we are surrounded by all manner of defilements. Butchers we are, that is true. But butchers, also, and butchers of the bloodiest badge have been all "CEO's" whom the world invariably delights to honor. And as for the matter of the alleged uncleanliness of our business, ye shall soon be initiated into certain facts hitherto pretty generally unknown, and which, upon the whole, will triumphantly plant the "speculators chambers" at least among the cleanliest things of this tidy earth. But even granting the charge in question to be true; what disordered "trading desk" of a "speculators chamber" are comparable to the unspeakable carrion of those "cherry desks" from which so many "corporate presidents" return to drink in all ladies' plaudits? And if the idea of peril so much enhances the popular conceit of the "corporate president's" profession; let me assure ye that many a "CEO" who has freely "signed quarterly earnings", would quickly recoil at the apparition of the "Market Mistress's hand", "fluctuating his capital up and down with reckless abandon". For what are the comprehensible terrors of "being a corporate officer" compared with the interlinked terrors and wonders of "Speculation"! But, though the world scouts at us "speculators", yet does it unwittingly pay us the profoundest homage; yea , an all-abounding adoration! For almost all the "TV shows", "Daily Papers", "Radio Programs" that spread "market wisdom" around the globe, "shout our language", as before so many "pulpits", to our glory!

I will save the last of the chapter for you to read. It is an impressive homage to the whaler or "speculator" as I have taken the liberty to implant. It discusses the heritage forgotten, the lineage of the men, the importance of the risk taken and the rewards reaped by those of the type. I got goose bumps from the reading. It was something I must have forgotten or hadn't thought of the first few times I've read Melville's masterpiece.

Gibbons Burke replies:

Interesting that you should run across 'Moby Dick' yesterday as November 14th was the 155th anniversary of the great novel's publication.

My favorite chapter is The Castaway, about Pip, who jumps from a whale boat on a sleigh ride and is abandoned to the solitude of the ocean alone:

He is treated to a vision of God, and returns and is adjudged to have gone stark raving mad. Of course, he is also given the gift of prophesy, and like Cassandra, can see what the future holds for the barky.

Equity Curve Random Generator, from Rick Foust

I found a fun and educational Equity Curve Random Generator where you can enter values of win/loss ratios and win probabilities and see their effect on returns over time. Note that increasing the number of lines (third blank) will overlay multiple runs on the chart. Playing with this revealed rather quickly that ratcheting up the win/loss ratio in tenths only gradually improves the curve, but ratcheting up the win probability in tenths rapidly improves the curve. Even hundredths are important. Try ratcheting the probability .55, .56, .57, .58, .59, .60 and you will see. Improving odds even a tiny amount can dramatically improve returns.

Dr. Phil McDonnell comments:

I would caution all that the author of the web site mentioned by Mr. Foust uses the Average Win/Loss ratio as his characteristic criteria. As Rick found the criteria did not seem to be the most helpful. Part of my caution comes from the author's apparent use of the Average Win/Loss ratio in conjunction with the Kelly Criterion. The Kelly Criterion applies only to gambling games with binomial outcomes.

Some people have tried to extend it to multinomial outcomes such as we have in investments. They try to use the average win and the average loss as though they were binomial outcomes. In so doing they commit a basic arithmetic mistake. Implicitly they are assuming that the distributive law applies to logarithms. It does not and that is where they go wrong.

This error has been repeated to the point of being a meme. Many books espouse it, much software is written to calculate it and articles proclaim it to the unwary. The simple fact is that the incorrect formula invariably leads to over trading and will CAUSE the ruin which it ostensibly promises to prevent.

Faith Of Our Fathers, from Ken Smith

Religion is good for most people. Others with logic on their mind do not take to it well. Philosophers and big brain people scoff. Let 'em. It's not for them so why do they make an issue of it?

Religion is for people who need it. And why deprive people of a valuable resource, both spiritually and materially since life is so, so short and happiness is so so difficult to come by?

If Randians praise happiness and are atheists they surely ought to understand why others also seek happiness. What difference does it make how one comes to happiness?

Philosophy is nonsense. Leave people alone in their happiness. I recommend this book: The Power of Kindness by Piero Ferrucci. Be kind to fools and thinkers alike. It won't hurt a bit.

Gary Rogan replies:

Religion does bring happiness to many people, that's undeniable. Studies in behavioral psychology have indicated that human beings are genetically predisposed towards religious beliefs. Evil ideologies have in the past tried to control religious thought because it interfered with their attempts at mind control, therefore one always has to be suspicious at such attempts. Religious freedom is a litmus test of free societies.

Nevertheless, by definition religious beliefs are not rational. People are trained from childhood not to exercise the same level of skepticims towards "facts" associated with religions as they would towards most other subjects. Therefore, when a significant number of people acquire similar religious beliefs, religion often stops being just a force for personal fulfillment and becomes an organization force to achieve some real-world ends. Since religious beliefs cannot be argued with on a rational basis, if they happen to contain elements of intolerance or imposition of one's will on others, they can and have led to great injustices imposed on those who don't profess them. Even today, it's a real possibility for whole cities and contries to be blown up in the name of religion.

The shifting lines between rationality and "magical" thinking patterns is something that has been with us since the dawn of our species. There are obviously no easy answers. People should be left alone in their happiness, but any attempts to impose their "happiness" on others need to be stopped.

Bayes: Complete Ignorance and Stated Truth, by Jason Schoeder

Ignorance is preferable to error and he is less remote from the truth who believes nothing than he who believes what is wrong. -- Thomas Jefferson (Notes On Virginia)

During my ongoing Bayesian spelunking, I have run across the idea of "complete ignorance" and "stated truth".

Reading probability theory shows background to things we know.

  1. The differences between people who both claim to know nothing about a situation must be tested anyhow.
  2. The similarities in answers between people do not differentiate the volume of perspective.

Complete Ignorance:

One might think that such a thing is an important part of Probability Theory, alot like zero-ness.

But it seems nailing down what you do not know results in discovering things one does know. Discovering if a problem is location or scale or rotationally invariant provides an idea of what one does not know: that is, the problem itself encodes what you do not know.

And that complete ignorance may only be relative to the problem and not the observer (being dumb does not count in this exercise).

A full blown modeling of "complete ignorance" would create a starting point for building knowledge, but that is off in another realm of thinking.

Stated Truth:

As an experiment, one can play with meta-distributions of probabilities: Ap

P(A | Ap, X) = p

Ap means regardless of anything else you might have been told, the probability of A IS p

The net effect of this "rule" is: for new information to update the meta-distribution Ap, the probability of P(New | Ap) must have some slope effect to either narrow the distribution or provide some focus to the uniform.

The integrals are fun to play with, the regular case of arguing with someone who has an Ap distribution in his head we all know, his receptiveness to new ideas is mathematically predetermined, if the new information creates unwanted redefinition, there is no need to reprocess the meta-distribution. Dogma about Ap is different than knowing why Ap is relevant.

Ehrenfest Urns, by Bruno Ombreux

I recently stumbled upon Ehrenfest Urns. The results from their simulations look like tick charts with no drift.

And I am wondering if things like advances-declines, ticky, basically anything in the market that is based on a sum of binary states, could not be modeled as an Ehrenfest process.

Going further, an Orstein-Uhlenbeck process seems better suited to a market drifting up against a wall of fear (fear is the viscosity), than a standard random walk. Why don't people use these?

I know this sounds like a lot of name-dropping, but this is merely to point out that the science of finance seems very backward. There is still a lot of progress to be made.

Herding Explanation, by George Zachar

A simple explanation of herding can be found in this week's Economist, with obvious parallels to the stock market.

A Book Recommendation from a Wise Speculator, by Victor Niederhoffer

I received a book recommendation from Stefan Jovanovich who, like Jim Sogi, utters something of profundity whenever he speaks. He recommends historical books by Peter Green and J. S. Holliday as models of good scholarship. I call on him and others for some good historical books that I can read and augment my library with and share with my children, who are studying history in school, and regrettably have been brainwashed by politically correct curricula, starting with Squanto as the archetypical American hero.

I recommend the book Lessons of History by Will Durant as well worth reading for its lessons on markets as well as a honest attempt to review the lessons from a life long study of the sweep of history in conjunction with this request.

Alston Mabry replies:

Inventing America is a  textbook that has an interesting approach and might be an alternative for homeschoolers:

Book Description; W. W. Norton presents Inventing America, a balanced new survey of American history by four outstanding historians. The text uses the theme of innovation--the impulse in American history to "make it new"--to integrate the political, economic, social, and cultural dimensions of the American story. From the creation of a new nation and the invention of the corporation in the eighteenth century, through the vast changes wrought by early industry and the rise of cities in the nineteenth century, to the culture of jazz and the new nation-state of the twentieth century, the text draws together the many ways in which innovation-and its limits-have marked American history.

Check out the TOC or get the second edition here or get a used copy of the first edition for a nominal amount.

Some other  longtime favorites are The Making of the Atomic Bomb by Richard Rhodes, The Devil's Horsemen: The Mongol Invasion of Europe by James Chambers, and King Harald's Saga: Harald Hardradi of Norway: From Snorri Sturluson's Heimskringla by Snorri Sturluson. You can get the wiki overview here, but the saga itself is a quick read and an amazing story.

Another audio book I have thoroughly enjoyed listening to on cross-country drives is Simon Schama's A History of Britain. The audio book is in 3 volumes. Schama, a professor at Columbia, is such an excellent storyteller that I would pick up anything he has written. The television series of the same name is also available on DVD and is outstanding.

Schama's most recent work, Rough Crossings, is about the British and slavery during the Revolutionary War: You can hear Schama talk about Rough Crossings on Book TV.

Stefan Jovanovich replies:

Simon Schama has the gift of charisma. When you watch his narration of the video documentary of the History of Britain, you are instantly aware of it. The trouble is that his histories are not to be trusted. At their worst they are little more than royalist propaganda. Too often he writes the story that the Queen would like to read, not the one that happened. Even though Cromwell was the first head of the United Kingdom to allow Jews to openly practice their religion, Schama finds the Great Protector to be a far greater villain than any of the crowned heads who so routinely persecuted the children of Israel. He is equally severe in his criticisms of those greedy speculators of the Dutch Republic who left Spinoza free to grind his lenses; in Schama's eyes, those Dutch Reform bigots were guilty not only of inventing capital markets but also of buying too much stuff. The common thread in Schama's works is the notion that sectarian Christians, with their notions of free markets, are to be feared as dangerous, greedy fanatics who will upset the natural order of the world. The meme continues with Rough Crossings. Schama makes a great deal of the fact that the British offered freedom to slaves who would join the Royalist forces in fighting Washington's Army while failing to note that the Confederates ended their struggle with the same concession to the dire necessities of war. In general, Schama finds the Christian deism of the slave owning signers of the Declaration of Independence proof of their hypocrisy and, by extension, that of the American nation as a whole. The fact that, for another half century, neither the Archbishops of Canterbury nor the Kings of England had any problem with sanctioning and enforcing slavery in their remaining territories is somehow put aside. So are the origins of the anti-slavery movement in both England and America (those dreadful Methodists). The nearly two centuries old Anglo-American naval alliance (the longest-lived military confederation between democracies in recorded history) had its origins in the anti-slavery patrols off West Africa by both fleets that began in the 1820s. Those were initiated as a political concession in both countries to those same cross-bearing nutballs who thought that the "common" people should have the right to vote even if they did not own a carriage. Ain't history grand?

Tom Ryan suggests:

Daniel Boorstin's three books, The Americans, written before 1973, provide a refreshing take on American history in my opinion. I recommend the third in the series, "The Democratic Experience", which covers the 1870-1970 period in American History. It is unconventional in the sense that it focuses on the stories of the individuals who built, invented, and created this country, the untold stories of the individuals as it were, rather than the typical history of Washington political leadership that is regularly fed to children in grades 4-12.

Steve Ellison adds:

I highly recommend British historian Paul Johnson's A History of the American People, which goes into detail on many topics, including the relentless economic growth that occurred almost from the outset. A small sample:

By the third quarter of the 18th century America already had a society which was predominantly middle class. The shortage of labor meant artisans did not need to form guilds to protect jobs. It was rare to find restriction on entry to any trade. Few skilled men remained hired employees beyond the age of twenty-five. If they did not acquire their own farm they ran their own business.

Rodger Bastien responds:

I just completed Rubicon: The Last Years of the Roman Empire by Tom Holland. I highly recommend this historical narrative of the final days of the Republic which deals with primarily the years 100 B.C. to 14 A.D.  For me, the book brought to life this period which I knew little about but was arguably as important to subsequent civilizations as any period before or since. Caesar, Marc Antony and Cleopatra may have existed centuries ago, but to me those centuries somehow feel a little shorter.

Gibbons Burke replies:

I am finding I am enjoying first-person narrative accounts of historical events and times, so, with that in mind:

and one that's not a first person, but which is fascinating and has many meals:

John O'Sullivan replies:

I recommend two books by Anthony Beevor: Stalingrad and The Fall of Berlin 1945. Both mesh grand strategy with individual detail and amazing narrative momentum. I also like three Middle & Far Eastern travelogue/history/biographies by William Dalrymple : Xanadu, From the Holy Mountain and White Mughals. Dalrymple has created his own genre and its a rich mix.

MacNeil Curry replies:

I would have to recommend Bury My Heart at Wounded Knee: An Indian History of the American West. Not only is it a fascinating account of the West from a different perspective, but it highlights quite well that there are two sides to every story and that both must be carefully studied before one can truly come to there own conclusion.

Tyler McClellan replies:

Speaking of John Wesley Powell, Beyond the Hundredth Meridian: John Wesley Powell and the Second Opening of the West by Wallace Stegner is a book with many practical lessons for investing and life that used to be required reading for the history of the American West.

Craig Cuyler replies:

My favourite historical novels are without doubt the three part trilogy by Neil Stevenson called the Baroque Cycle. This body of work, over 2500 pages long, covers life in 17th-century in England, Europe, Russia with special reference to natural philosophy & science. Stevenson weaves in his ideas about currency, calculus in speculation which took place around the central characters like Isaac Newton, Huygens, Hook, Leibniz. The courts of Louis XIV in the battle for the monarchy in England feature strongly. The Baroque Cycle is to science what the Lord of the Rings is to fantasy. Fantastic read!

A Wing in A Wind Tunnel, from Chris Cooper

I recently returned from a month in the Philippines and Vietnam, and one of the highlights of the trip was learning how to drive competently in such alien conditions. For example, I spent a lot of time in General Santos, a city of about 500,000 on the island of Mindanao. GenSan has only one traffic light, and it doesn't work, anyway. The roads are packed with bicycles, tricycles, motorbikes, "cyclos", cars, and trucks, and the widely varying speeds mean that you are passing somebody, or being passed, every few seconds. And of course, there are people, dogs, kids, pigs, and buffalo wandering onto the road at random. You have to drive with one hand on the wheel and one on the horn, as the horn is used to warn pedestrians and slow traffic that you are about to hit them if they don't move over. The concept of traffic lanes is a very fluid one, but at least the slower traffic tends to stay to the right. I also did a lot of motorcycle riding on dirt roads in the country.

In Vietnam, you cannot yet rent a car, which would probably be a very bad idea, anyway. But you can rent a motor-scooter if you are brave. The traffic, especially in Saigon, is incredible. What used to be a human flood of bicycles is now the same, but faster, on scooters. If you go too slow, you die. If you are hesitant and unpredictable, you die. If you don't react quickly when cars and trucks try to squeeze you out of the way, you die. For me, driving in Vietnam was exhilarating, but for my partner riding on the back it was terrifying. Crossing the street on foot is also a mind-expanding experience. Since there are few traffic lights, and no crosswalks, there is only one way to do it. You have to just step out into the middle of the flowing traffic and trust that you won't be hit. Just keep walking slowly and predictably, and amazingly the traffic flows around you. It reminds me of smoke flowing around a wing being tested in a wind tunnel. I did see some accidents, though. Usually they were motorcycle riders, and since helmets are rarely used, accidents can be traumatic. I don't know if the lack of traffic lights, laws, and cops makes people better drivers. Maybe it is just survival of the fittest. It is a fun adventure, but I must admit that modern traffic engineering leads to faster, and probably safer, travel.

More Carly Haiku, from Gary Rogan

Snub at AT&T.
Metioric rise at Lucent.
Trust first impressions.

She may take a stab
 At politics after her stab at business.
And Lucent stock price.

She still has so much to offer.
550 local business leaders
Can't all be wrong.

Trader Bob, from George Zachar

Alternative Minimum Tax Targeted
Democrats Seek Fix For Middle-Class Families

By Lori Montgomery
Washington Post Staff Writer

"You cannot solve this nation's fiscal problems without increased revenue," Robert E. Rubin, the Clinton administration Treasury secretary, told the Economic Club of Washington this week.

Federal revenues, from Bloomberg:

Fed Budget
2406.4560  Billion
HI 2406.4560 ON 12/31/06

12/06  2406.456
12/05  2154.305
12/04  1879.783
12/03  1782.108
12/02  1853.173
12/01  1991.194
12/00  2025.218
12/99  1827.454
12/98  1721.798
12/97  1579.292
12/96  1453.062
12/95  1351.830
12/94  1258.627
12/93  1154.401
12/92  1091.279
12/91  1055.041

Over the past 15 years, Federal revenues have increased a full 128%, more than double the increase in CPI over that span, and more than seven times the rate of population increase.

If increasing flows to Washington at seven times population growth didn't "solve this nation's fiscal problems," I would dearly love to hear what level of taxation the senior Democratic economic advisor thinks would do the job.

Gary Rogan comments:

The "income redistribution" wing of the Democratic Party didn't waste even a week in asserting itself. After propelling its fiscally radical leadership to the top of the party hierarchy by the clever trick of running moderate and conservative Democrats in a large number of elections, and capitalizing on the newly profligate spending habits of the Republicans as well to the dissatisfaction with Iraq, the logical solution is to:

This will of course create such serious fiscal problems that it will not be possible to solve them without increases in revenue, thus proving Rubin right beyond the shadow of a doubt.

A Letter from the President of the Old Speculators Club

I was watching CNBC over a bowl of cereal a short while ago and Pisani said something along the following lines: "The S&P cash hit 1388 or 1389 again this morning and backed off. This is about the seventh time this has happened." I don't generally follow information like this but have seen lengthy List conversations about various indicies at various levels (including "the round"). First, is Pisani's information accurate (or at least close)? Secondly, is it indicative of anything important? I've heard much of "levels of support and resistance" but am not sure that they, or double and triple tops, are significant (it wasn't that long ago that Dow 11350 was being watched as an area of resistance - obviously it has been overcome).

John Bollinger replies:

I find repeated visits to a level, line, band, etc... useful as 'logical places' to take decisions. This is the sort of thing that is hard to 'count', but relatively easy to trade. Some of you may know Fred Wynia, it was he that taught me the importance of making decisions at 'logical places'. I put 'logical places' in quotes as it is Fred's term.

Dr. Phil McDonnell replies:

Pisani is accurate. The previous 6 dates and highs are:

11/13  1387.61
11/8   1388.92
11/8   1388.61
11/7   1388.19

10/27  1388.89
10/26  1389.45

So this morning's high made the 7th such high in the 1387-1389 range.

Under the category of knowing one's adversary I would note that there has been a long term up channel which one can draw on a chart over the last few years. The tops of significant rallies appear to be collinear, so drawing a line through them gives an upper limit to the channel for chartists. We hit that line on 10/26 at 1389 (or so) on the SnP.

Note that the line is an up sloping line but it has a much more gradual slope than the recent advance from the June-July lows. I would put this in the same category as round numbers and other such things which cannot possibly work but do. Human beings are superstitious and those who look at charts may sell at such junctions 'just to be safe'.

Operant Conditioning, by Victor Niederhoffer

The Hawaiian polymath James Sogi recommends Coercive Family Processes by Gerald R. Patterson. The book discusses how to measure and study aggressive behavior, and has already lead to great controversy in my family, as it recommends an authoritarian approach to raising children by removing what kids value, e.g. attention, when they are bad. Don't give them attention when they cry. Removing the attention is called negative reinforcement. The whole subject of how we behave when faced with stimuli of various kinds, with selling and buying being the behavior, and the environment, e.g. an economic announcement, a vivid change in a related market, or a backdrop of staged conditioning by the Fed Commissioners, would seem to call out for study and testing. This introduction to operant conditioning provides a nice summary of the kinds of things that behavioral psychologists study and might open up some fruitful lines of inquiry. A good reference to Patterson's work can be found here.

In examining the diverse bodies of stimulus and response schedules covered by behavioral psychologists, one comes away with the impression that the grass is always greener on the other side and that if instead of following the promiscuous theories of cognitive psychology, that have a hypothesis for any seemingly irrational behavior, (albeit most of them are completely rational and based on rules of thumb that people in real life as opposed to college students for a buck an hour would choose), the often validated and completely specified studies of operant conditioning would be a much more fruitful line of inquiry for market people. One feels he is one the right track here as "Operant Conditioning" and "Stock Market " is almost a Google whack at 337 mentions but "Operant Conditioning" "Cognitive Psychology" has a promiscuous 38,700 mentions.

It would be good to take the basic two by two table of operant conditioning and classify it by fixed ratio, fixed interval, variable ratio, variable interval, and see how these relate to predictive patterns. For example: bonds up/ stocks down, a positive reinforcer when it occurs at a steady rate with little variation (fixed interval) versus when it occurs with great variability (variable ratio). But bonds up/ stocks down, if it occurs at an unsteady state, it is an example of a positive punishment variable ratio. All the predictions of operant conditioning could be tested in the real world of humans with prices in markets, instead of on rats.

(behavior increases)
(behavior decreases)
(something added)
Positive Reinforcement:
Something added increases behavior
Positive Punishment:
Something added decreases behavior
(something removed)
Negative Reinforcement:
Something removed increases behavior
Negative Punishment:
Something removed decreases behavior

Source: "An Animal Trainer's Introduction To Operant and Classical Conditioning"

Alston Mabry Replies:

As I understand it, in animal learning trials, if you put the rat in the cage with the little lever, eventually, in the process of exploring the cage, the rat pushes on the lever, and there is some possibility that a bit of food plops out. The process repeats, and the rat learns to associate pushing the lever with getting food.

Interestingly, if what you want is for the rat to push the lever a lot, you provide the food reward only intermittently and randomly. If the food is provided each time the rat pushes the lever, the rat will push the lever only when it is hungry. However, if the food appears only occasionally when the lever is pressed, the rat will press the lever over and over, brimming with anticipation.

Now let's assume the Mistress is a master trainer, to her own benefit. She places the rat (trader) in it's cage (home office with high-speed internet access, TradeStation account, etc.) and waits until the rat discovers the plastic keys on the keyboard and starts tapping them. Then she provides the rat with a food pellet (profitable trade).

If the Mistress wants the trader/rat to trade as often as possible, she will reward the trader/rat with a profit (food pellet) only intermittently and randomly. If the trader/rat could get profit/food any time it pleased just by tapping the keys on the keyboard, then it would tap the keys only when it needed money. But because it is actually the Mistress who is in control, and she wants to maximize trading behavior from each rat, she keeps the rewards as random and unexpected as possible.

In fact, "unexpectedness" is one of her most important tools. By the Rescorla-Wagner model of conditioning, the greater the unexpectedness of the reward, the higher the associative strength of the learning. This is why it is so effective for the Mistress, after a rat has tapped the keys many, many times with no reward at all and become convinced in bleak despair that no further reward is possible, to toss a nice food pellet into the cage and provoke the rat to even greater efforts.

Russell Sears responds:

This is of course the opposite of what is recommended for a baby totally dependent on the parent. I find this one of the greatest challenges of parenting, determining when to use negative reinforcement to cut off the dependency. And looking around to family and friends, especially with young adults, it seems many have never truthfully acknowledged this.

Steve Leslie adds:

This is exactly the foundation of slot machines. Intermittent rewards promote more activity on behalf of the participant. The theory is that if one gets rewarded on equal installments the activity is seen as work, whereas if one receives an intermittent reward then it is seen more as recreation.

This is also how companies motivate their salesmen and saleswomen. They conduct sales contests but they do it randomly. It is one way that the company keeps the salespersons attention. Brokerage firms were famous for offering sales contests during the summer months, typically the slowest months for commissions to keep the brokers working and keep the revenue flowing.

Here is a sidebar to this discussion. In Las Vegas, if a casino advertises that they give a 99% payout on their slots, then they must pay out on average the machines that they have posted to pay out that amount.

This does not mean that every slot machine in the casino pays out 99%. It applies only to the bank of machines that are listed as paying out this amount and the patron has to look long and hard inside the facility to find those.

What this does mean is that if you took a large enough sample size for example a $1 slot machine and played this machine forever and each individual were to put $100 in and no more, taken collectively they would receive back $99 on average.

Now statisticians will tell you that everyone who plays slots will eventually go broke. The reason for this is that people continually take their reward and plow it back into the machine until eventually they have spent their full bankroll. Therefore the machine will collect everything, it just takes longer if the payouts are higher.

This applies to all other games as well including roulette baccarat and dice. Even though you can approach almost even money odds such as betting the color on a roulette wheel, the player only on the baccarat table, and the line on the craps table, if you keep playing them long enough you will lose your entire bankroll.

Jay Pasch replies:

Markets are authoritarian, nature is authoritarian, society is authoritarian, the world they're going to live in is authoritarian, "ya gotta serve somebody" as Dylan would say. Of course there is great benefit to self and others in going against at times, i.e. Thoreau's Civil Disobedience, the rebel call, et al. But on the battlefield of child-rearing, relieving one's self of authority is like dropping one's arms on the field, and pants, and waiting to take one between the... eyes. What works best for the young warriors is that they have 'contracted' to decency and respect with all of the ensuing benefits and luxuries given their meritorious behavior; but break the contract and it is they that surrender their benefits, rather than the mindset that some sort of entitlement has been 'taken away'. Under this arrangement the kids have buy-in, they feel important, creative, their ideas beneficial, because they were asked to help create their world in the first place. They see clearly the reality of their own behavior, understanding it was they that surrendered their privileges rather than the big bad general removing their stripes...

Daniel Flam replies:

It would seem to me that all education revolves around pain. So you say we can't "flik" the kids? Ok let's give them a mental pain Like take away something they like, put them in the corner, its like the way the intelligence interrogators in the western world operate under the democratic laws, we just find a better way of inflicting pain in confines of the law...

I find the same with the market... which bring an old adage... "No pain, no gain"

How would we go about studying pain in the market?

Steve Leslie replies:

First let me say that "No Pain No Gain" is a very dangerous statement. Physical pain while training is an indication that one is approaching a physical limit. By going too far, one can instill permanent damage. Only a fool would feel a muscle tearing during a set of lifting weights and continue to lift weights. Now there are minor aches and pains that an athlete must endure however there are limits that the body can withstand. An athlete who is in touch with their body is well aware of the difference.

I am sure my good friends Dr. Goulston and Dr. Dorn are much more qualified than myself to comment on this subject matter and I hope that they do weigh in.

However, there are three distinct subjects here.

Giving a child an iPod for excellent grades is positive reinforcement. Withholding a reward from a child or taking away privileges would be negative reinforcement. Yelling and/or corporal punishment would be forms of punishment

They are very different.

The problem with punishment is that it has a very short term result. And repeated punishment eventually will result in no positive result whatsoever.

Please forgive me for probably misrepresenting this study but here goes: There was a famous study performed where an electric grid was installed in an enclosed box. Mice were placed in the box and half of the box was shocked. The mice went over to the other side away from the pain. Then a barrier was installed so they could not move from one side of the box to the other. Then the mice were shocked. They initially tried to escape to the other side. However the barrier would not allow them to move over. After repeated shocking, the barrier was removed. The mice were shocked yet they did not move over to the safe side. In effect, they were conditioned to just sit and take the pain.

Think about this: When your dog runs away and you beat it. That is punishment. If the dog runs away and you beat it again it will be trained to stay away. If you beat a dog long enough eventually it will just lie there and allow itself to be beaten.

This is shown dramatically in abused wives. They become beaten physically and/or mentally and that if this occurs long enough that eventually they just sit there and continue to be beaten. And should someone come along and offer them sanctuary, the abused wife will chose to stay with the abuser.

Someone once said you train animals but you teach children.

If you really want to go into deeper understanding of this, I recommend an exceptional person Dr. James Dobson either in his numerous books on this subject most notably Love Must Be Tough. He also hosts an extremely informative radio show entitled Focus on the Family. My church radio station broadcasts this as do many Christian radio stations around the corner. He is seen very regularly on Fox shows such as Hannity and Colmes.

Daniel Flam adds:

Having spoiled brats that everyone in the room hates to be around because you don't want to put them in their spot, Will just delay the point in time where someone that is not a family member will put him in place in a most unpleasant way.

Bringing up Children is like painting a work of art. You must use all the colors of the spectrum, although some colors should be used a very small dose, or you might get an ugly result.

I see additional factors to the one suggested:

Today we find names for anyone who doesn't behave like a sedated rabbit.

This reminds me of that shirt "I hate it when people think I have ADD! Oh look, a chicken!"

James Sogi replies:

Rather than 'greed' and 'fear', counting, like behaviorism, is more scientific. Quantify to predict. The market trains everyone to do the wrong thing. When one is trained to go long, the market goes south. When one is trained to play the range, it breaks out. Of course it trains one in the just the most intermittent and thus most powerful manner, like slots, to go the wrong way. It is called variable reinforcement. Counting gives the clue that the training is in play and not to follow the masses and to stay a step ahead of the market. Be the trainer not the trainee. Who is in control here after all.

Little babies train their parents. It is the brat in public that has the haggard parent running around like a chicken. Both are miserable. Proper training involves the use of love attention and affection. It is not the rats-in-a-box syndrome. The natural reaction is to run to the crying baby. That merely reinforces the crying. The natural crying pattern has variations. When there is a break in the first few moments of crying, use that moment variation to sooth the child. The reinforces the calm not the cry. Inconsistent parents give mixed signals can cause confused children, unhappiness. Consistency give certainty and clearness to the child. I tried to see how many days we could et my kids without crying. How many times per day would they cry? Why did they cry, what were the operant conditions? Quantify the responses. Forget the mumbo cognitive jive.

In the market, the public rushes to the upsurge, but is this the correct response? When the market tanks, the public trained panics. Again, scientists, is this the right response? Quantify one's own responses to get an idea of what works, what doesn't. consistency brings profit.

J. T. Holley reminisces:

My PaPa would espouse to me "the grass might be greener on the other side but someone has to mow and rake it too" whenever I would act like those cognitive psychologists! I think the operant conditioning like B. F. Skinner is appropriate for those dealing with the markets. The classic philosophy (shortened and brief) is that Plato felt to "know the good was to do the good", whereas Aristotle had a more operant conditioning belief in that "to do the good was to know the good".

Russell Sears suggests exercise:

What the kid needs is an outlet for his energy. Have the kid run a few lapse, go a few miles on his bike, or even shoot some hoops. I would suggest, that what Lackey encourages his kids to do has more to do with his kids well adjusted behavior . Lackey little league, and coaching wouldn't see these kids. Kids with no competitive outlet, takes it out on the adults. Exercise generally works better than any drug for mild depression. But what Doctor will prescribe 2-3 miles run everyday for 2 months to a single Mom for her kid. Its called "child abuse". But giving him mind altering drugs, to a developing growing brain, is called "therapeutic care."

Pamela Van Giessen laments the loss of just being a kid:

This seems to be part of a larger issue where every single moment of childrens' days are being structured and moderated by adults. There is school, soccer practice, swim lessons, judo, music lessons, play dates, etc. It's kind of like jail. Even worse because at every turn there are adults loitering, supervising, and otherwise keeping a watchful eye. I call them helicopter parents. They mean well, but I can't help but be eternally grateful for my parent's lack of vigilance. I read an excerpt from John Dickerson's book about his mother, Nancy (first female TV news star), where he noted how absent his parents were and that he and his siblings were often left to their own devices, and how, in the long run, that turned out to not be an entirely bad thing. My American nephews are supervised 24/7 and while they are smart and adorable children, I notice that they are more prone to temper tantrums and the like. My Dutch nephews roam free; they rarely have a baby spell. And, honestly, the Dutch kids seem more creative and amusingly naughty. I like children who stick carrots up their nose at the dinner table, provided they are stealthy and quiet about it. Kids don't put up with other kid's temper tantrums and so children who hang out with children stop behaving like brats -- at least if they want to have friends.

At the age of seven, I was biking a mile to go get candy. I rarely see children about my 'hood without adults. Can't they even go to the bodega without Mom? At what point will they not be supervised and watched over?

I've also noticed that the young women (oh, how I hate saying that) that work for me seem to approach their jobs, careers, and even daily to-do list like a school exam that they must ace. They miss the larger point about spontaneity, about creating, about doing as you go and it all becomes about getting an A and moving on to the next "test." They also seem to structure their lives accordingly. From x-time to y-time is work time, from z-time to a-time is not work time. One hopes that romance isn't scheduled so rigidly.

When I think of all the wonderful experiences and successes (and even some failures) I've had by being spontaneous, by looking in rooms I wasn't due to be in, by not scheduling my life with much structure it makes me sad to see us creating a society of automatons.

Nat Stewart adds:

One of the most worrisome trends in my view is the "bans" on student organized, spontaneous recess games, which for me were always the highlight of the day in the early grades. The spontaneity and sense of it being "ours" and not a teacher/instructor lead activity also increased the value and fun of these activities.

I think for many kids this type of vigorous exercise is almost a need or requirement, It certainly was for me.

Kids who are naturally curious, such as this kid in the article who is a "gifted reader" need independent outlets to exercise their own curiosity, and opportunities for individual study and thought.

I think many of these kids are just bored stiff! The extreme bureaucratic environment is not a good learning environment for many children.

Kid can use logic, and I believe many start to rebel and have trouble when they are repeatedly asked to do things that they do not find logical. "Johnny has a problem..." Well, maybe he is mad that so much of his day is wasted in useless, pointless, mind numbing activities? Maybe he would rather be off on his own, reading a book. Kids can be sensitive to injustice, and little things over time poison can poison ones attitude to the entire process or system, which is unfortunate.

All kids are different. Labeling children with 1000 different Disorders is only a smokescreen that hides our severely dysfunctional system.

Profess Gordon Haave replies:

I would suggest that what is wrong with the children is nothing... except a total lack of discipline and their learning at 5 when taken to a psychiatrist that being crazy is normal and they can do whatever they want because they are not being bad, they are "sick".

Another good thing about Oklahoma: I don't know anyone who sends their kid to a psychiatrist. Kids get discipline, hard work, and an ass-whupping if they do something particularly egregious.

November 11, 2006 Troubled Children What's Wrong With a Child? Psychiatrists Often Disagree By Benedict Carey
Paul Williams, 13, has had almost as many psychiatric diagnoses as birthdays.
The first psychiatrist he saw, at age 7, decided after a 20-minute visit that the boy was suffering from depression.
A grave looking child, quiet and instinctively suspicious of others, he looked depressed, said his mother, Kasan Williams. Yet it soon became clear that the boy was too restless, too explosive, to be suffering from chronic depression.
Paul was a gifted reader, curious, independent. But in fourth grade, after a screaming match with a school counselor, he walked out of the building and disappeared, riding the F train for most of the night through Brooklyn, alone, while his family searched frantically.
It was the second time in two years that he had disappeared for the night, and his mother was determined to find some answers, some guidance.

Steve Wisdom responds:

The long-time sense of the word "discipline" was to instruct, educate, train. It somehow became twisted (as has the word "liberal") to mean, in common usage, Prof. H's "ass-whupping."

What does an "ass-whupping" instruct or educate? Well, it teaches that if you're frustrated, angry, tired or stressed, and have the advantage of being bigger and stronger than the other guy, then it's OK to indicate your frustration with verbal or physical violence.

Is this the what a parent wants to teach?

"Discipline", in the bastardized sense of the word, means the parent has failed. Failed to authentically instruct, educate, train. And is now lashing out, motivated by frustration, not by a desire to educate or improve the child. The parent's reptile brain is in charge.

And what becomes of kids who are beaten into submission for 12, 14 years.. But then become teenagers? How will they conduct themselves "out of eyeshot" of their parents, when their parents are around to "control" them with "discipline"?

What actually does work in parenting -- since "discipline" doesn't -- is spending time with kids, and most especially, meeting them at their level, not at your own. Becoming engaged in their lives, their interests, their hopes, fears, dreams. Really hearing them, rather than lecturing them.

My kids have never been "disciplined", and many parents in our town have commented to us that there are -- far from being "undisciplined" -- among the kindest, most thoughtful little boys they've met. The proof is in the pudding.

Profess Gordon Haave replies:

Although, as I have said, I don't believe in Ass whupping, I don't think what you are stating is correct. In its simplest form, it is the most crude way of stating "actions have consequences". Most of this on this list know that there are better ways of teaching that then ass-whupping, therefore they don't do it. Around here in Oklahoma, it is probably not very common, but was even just 15 or 20 years ago.

Now, what goes on in NYC is simply the opposite message, that actions don't have consequences, that nothing is your fault, that if you look out the window during class or talk back to your mother you have a problem that needs to be medicated.

Mr. Wiz suggests that those who receive an ass-whupping grow up having learned the wrong lessons, etc. I submit that it is better than the weirdos who grow up thinking that actions don't have consequences. They are more prone to destroying families and societies, in my opinion.

So, I will restate: Ass-whupping is preferable to the NYC psychobabble approach, even if it is crude in its own right.

Stefan Jovanovich replies:

The "ass-whupping" meme seems to me more than a bit overdone. Striking a small child is like beating a cat. Children are small creatures compared to us adults, and they spend most of the years up to the age of puberty navigating around us comparative giants. Simply restraining them physically - holding them still - is enough physical punishment for "acting out". What was notable in the article about poor Paul Williams is that his father - the person most likely to have the physical strength to be able to hold him still - is nowhere mentioned.

You can step on a cat's tail, and she will instantly forgive you even though the pain was excruciating. Intentionally strike the same animal with one-tenth the same force, and she will view you as an enemy until the day one of you dies.

I agree with Gordon's skepticism about psychiatric diagnoses. Since they almost always have no clinical basis in blood chemistry or any other quantifiable physical symptom, they are usually like visits before the parole board. The patient - i.e. prisoner - has to reassure everyone that he is "sorry" and will make a sincere effort towards "rehabilitation" - i.e. sitting still in school.

My Dad's theory was that compulsory education was invented so that the adults could find somewhere to warehouse the children during working hours. In his darker moments he also speculated that it was an expression of society's underlying belief that poverty was a crime. Since almost all children were destitute, society was simply doing what it did with other criminals - locking them up and then pretending that incarceration had some useful purpose.

GM Nigel Davies responds:

I agree. And given that one of the tenets of libertarianism is to remove physical force and coercion from human affairs, this seems to be given quite the wrong message. I strongly suspect that kids who get beaten will tend towards an authoritarian attitude to life.

There are more creative ways to instill discipline, such as gaining a child's attention by showing them something that actualky interests them and using a system of reward and punishment based on what they like to do. If good behaviour is rewarded it represents a trade and fosters an attitude to life based on exchange rather than force.

The President of the Old Speculators Club replies:

I recently read an article with a darker view -- suggesting that Americans who send their children to public schools are allowing the "state" to "kidnap" their children for 8 hours a day. Hours in which they are taught what it is believed they should be taught, and shielded from those things that might make them less than docile, cooperative citizens. The goal is to produce individuals who will view governments the provider of all solutions.

Roger Arnold replies:

When I was a boy, getting a butt tannin from time to time was a part of growing up, as it was for everyone else I knew. I can still hear the sound of my father's belt as it is pulled through his belt loops. My mother would send me and my brother to our room with a pronouncement of "wait til your father gets home", and we would sit in there laughing and joking until we heard the front door open -- and oh my god that's when the terror began.

Nowadays we joke about it at family get togethers and, although I have never raised a hand to my own child, I can understand the utility of the spanking as a tool of nurturing.

Jim Sogi adds:

The characterization as 'authoritarian' places the wrong emphasis. The reason is that firstly operant conditioning is not necessarily controlled by parents as the authoritarian and that secondly rewards are more powerful than punishments. Everyone is subject to operant conditioning regimes, some of which they may be aware, but also by many others of which they are not aware. There are in fact random conditioning regimes that wreak havoc on the unsuspecting. The result is superstitious behavior and the development of personal "issues" and psychotic behavior due to the various random influences at work creating random patterns in people without their knowledge. We see this in the markets daily. When one is not aware of the theories of social learning, feedback loops can be created that are destructive and create bad habits. When one is aware of feedback patterns in social situations one can control the bad influences and foster the good. A human cannot opt out of conditioning regimes. They exist everywhere in the family, in society, at work, and also as random elements in daily life. The question is not whether social learning takes place, the question is which regime is going to dominate your development? The random crying of a baby? The whims of a teenager? The random flow of traffic? Or the structured goal oriented regime of successful adults in the pursuit of happiness. To believe one is not conditioned every minute is denial. The question is who is doing the conditioning and to what ends?

In the delightful and hilarious book, Taxonomy of Barnacles by Galt Niederhoffer, read during the last vacation, the issue posed by the author was whether nature or nurture were the determining factors in the success of a person. This issue has been a great debate in our family and I agree with the author that nature is the predominant influence, and that we in fact are subject to many of the same traits our grandfather's displayed to a remarkable degree, and that conditioning might try to guild refined gold or paint the lily, but the mold is cast genetically to a much greater degree than most are willing to admit.

Steve Leslie offers:

Jim, you have nailed what I find one of the most difficult aspects of trading. If I open a trade and the price goes the direction I want, I feel rewarded; if it goes the other way, I feel punished, but these feelings have little to do with actual success. Success is trading when, and only when, one has an edge. Individual trades may not be profitable because of variance or because the hypothesized edge is illusory or has fallen prey to changing cycles. Success is managing risk so that, after the inevitable setbacks, one lives to fight another day.

Quote of the Day, from Victor Niederhoffer

"The fund will be people of limited income, employees, and others, this groups matters most to me . If they win then this is their luck, with God's will, and if they lose, then their capital is preserved with us" -- Saudi King Abdullah in commenting on his implemented plan to allow 3 Million investors, out of their 10 million population, to invest risk free in the face of a 50% drop in marriages this summer in Saudi due to the 60% decline in the stock market in which 50% of the population plays.

J. T. Holley replies:

A Google search of the words "Saudi Arabia Market Crash" produces 969,000 hits. If you read any of the articles and also look at the headlines scrolling down you'll see the same "editorial propaganda" as if it was here in the States. The Body Snatchers have no borders!

A Perspicacious Spec Reads the Newspaper, a Continuing Series

Hedge Manager Is Almost Famous
Published: November 14, 2006

Managers of billion-dollar hedge funds do not usually drive Hondas -- except at Goldman Sachs, that is. Traders at Wall Street investment banks are now priming themselves for another big bonus haul this year. And Raanan A. Agus, the manager of one of Goldman's largest internal hedge funds, and the owner of a Honda minivan, will be in line for one of the richer paydays.

This puffpiece on a Goldman trader in today's New York Times lacks a discernable "news peg". Anyone have a theory as to why the agenda-driven broadsheet would run a story like this?

Gregory van Kipnis replies:

NYT does human interest stories, usually about the downtrodden. However, perhaps the angle is that there have been so many stories about hedgefund types who live rich, conspicuous (and sometimes dishonest) lives they (Goldman Sachs) felt it is time to show a counterexample to minimize public backlash.

Kris Humbert adds:

There is a new TV soap-opera/series that will stereotype hedgefund managers. Among the images to be broadcast are self-praising or youthful managers with advanced degrees, arrogance in winning at all costs, overcoming defeats and obstacles, and of course media stardom, all with a lack of humility and humor...

Ivy League Basketball: An Example of Market Evolution, by Nicholas Marchitto

As an undergrad at Yale I entertained two passions-Ivy League athletics (particularly basketball) and markets. The former drew me to nearly every contest in New Haven and its vicinity while the latter compelled me to keep a close eye on game lines and eventually pursue a career in investing. After following Ivy League Basketball for nearly two years and always being cognizant of each game's spread, I began to find wild inefficiencies in certain contests. My thesis was that because Ivy League Athletics, particularly basketball, were not televised or particularly well covered in the press, the market was relatively inefficient. Having followed the teams for nearly two years and watching each team play in New Haven, I believed that I had a fair amount of differential insight and could take advantage of the inefficiencies offered. For the next two years I played specific contests where I thought the spread to be wildly inaccurate and was successful to the point that I was able to pay for my textbooks in both my Junior and Senior years with my winnings.

After graduation, I decided to revisit my thesis, with the belief that I would continue to bet on contests. However, I noticed that during the 2005-2006 season, spreads seemed to be relatively fair and I was having trouble finding those ridiculous spreads that screamed of opportunity. I attributed this to increasing media coverage of Ivy League contests-particularly television coverage on YES and ESPNU of many Ivy League games. In an effort to test my thesis, I compiled empirical data. Unfortunately, I had a rather limited data set (the last 20 contests of each Ivy League team) and so could not look at the relative efficiency of the market pre-coverage and post-coverage; interestingly, however, the data suggested another opportunity. Eliminating overlapping contests and including contests outside the league, I have 104 observations. Collectively, Ivy League teams won 48.1% of games vs. the spread, roughly in-line with the 50% you would expect in an efficient market. Yet, in -- of the observations, the collective score of the game exceeded the Over/Under line (estimate of total number of points to be scored in the game) published prior to the game. This is an important observation, one that leads me to believe that deep-seated biases, particularly the belief that Ivy League affairs are always low-scoring defensive battles, are manifesting themselves in the spread makers over/under decision.

Markets will always evolve, but it is important to remember that the demise of the status quo does not portend a similar fate for opportunity.

On The Wrong Foot, from James Sogi

When you start out in a game, a fight, a competition or a trade and right off the bat make a mistake or two, it puts you "on the wrong foot". It's a stumble coming out of the gate. You are in bad frame of mind because of making errors. You are fighting to catch up. These two factors set you off balance, not on the right foot, not leaning forward into the trade, off balance slightly, unable to attack strongly at the prime opportune time to attack when the opponent is weak and also off balance. These problems are compounded by distance and time. In longer term events this balance issue is critical in maintaining the correct mental attitude. Then at the end of the trade, you are so glad to be past the trouble caused by the original errors, you end badly as well. Champs don't make mistakes right off the bat, or if they do, can overcome them and put them behind, make the extra effort and come from behind. That's what makes them champs. How do you fight back, when you are weak, and behind?

In everyday endeavors, a regular discipline can help avoid the occasional errors. Errors are going to be part of every human endeavor, so it is important to be able to work with the situation and come out productively in the end, especially in areas that require judgment calls. Perfection is not possible. Admission of the error is important. Denial can cause further, irreparable damage.

Peter Earle responds:

With respect to preparation, and since you mention fighting -- an apt field, indeed, for cultivating trading metaphors -- I am reminded of an old boxing truism revolving around coming in dry: part of the informal intelligence casually gathered by cornermen (and sometimes fighters themselves) on the way to the ring and while waiting for a fight to start is whether the man across the ring is perspiring or not. This can sometimes give a clue as to how seriously he is taking the match/his opponent, how adequately he has warmed up, and even his level of anxiety.

If one's opponent appears to be dry, sometimes -- depending upon how he is known to perform under pressure -- the game plan can suddenly shift; not, as may have been planned, to engage in a multi-round chess game, applying increasing pressure, but instead to come in with guns blazing at the open.

Though examples are numerous, I'm reminded of the mid-1990s undercard fight between John Ruiz, who would eventually become WBA heavyweight champ, and David Tua. Tua's corner, noting Ruiz's stiffness and lack of perspiration, urged Tua to jump on Ruiz right at the open... with resounding success.

David Lamb replies:

Frederick the Great started off on the wrong foot, but he never thought so. He just retreated for a few weeks, came back after doing some readjustment at home in Berlin, and accomplished what he first set out to do.

During his first campaign (at the ripe old age of 29) he led (very literally) a part of a two-columned Prussian army toward Neisse, the strongest Austrian fortress in Silesia. I now quote from the book on Frederick the Great I am reading (written by David Fraser):

"Both wings of the Prussian army ultimately converged on Neisse, where they found an Austrian garrison prepared to resist. There could be no question of exposing the troops to methodical siege operations in the conditions of winter and after trying, without success, intimidation by a ferocious ten-day bombardment, Frederick decided to leave Neisse... to return to Berlin, which he reached on 26 January. He had lost only twenty men in all."

While back in Berlin he acted as if all was going as planned. In other words, he seemed not to worry too much about momentary setbacks. He acted as if they were the undesirable fatty parts of a great T-bone steak: He wouldn't eat it, but regularly expected it upon ordering a steak. He even wrote all the neighboring Kings and Emperors that everything was going great and they could back him up or not. He acted alone, acted first, and never hesitated. But he never gave up once all his homework was done and all the data was aligned his way.

Furthermore, perhaps Frederick never felt he was fighting back, or on the wrong foot, or playing catch up. Perhaps the feeling of vulnerability and weakness and initial loss is what places the competitor at a disadvantage, not necessarily his actual numeric disadvantage.

Stefan Jovanovich responds:

Christopher Duffy, an exceptional scholar, wrote a fine book on Frederick the Great. I have not yet read Duffy's new book on the Somme, but the people I trust think it is the most important book on WW I in decades.

Carly Haiku, a Continuing Series, by George Zachar

Fiorina's Winding Road Points to an Uncertain Future

Monday, November 13, 2006; Page D02

Carly Fiorina knows what it's like to be an outsider. The law school dropout started her career as a secretary in a male- dominated business world. She was initially rejected by the University of Maryland's business school, was once referred to as the "token bimbo" at her job selling telephone service for AT&T, and later became the chief executive of Hewlett-Packard.
Carly, Georgetown part-timer,
tries "pity me" tack.

She works the lecture circuit.
Oh, she's lonely too.

Playing With House Money, from Ace Siegel

Rafe Furst of FullTiltPoker states that each chip in a short stack is worth more than same amount in big stack and should be played more carefully (e.g. you might fold a 50/50 shot with short stack whereas you'd call with big stack). I wonder if there is analogy to money management. Should a certain amount of risk or certain trades not be taken when fund is short stack vs. big stack?

Fedwatching, from George Zachar

Fed chair Bernanke's speech, "Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective" is simply a litany of failures by the central bank to understand its own core product: money.

Kudos to Bernanke for his clear-eyed ability to acknowledge failure... but would you take your car to a mechanic who said that despite decades of study, he still didn't understand engines?

The Age of Gold: The California Gold Rush and the New American Dream, by H. W. Brands, reviewed by Stefan Jovanovich

J. S. Holliday's scholarship is Brands's primary source for the actual details of the Gold Rush. The Age of Gold is a decent overview, but it has more than a touch of the Stephen Ambrose disease -- why let the stubbornly complex and contradictory facts get in the way of a grand historical thesis? Like Peter Green, Holliday is that rarest of all humans -- a completely open and honest writer, scholar and teacher who is without prejudice or animus.

All the Same, from Kevin Eilian

SEC Plans to Raise Hedge-Fund Investing Requirements

Nov. 10 (Bloomberg) -- U.S. Securities and Exchange Commission Chairman Christopher Cox said the agency will propose rules next month making it harder to invest in hedge funds. "We're going to make it very clear that hedge funds are risky investments that are not for mom and pop by fencing it off with higher standards to accrediting investors," Cox said in an interview today.

Nice meme imagery, "We're going to make it very clear that hedge funds are risky investments..."

What does that mean? Leverage? Commodities? Long/short? Short only? Unlevered equity? Fixed income subordinated leverage? Not important. They're all the same!

On Kenneth Fisher, by Martin Lindkvist

I like reading Kenneth Fisher's columns in Forbes and Bloomberg Money (also available on Fisher's own site), and I liked his books Super Stocks and Wall Street Waltz (I have not read his 100 Minds That Made the Market). In early December he is due out with a new book The Only Three Questions That Count (excerpt here). Apart from some inspiration for testing, it seems hilarious.

One of the reasons why I like his writing is that he dares to be different and stick his neck out. It also seems that he does a lot of testing of different hypotheses about the market. His works are full of ideas and inspiration for further testing. But -- the million dollar question -- I have no idea about what his returns have been like. And he has been in the business since 1972 with his own fund from I think the late 70s. He is currently managing $30 billion, so there has to be a long track record somewhere. Can anyone enlighten me?

Steve Ellison replies:

The Political Economist reviewed his book.

"First, what do you believe that is actually false? You may be preventing yourself from making smart investment moves because you're blinded by falsehoods - ones that you get suckered into believing just because everyone else believes them.

Fisher comes up with some good examples of such falsehoods. You probably believe that stocks perform better starting at times when price/earnings multiples are low - and that they perform worse starting when multiples are high. Haven't you heard that a million times? Isn't it the core tenet of 'value investing?'

According to Fisher's research, it simply isn't true. He's crunched the numbers. Over history, it turns out to just not make much difference whether market multiples are high or low."

"The second question is, what can I fathom that others find unfathomable? If you're investing based on ideas that everyone else can grasp, those ideas are probably too stale to make you any money. Go for the things that you think are true - but that everyone else thinks are crazy."

"The third question is, what the heck is my brain doing to blindside me now? Here Fisher walks us carefully through a minefield of cognitive dysfunctions that trick even smart investors into doing very dumb things.

Fisher points out that two emotions rule most investors' souls -- pride and regret.

We seek to build up our self-image by successful investing, rather then treating success as an end in itself. When we do succeed, we swell up with the pride of it and start believing we can do no wrong. At the same time, we will do nearly anything to avoid the shame of regret - that horrible sinking feeling we get when an investment goes bad, and you have to accept the fact that we really blew it.

Fisher says to turn these emotions inside out. Seek regret - that is, embrace your mistakes and learn from them. Shun pride -- invest to make money, not to pump yourself up, and never, ever imagine you are invincible."

J. T. Holley replies:

Vic and Laurel in Practical Speculations (chapter 2) did a wonderful job of illustrating and showing the reader with the added education of Scatter Plots the "Propaganda of Earnings". A fish for a lifetime more importantly was the 7 techniques that came from the book "Fine Art of Propaganda". Since reading the book the two that have come up the most in my observations is Plain-Folking and Bandwagoning. When I read an Ezine or online paper dealing with Finance those two seem to be the most frequent to me or the ones that I find easier to identify.

A Very Strange and Unsettling Day, from Victor Niederhoffer

Tremendous inflation in the air today with gold and silver up 5%, grains having just risen 50% in the last three months, Sage at a new high at 108,400 a share, crude oil up 3% in a week, GSCI commodity futures at a several month high, copper up 2% and natgas up 15% in the last week or so.

Hubris, by John DePalma

Talk of a new stadium for the Oakland A's:

"In what could evolve into a high-profile branding and technology testing ground for Cisco Systems, the networking giant is reportedly close to handing the Oakland Athletics almost 150 acres of undeveloped land for a new stadium.

...The Chronicle reports that Cisco will likely be a major sponsor and could have its name on the proposed $300 million stadium.

Corporate sponsorship of sporting venues is nothing new, but Cisco seems to be especially keen on leveraging a relationship with the A's to go beyond simply attaching its name to a building."

Flashback: "The Wall Street Journal recently documented the inordinate tendency of companies that bought the rights to name stadiums after themselves to fall into bankruptcy, financial difficulties or drastic declines in market value.

...After completing a comprehensive study of every company that named a stadium after itself, beginning with RCA in 1984, we can confirm the gist of the Journal's article."

Memes, from Fred Belsak

One can hardly fail to trip over mantraic forecasts that a Democratic majority is bad for the valuations and fortunes of hydrocarbon-producing/using companies. Contrarily speaking, what if such forecasts are memes fanned by deft teal-tinted uber-investor/advisors seeking to increase their overplusses by playing against public herd movements?

Delays, from Victor Niederhoffer

One of the most common phenomena that those of us who trade every day face is the delayed reaction to an event. Nothing happens when you expect it. For example the positive Employment number, seemingly so bullish, was greeted with a 1% decline from open to close on Friday. and now the election, which on the surface seems to create so much uncertainty among investors, especially vis a vis discredit of the Administration through impeachment forays and propaganda.

These delays in electric circuits are called hysteresis and I've discussed the various negative feedback loops and components that ordinarily are used to create same for practical purposes, e.g. in the Schmidt Trigger, which is very succinctly reviewed in the excellent book by Michael Merchant, Exploring Electronics Techniques and Troubleshooting.

I wonder what the general concomitants or preconditions for a delayed reaction are, whether they are predictable, and whether the seemingly fantastic positive response to the recent Democratic sweep, which was 16-1 on TradeSports from 9:45 am on Wed, Nov 7, and continuously higher at all times subsequent until the current finalization as of 11:00 pm, Nov 7, will be an example of the beaten-favorite/hysteretic reaction, and whether such delays can be predicted with similar events regarding individual stocks and or economic announcements.

Gary Rogan observes:

I don't know how to quantify it but this has been my observation: often if a person or a group of people are acting out of negative emotions, such as anger, frustration, irritation, or boredom after a forced delay, they will go further than a rational observer will expect. Thus delayed action based on negative emotions seems related to hysteresis by overshooting the rational point. The voters have acted out of delayed frustration, so there is hysteresis involved in how that carried over to the markets to the extent that some of the voters are also investors. However when the realization sets in that Nancy and Chuckie will be acting out of a bit of their own frustration, and their "rational" point is a bit displaced from Adam Smith's to begin with, I predict there will be a bit of a chill in the equity markets and it will last for a while. On a separate note, the more "bi-partisan" Bush acts, the lower the markets will go.

Jay Pasch adds:

This election day reaction is reminiscent of FOMC report days but with a wider timeframe; it so often 'seems' on FOMC announcement days there is an immediate reaction, then a brief counter move, followed by the real deal, a trending move in the direction of the initial reaction. Admittedly descriptive and uncounted...

Rick Foust replies:

Years ago, when I watched tick by tick, I noticed the same pattern on FOMC days. A quick knee jerk, then a larger head fake, and then an extended run in the direction of the knee jerk. I suspect it also happens in longer time frames for larger events (such as elections).

The knee jerk could be up or down. It usually lasted only moments and could sometimes only be seen on a tick chart. The head fake was a longer movement in the opposite direction and lasted a few minutes. The final move typically finished out the day. The duration and magnitude of the moves varied from time to time. These were days when the the market treaded water waiting for the the Fed to announce the next interest rate move.

This three step process reminds me of a simple but effective Judo technique. First comes a quick and subtle jerk to freeze the uke (throwee). Then a push to get the uke to instinctively lean against the push and into the throw. Lastly, a long pull to guide the uke through his flight.

A 16 year old Japanese girl appeared at our dujo one day. I had worked with girls before, and I had learned to go easy on them. She was a foot shorter and a 100 pounds lighter. As a warm up, we were to alternate practice throwing each other. Being of the highest rank, she went first. Even though she was a blackbelt, I expected to have to help her throw me (that is, jump). Suddenly, and without warning, I found myself doing an airborne somersault. A split second after that I was lying on my back looking up at her with an astonished look. Her execution had been so skillful that all I had felt was a bump and then weightlessness.

The key to most Judo throws is to stiffen and off balance the uke, fix one part of their body in place and then rotate the rest of the body about the fixed point. A well-executed Judo throw relies more on finesse than strength.

Scott Brooks replies:

I believe the question that Victor is asking is "how do we know how the masses are going to react to news or an event that is possibly a surprise, or at least, not known in advance.

I'll let those who are better counters than me handle the quant side of this. I'd like to explore the personal side of it.

How do I (or you) choose to react to an unexpected event or news. As investment professionals, or as speculators running our own money, I believe that one of the things that is incumbent upon all of us is to be prepared for the unexpected. One of the ways we can do that is to know the numbers....to calculate in advance what are the odds of "X" happening, and if it does, what are the most likely resulting reactions to follow....then....

What do we do from there? There is nothing worse than not being prepared.

My secretary (excuse me, she prefers to be called my "executive assistant") has asked me on more than one occasion if I'm going to be doing any work that day. She'll walk into my office and catch me staring up at the ceiling, or just passing around my conference table, making hand gestures at invisible people.

I tell her, "I am working". I'm role playing in my mind scenario's. I'm trying to cover every possible path the scenario may take. I'm trying to see problems before they occur, and then figure out how to solve them...but solve them in my mind before they actually happen so I don't have to deal with the unexpected later....and if I can't find a solution, I ditch that course of action and move on.

Since I'm up at the farm deer hunting this month, I'll use a deer hunting analogy.

One of the biggest problems that many hunters have is buck fever. When they see a big buck, they come unglued. They can't stabilize the gun, they can't concentrate or hold the crosshairs on the vitals, and in some cases, get so nervous that they can't even raise their gun. In some cases their knee's shake so bad that they can't even stand.

I have never had that problem. Oh sure, when I see a deer, I get excited. If its the buck that I'm looking for, my heart may skip a beat and leap up into my throat.

But then I go into the zone. My mind focuses in on the task at hand. I begin to assess the situation. I wait for the right moment and BAM. I do what I came out to do.

Why is this so seemingly easy for me to do? Because I've killed that buck thousands of times in my mind before the moment of truth came. I've visualized him coming from that exact direction hundreds of times. I know every possible path he could take before moving into a killing position. I've falsified hundreds of situations in my mind and role played them to figure out how to overcome the obstacles (i.e. is the buck alone, or is there another deer with him? What is the wind....blowing to or away from him? etc.).

I practice in my mind slowly squeezing the release on my bow and watching the arrow leap forward at 300 fps right toward his vitals, or slowly squeezing the trigger while staring at the crosshairs right on the bucks shoulder and actually seeing the bullet (thru the scope) hit the deer at the exact spot where I was aiming.

You see, just like I don't know exactly where the deer is going to come from, or exactly what the conditions are going to be when he shows up, market events and news comes at us from unexpected directions and brings unexpected ramifications.

We simply don't know what to expect....but we can role play what to do, have a playbook (that we've thoroughly memorized) ready to tell us what to do, and then execute the appropriate play to give us the highest probability of harvesting the big bucks!

Steve Bal replies:

This would suggest that the news makes the markets. I would suggest that the news is in fact talking points - just as some individuals believed that Kerry's mix up of words would hurt the democratic vote (which we now know did not happen).

I do not trade every day but for some reason watch the business news regarding this number or that coming out. Further, it now appears that revisions happen more often than not (even if not true I believe it) and thus I may act upon it.

Individuals have different trading time frames, along with different strategies. It is times when multiple time frames for individuals coincide that markets can move. This is not support for cycle trading but a recognition of different trading motives. As new news comes into the market, traders then attempt to mesh with older news to reinforce their views of future market direction.

As Vic had previously pointed out when a big pharma increased their dividend (mostly dividend collectors noticed) a few days later they announced a big jump in earnings and the stock promptly moved. Everyone needs some form of extra comfort.

The collective consequences of many traders (individuals) often defy intuition.

Variations on a Theme of Greenblatt, from Prof. Charles Pennington

Victor and Laurel note: A heated debate regarding Joel Greenblatt's "The Little Book That Beats the Market" recently cropped up among our colleagues. Below is some detailed follow-up work from one of our eminent researchers who is as adroit at analysis of single crystal NMR of high temperature superconductors as he is at uncorking the seemingly suggestive system work of hedge fund managers with putative 40% returns. Please note our response, which follows, as well as earlier intriguing commentary which began in early November and is found further down on the site.

I'll report here the results of a study that I did that addresses the results in Joel Greenblatt's book. This study focuses on the large cap stocks that make up the S&P 500 index. Just as in Greenblatt's work, I used the Compustat Point-in-Time database, in which the fundamental data are listed as they were at the time, and not restated.

Greenblatt's ranking method involved both "earnings to price" ratio and "return on capital". For "earnings to price", he actually uses "EBIT" (earnings before interest and taxes) divided by "enterprise value" (market cap + debt + preferred stock), and for "return on capital" ("ROC") he uses EBIT/(working capital + property, plant, and equipment). All these items can be specified using Compustat Point-in-Time.

After ranking stocks separately by E/P and ROC, he then takes these two ranking numbers and literally adds them together, and then finally ranks again based on that sum. He finds that the stocks that have both high E/P and high ROC tend to do well.

Here are the ground rules for my study. Stocks are ranked and then purchased at the end of each quarter, and held in that decile until the next quarter, when stocks are re-ranked. The most recent trailing four quarters of EBIT are summed to find the trailing yearly EBIT. In order to be purchased, stocks must have been components of the S&P 500 as of the start of the calendar year under consideration. As of the purchase dates, their share price must be greater than $2.

I checked and found that yes, the study did include Enron and WorldCom. Enron was bought on 9/28/2001 at $27.23 and sold at $0.60 for a loss of 97%. It was not re-purchased the next quarter because its share price had fallen below $2. At the time of purchase, Enron was near the middle of the rankings in terms of both E/P and ROC.

For each stock the "total return" was calculated, including dividends, using data from what we believe to be a reputable commercial vendor. However, I confess that I need to check on what the exact algorithm is for computing total return when there is something complicated, such as a merger or a spinoff.

At the start of each quarter the stocks were sorted into deciles according to Greenblatt's ranking method. For each decile, the average of the forward 1-quarter fractional total returns for the approximately 50 stocks was calculated. Calling that number "R", we then calculated 100*ln(1+R) for that decile and that quarter, and I'll let Dr. Phil McDonnell (a frequent site contributor, trader and academic) explain why we did that. (As long as that number is not too big or small, it's going to be pretty close to the percentage change in the portfolio.)

Our study covers 1992 to present, 59 quarters of data. The reason that we went back to 1992 was simply that we happen to already have had a convenient file listing the S&P components year-by-year back to 1992.

For each decile there are 59 quarterly returns. Below we give the results of our study, the average and standard deviation of those 59 numbers for each decile.

Decile 1 is the one with high E/P and high ROC; decile 10 is the one with low E/P and low ROC. The last column is the average divided by the standard deviation. Multiply that number by two and you have the annualized "Sharpe ratio" for that decile, if I understand the definitions correctly.

       1    3.84    7.89     49%
       2    3.33    8.57     39%
       3    3.07    8.23     37%
       4    3.69    7.46     49%
       5    3.34    6.79     49%
       6    3.04    7.40     41%
       7    2.44    7.32     33%
       8    2.47    7.46     33%
       9    2.35    9.98     24%
      10    2.51   13.27     19%

The Greenblatt "favorites" portfolio averages 3.84% per quarter with a standard deviation of 7.89%, with an average/standard deviation of 49%. The Greenblatt "bad guys" decile, decile 10, averages 2.51% with a standard deviation of 13.27%. So this confirms that the Greenblatt strategy has worked reasonably well since 1992 on the kinds of large-cap stocks that make up the S&P 500.

An investment of $1 in decile 1 stocks grew to $9.63; $1 invested in decile 10 stocks grew $4.39, and it was more volatile along the way.

Greenblatt's data end at the end of year 2004, so below I will show you how this S&P 500 version of Greenblatt has performed since then. However, first, I will show you how some other strategies fared during the same 59 quarter period since 1992.

First, here are the results for a ranking based solely on E/P:

     Avg      SD  Avg/SD
    3.54    8.91     40%
    3.88    8.20     47%
    3.50    8.55     41%
    3.01    7.00     43%
    3.04    6.62     46%
    2.77    6.78     41%
    2.65    6.97     38%
    2.40    7.76     31%
    2.88   10.05     29%
    2.36   13.78     17%

(First row: Highest E/P, Last row: Lowest E/P)

The results are similar to Greenblatt's, though perhaps not quite as good. All that's not surprising (if you believe Greenblatt's thesis), since E/P is one of Greenblatt's two ranking factors.

ROC is Greenblatt's other ranking factor, and below is the performance of deciles sorted based on ROC alone:

   Avg      SD    Avg/SD
  3.72    8.03       46%
  3.65    7.92       46%
  3.08    6.69       46%
  2.97    7.68       39%
  2.68    7.81       34%
  2.77    7.72       36%
  2.72    8.25       33%
  3.09    8.16       38%
  2.85    8.76       33%
  2.62   13.02       20%

(First row: Highest ROC; Last row: Lowest ROC)

Again, the highest ranked ROC deciles performed better than the lowest ROC deciles.

So it seems that both E/P and ROC each have some independent value as ranking criteria (though we haven't examined the extent to which E/P are correlated or anti-correlated).

Finally, here are a few other ranking methods.

First, here's another "value" ranking method. Many value investors claim that it's bullish if a company has a high ratio of cash-and-equivalent on hand to market-value-plus-debt. Below is the performance according to that ranking:

   Avg      SD   Avg/SD
  3.96   10.40      38%
  3.42   11.43      30%
  3.14    9.68      32%
  2.73    8.95      31%
  3.44    7.72      45%
  2.81    7.47      38%
  2.91    6.73      43%
  2.81    6.79      41%
  2.49    6.26      40%
  2.57    6.05      42%

First row: Highest cash/(market value plus debt); Last row: Lowest..

Here the firms with the highest cash had the highest average return, but they also had a relatively high standard deviation, and there is no clear trend in the Sharpe ratio vs. decile number. I would argue therefore that this "cash" ranking did not have much value.

Others have suggested that the Greenblatt effect might be some artifact of share price and/or market capitalization. So here are studies of those factors.

First, share price:

  3.04   14.94    20%
  3.14   10.12    31%
  3.39    9.11    37%
  2.62    7.43    35%
  3.35    7.58    44%
  3.19    7.14    45%
  2.76    7.75    36%
  2.75    6.37    43%
  2.71    6.74    40%
  3.03    6.76    45%

First row: Lowest share price; Last row: Highest share price

This table shows no trend in return vs. share price. The lower share prices, however, do have higher standard deviations in their returns, so arguably one should focus on higher share priced stocks for a smoother ride.

Next here are the results for a decile ranking based on market capitalization:

  3.33   12.14    27%
  3.52    9.94    35%
  2.89    9.36    31%
  3.35    8.21    41%
  3.46    7.48    46%
  3.36    6.49    52%
  2.62    7.71    34%
  2.45    7.19    34%
  2.57    7.22    36%
  2.66    7.67    35%

First row: Lowest market cap; Last row: Highest market cap

The lowest market caps did outperform the highest market caps by a small amount. However, their volatility was much higher, and their Sharpe ratios were about the same or lower. So it is not plausible to think that the Greenblatt effect, as observed in this study, is an artifact of small market capitalization.

Victor and Laurel compliment and caution:

We would just add that the "Minister's" study leaves out the performance since the retrospective data ran out and it ain't pretty. The Minister is complimented on the perfect study for DailySpec: totally good methodology suggesting fruitful lines of inquiry, but nothing that violates his mandate as "Minister of Non-Predictive Studies".

Professor Pennington returns with updated figures:

Here is an update of the recent performance of the Greenblatt ranking system applied to S&P stocks. Greenblatt's book gives data through the end of 2004. Shown below is data since 2004.

              10      9       8       7       6       5       4       3       2      1
12/31/2000  -7.6   -3.4    -0.9    -5.3    -2.0     0.8    -0.7    -0.1    -2.2   -1.5
03/31/2005   5.6    0.9     4.7     1.1     3.0     2.6     3.1     0.9    -0.2    5.3
06/30/2005   7.1    7.8     3.9     6.3     3.7     0.8     4.8     4.0     4.7    3.5
09/30/2005  -2.9    2.1     1.6     2.4     1.6     3.6     3.2     4.8     1.9    5.9
12/31/2005  10.2    6.6     7.8     4.4     7.3     6.7     5.9     4.9     5.9    1.8
03/31/2006  -7.9   -4.5     1.4    -1.8    -0.1    -0.9    -1.2    -1.8     0.4   -1.4
06/30/2006   0.9    3.3     2.7     4.8     3.9     7.9     1.6     5.7     3.2    4.9
09/30/2006   3.5    3.8     3.6     4.5     2.6     4.3     4.4     3.6     3.6    1.4

    Avg      1.1    2.1     3.1     2.0     2.5     3.2     2.7     2.7     2.2    2.5
     SD      6.7    4.3     2.6     3.9     2.8     3.0     2.5     2.7     2.7    2.9
 Avg/SD      17%    48%    120%     52%     89%    106%    104%    101%     80%    85%

Short story is that the high ranked decile, decile 1 (high E/P, high ROC), gained an average 2.5% per quarter since 2005 with standard deviation 2.9%, and the least favored decile, decile 10 (low E/P, low ROC) returned an average 1.1% per quarter with standard deviation 6.7%.

In such a short time frame, this one's probably a coin toss, but it looks like it did go in Greenblatt's favor.

Dr. Phil McDonnell lauds and extends:

Kudos to Prof. Pennington for his thorough review of the Greenblatt study. His use of the log of the price relative is exactly the right way to go to take into account compounding.

In my opinion the best time period to study is the out of sample post publication time frame from 12/2004 to the present. Using this period eliminates most of the concerns and biases which I feared including the post publication bias.

Based upon that period I looked at the Spearman rank correlation coefficient for the mean and the Sharpe Ratio(*). The basic idea is to see if there is an overall correlation beyond just a differential between the top decile and the bottom. In this case we would expect a negative correlation simply because of the arbitrary ordering of the deciles by Dr. Pennington. The following R code gives us our answer:

# Test the Pennington-Greenblatt data using robust Spearman rank correlation
cor.test( av,n,method="spearman" )
cor.test( sr,n,method="spearman" )

With respect to the average we get:

Spearman's rank correlation rho

data: avg and n S = 226.3731, p-value = 0.2899 alternative hypothesis: true rho is not equal to 0 sample estimates: rho -0.3719581

Here the rho is -37% and has an insignificant p value of 29%

With respect to the Sharpe Ratio(*) we get:

Spearman's rank correlation rho

data: sr and n S = 218, p-value = 0.3677 alternative hypothesis: true rho is not equal to 0 sample estimates: rho -0.3212121

Here rho is 32% and the p value is 37% also non-significant.

(*) Minor quibble on the Sharpe Ratio: The usual formula for the Sharpe Ratio is:

SR = (average - tBillRate) / stdev

The idea is that it purports to measure excess return over and above the riskless tbill rate. It is thus the excess return one received for taking on risk. However in the present case making this adjustment would not change the ranking of the deciles at all since each average is being adjusted by the same thing. Thus the Spearman rank correlation test is robust even to this factor.

Victor and Laurel rejoin:

We suspect, as does Russell Sears, who ran a four minute mile and is always on target, that Greenblatt isn't as careful with his data as he would lead us to believe, and that a student did it for him, and that there are millions of multiple comparisons involved in his original work. it doesn't make sense that you could make a profit without a forward earnings estimate, and that you would be paid just for assuming things so close to cost, with little risk.

Robert Pinchuk adds:

I concur with the essence of your doubts (What!, no expectations!?) even with Prof. Pennington's detailed validation. Haugen also re-did Greenblatt's work verbatim on his (cleaner? better?) database (written up in Barron's some time ago) and derived some different numbers -- but not wildly different. But then Haugen is touting advice-for-profit of nearly the same kind, so there are caveats. But, Haugen is not dishonest, and the advice he sells also does carry expectational measures that help him squeeze more alpha with less variance (so he says), as we would both expect.

I am hesitant to disagree with you that the market rarely offers "freebies" for naively assuming risk, but I cannot help but ruminate upon the question: "Do the results make sense?" Bogus data, future information, dredging and questionable strategy heuristics aside, "loss-aversion" and "disposition effects" are powerful anomaly creators, especially in combination with feedback trading. I will grant you that "The Price Is (rather often) Right", especially when conflicted with sparse non-price time-series data. Maybe elevated short-interest levels will soon make these disappear too, or at least delay gratification for a sufficiently demoralizing period of time.

One nagging thought: Is there really, as you suggest, such "little risk" in the undertaking? I think one might be surprised by the qualitative "risk", when anecdotally assessed over time. Someone like Lakonishok might answer: "How can they be riskier if they produce more return?" But this seems insufficient. Risk, like HIV, can hide or remain dormant for extended periods (e.g. inflation in the 90s). I posit that there is risk being shouldered, but perhaps it's different (i.e., a different array of factor risks) in each epoch, so it's hard if not impossible to systematically isolate, let alone forecast. How can one measure the risk of buying a Chapter 11 candidate concurrent to potential deflation? It's binary. Perhaps it's just this embedded tail risk for which, like a reinsurance company, is good business to write if properly priced (The Reversion Trader?). And perhaps one day, the inherent risk will manifest itself and thereafter, disabuse anyone from naively pursuing The Magic Formula. Then again, maybe there are just a preponderance of traders with differing forms of myopia.

By the way, Prof. Pennington's high/low return spread numbers for RoC seem elevated. The E/P spreads look about right, but it remains the inferior value proxy. "Quality" in general seems more efficiently priced.

”If It Ain't in the Good Book, Pappy”, by Dr. Kim Zussman

(Chapter II), how can I keep me cross-hairs steady on the private vittles of big bucks?"

(Seems catchier than "Are volatile markets trendier?")

Using SP500 index weekly returns since 1950 (div adj), divided series into non-overlapping 20 week periods. At the end of each period, calculated STDEV for the period, as well as correlation between weeks (each week with the next for 20 weeks). Then regressed correlation of the 20 weeks with the contemporaneous STDEV.

Regression Analysis: correl 20 versus stdev 20

The regression equation is correl 20 = 0.0442 - 4.68 stdev 20

	Predictor   	Coef   SE Coef      T       P
	 Constant      0.044     0.052   0.85   0.396
	 StDev 20     -4.681     2.658  -1.76   0.080

The slope approaches significance, but the relationship is the opposite of what was claimed. It seems that more volatile periods are more negatively correlated (less trendy-attached chart is helpful).

Whip Inflation Now, from George Zachar

The New York Cost of Living Calculator is a Flash-based question tree that is roughly accurate. Bear in mind what you're up against...

The Perfect Crime, by GM Nigel Davies

Last weekend I went to play in a tournament in Tenerife. On the Sunday I was not quite as careful with my luggage as usual (it was Spain and I was relaxed), leaving it in the luggage compartment of the bus that would take us to the airport. It was going to be locked, but still... When they heard what I'd done some GM colleagues enjoyed recounting various luggage horror stories, adding to the torture with looks of mock concern. And Bojan Kurajica told me about how he'd lost his luggage once in Germany, apparently the victim of a perfect crime.

He left it in a locker at a railway station, taking the key and setting off for some tourism. When he came back his luggage was gone with no sign of a forced entry. He complained to the authorities who were as dumbfounded as he was - they even asked him if he had the right locker. Eventually he figured out what had happened.

The locker keys could be duplicated for just a few DM, so the thief would deposit some money to get the key, have it duplicated and then wait. As soon as he saw someone deposit valuable looking luggage he'd use his duplicate key to open the locker and make off with the luggage. A theft in broad daylight at a crowded station and with very little risk. The perfect crime?

S&P Moves on the Day After Election Day, from Prof. Charles Pennington

                                                                 Open to
Election Day   Close  Day after     Open    Close  Open Move  Close Move
11/4/1986      246.3  11/5/1986    245.7    247.2       -0.6        +1.5
11/8/1988      275.1  11/9/1988    274.0    274.1       -1.1        +0.1
11/6/1990      311.8  11/7/1990    312.1    307.3       +0.3        -4.9
11/3/1992      419.9  11/4/1992    418.5    416.2       -1.4        -2.3
11/8/1994      467.0  11/9/1994    471.6    465.8       +4.7        -5.8
11/5/1996      715.4  11/6/1996    715.8    729.4       +0.4       +13.6
11/3/1998     1114.0  11/4/1998   1125.5   1124.6      +11.5        -0.9
11/7/2000     1444.0  11/8/2000   1445.0   1413.3       +1.0       -31.7
11/5/2002      914.0  11/6/2002    920.5    925.7       +6.5        +5.2
11/2/2004     1130.6  11/3/2004   1145.8   1145.1      +15.2        -0.7
11/7/2006     1389.0  11/8/2006   1382.5   1391.6       -6.5        +9.1

Humble Pie, by Stefan Jovanovich

Jay Cost's Horse Race Blog was the best single source of political information for the 2004 race. Alas, Mr. Cost is now pursuing his doctorate in political science at the University of Chicago and has retired his blog. He still writes for Real Clear Politics occasionally. Before the election, he saw the Democrats picking up between 15 and 18 seats in the House; being a biased Republican I thought the range would be 12 to 16.

Jay and I will both be dining on humble pie and crow for a while. He can make his own explanation. Mine is that I failed to look at what was the appropriate parallel -- the Korean War elections. In 1950 the Democrats lost 28 seats; in 1952 they lost another 22, and the Republicans gained control of the House. I should have listened to the smart people in my clan, all of whom are women. As mother, wife and daughter reminded me this morning, "Americans don't like foreign wars, especially those where the natives seem not be willing to do any of the fighting."

Adam Smith Revisited and A Volley of Questions, by Steve Leslie

With the recent success by Democrats in the House of Representatives and in the Senate, coupled with the recent rally in the US stock markets there are some thoughts that come to the surface.

A quick review of Adam Smith's comments:

In 1776 he wrote "An Inquiry into the Nature and Causes of the Wealth of Nations" in which he promulgated his invisible hand theory, which stated that each individual, while striving for his own gain, of necessity advances the public interest by the free exchange of goods and services creating division of labor and a free market economy.

Some natural questions:

Gary Rogan replies:

The market is obviously saying that major pharma, HMOs, and large defense contractors are likely to lose. It's re-valuing non-dividend-paying stocks slightly higher relative to dividend-paying stocks and smaller stocks slightly higher than large-caps. It obviously thinks that gridlock is good, and it seems to have preferred the House and Senate to be controlled by different parties, at least as far as above-mentioned groups are concerned. Overall, it's happy with the results.

The only thing that's likely to get done for sure is "immigration reform". Whether that's good or bad is in the eye of the beholder. I think it will be a long-term disaster, but the short-term economic impact just isn't enough to worry the markets.

The market got the big picture correct, the House situation and the Republican loss of control, because it was a relatively well-behaved stochastic event that could be pre-sampled and processed, but couldn't deal with the Senate because it simply could not have known what fewer that ten thousand people who decided the election in Virginia and Montana would do. This illustrates perfectly both the power and limitation of markets: they deal with distributed information better than almost any individual, but fail with highly non-linear situations where small noise-like perturbations are amplified dramatically in a digital fashion to produce a significant outcome.

Rick Foust adds:

I just had a visit with a good friend and fellow engineer here in the risk-averse world of nuclear power. He is a devout Democrat and Bush-hater. He has been strongly bearish since 2001. I have pulsed him since 2003 when I first advised him to become bullish. He has consistently responded that everything is horrible and will stay that way. In return, I have teased that when he finally turns bullish, I am going to sell everything. This teasing has only strengthened his resolve. Today I asked him how he is feeling now that Washington power is shifting. He tells me that today he increased his 401K contributions and the increase is going to stocks. His choices are popular with risk adverse engineers: Fidelity Magellan, FMAGX, and Fidelity Equity Income, FEQIX. He believes that the market does better when the power in Washington is divided. He is eagerly anticipating trouble for Bush. If I am guessing correctly, he will be right (for a while) and one day he will come to my desk gloating over how the market has advanced coincident with Democrats' taking vengeance on the Evil One. I will sell on that day.

A Disappointing Book on Market Masters, By Tim Humbert

If you asked me would I recommend Hedge Fund Masters by Ari Kiev or buy it for someone, I would have to respond weakly with a shrug of my shoulders and a non-committal "I don't know". I'm torn because I felt the book was reasonably expensive at >$50 (for a book with no pictures) and I just didn't get what I hoped to get out of it.

Kiev lures unsuspecting traders with the title above and subtitle: "How traders set goals, overcome barriers and achieve peak performance". Stirring stuff indeed.

The book is subdivided into three parts, "What is mastery?", "How do you get there?" and "What comes next?", and takes the form of interviews/case studies with 70 hedge fund managers.

This is where I had a slight problem. Often, the traders in question are not masters per se. In fact, they are having some difficulty in their trading, and they talk to Kiev, who prescribes a pretty inoffensive remedy- "cut your losses and hold onto your winners!".

This isn't a book where you are reading interviews with Market Wizard types where you can learn from their mistakes...or how they overcame obstacles and disciplined themselves: no such luck! To me the interviews and the running commentary all seemed a bit vague and muddled by the end of the book, and I don't think there was much follow up with the interviewees as to how they got on...certainly nothing of a verifiable nature.

The message he keeps repeating is not one without value: that the best traders, the masters, are the ones who are the most committed. Moreover, in taking risk, he says that one should shed one's inhibitions and if one has done the work then in the long run, it'll pay off. Messages not without value, but I didn't feel the the price or length of the book (298 pp) was worth it.

Finally, looking it up on Amazon, there appeared to some diverse opinions on the merit of the book, such that one reviewer pointed out 11/14 reviews at the time were 5 stars, and all posted over two days!

Dave 'Surf' Goodboy adds:

I interviewed Ari Kiev for Yahoo and TradingMarkets. He works with the king, Steve Cohen, for what that's worth.

A Ground Level Observation (Literally), from Scott Brooks

I got to ride in a Combine last night for the first time in my life. Neat  experience. My farmer and I were talking as we watched coons run out of the corn. One of the things he said that this is a very unusual year. Corn  prices are rising nicely going into harvest....according to him, not a  normal occurrence.

Michael Ott replies:

Prices usually go down around harvest time because farmers are forced to increase supply because they simply can't store any more corn. Most farmers have decent storage capability on their farms and sell throughout the year when they get a good price or need money. Obviously at harvest time storage is at a premium, so overflow goes immediately to market.

The huge demand for local corn due to ethanol has dramatically shifted the use, storage, and transportation of billions of bushels of corn. We're seeing a lot of interest in building grain elevators, railheads and other fixed installations. I think this is the next wave of biofuels spending, because investing in new grain ethanol plants is nearly dead.

J.T. Holley Replies:

My buddy has a Deere 9660 with a satellite equipped system that literally drives the combine for ya "hands-free". It also has A/C and XMFM built in. He could literally utilize wireless internet connection w/ a laptop, trade, harvest crop, and have lunch/dinner in that bad boy! Once seeing and riding in that fine piece of machinery you know why Mr. Simon won his bet.

Fedwatching, by George Zachar

Nov. 7 (Bloomberg) Federal Reserve Bank of Richmond President Jeffrey Lacker, who dissented from the last three decisions to forgo an interest-rate increase, said the central bank has failed to communicate sufficiently its willingness to reduce inflation, the Financial Times reported.

A big deal? No. A "big deal" in Fedland is an official action, Bernanke diktat, or data point. Lacker is speaking truth to power, but he's not powerful enough to actually do anything besides stake out his ideological turf. Such posturing by regional bank heads has ample precedent, and, at the end of the day, does next to nothing policy-wise.

Rewriting History?, by Jaime Klein

Just when you though corruption allegations might be abating in equity markets, along comes an explosive new study. A paper to be delivered to the January 2007 American Finance Association annual meeting in Chicago suggests that investment analysts' historical buy recommendations have been manipulated to put them in a better light. Rewriting History, by Alexander P Ljungqvist (Stern School of Business, NYU), Christopher Malloy (London Business School) and Felicia Marston (University of Virginia) provides evidence that nearly 20,000 records in I/B/E/S, a database of research analyst recommendations owned by Thomson Financial and widely used by investment professionals and academics, were manipulated between September 2002 and May 2004. This took the form of selective, ex post removal of analysts names from some of their historical recommendations. These were not random; they were concentrated among the worst performing recommendations. Here is the authors' abstract:

Comparing two snapshots of the entire I/B/E/S analyst stock recommendations database, taken in 2002 and 2004 but each covering the same time period 1993-2002, we identify nearly twenty thousand changes of an unusual nature: the selective removal of analyst names from historic recommendations (anonymizations). This practice turns out to be pervasive and non-random: Bolder recommendations are more likely to be anonymized, as are recommendations from more senior analysts, Institutional Investor all-stars, and those who remain in the industry beyond 2002. Abnormal stock returns following subsequently anonymized buy recommendations are significantly lower (by up to 11.0% p.a.) than those following buy recommendations that remain untouched, suggesting that particularly embarrassing recommendations are most likely to be anonymized. Analysts whose track records appear brighter due to anonymizations experience more favorable career outcomes over the 2003-2005 period than their track records and abilities would otherwise warrant.

As the authors note, the period not only coincided with close scrutiny of Wall Street research by regulators, Congress, and the courts, but also saw a substantial downsizing of research departments of major brokerage houses in the US. The manipulation benefited the careers of those whose dud recommendations were anonymised. The paper concludes: Whether or not analysts were in fact behind these changes, however, their track records undeniably look better than they should, and we show that the analysts concerned apparently benefited in the sense of experiencing more favorable career outcomes than their track records and abilities would otherwise warrant: Anonymizers are more likely to move jobs, to be hired by a large brokerage firm, and to move from a small to a large firm (Hong, Kubik, and Solomons (2000) measure of a promotion). Anonymization easily has the largest economic effect in our career outcome models. These are very disturbing findings, and as the authors note, given the "non-random nature of the results" it is very unlikely they are attributable to chance. While "it is possible that the brokerage firms were in fact the culprits ..the patterns we document seem at odds with this interpretation".

A Goddess Worthy of Speculators, by George Zachar

In Roman mythology, Disciplina was a minor deity and the personification of discipline.

The word "disciplina" itself, a Latin noun, is multi-faceted in meaning; it refers to education and training, self-control and determination, knowledge in a field of study, and an orderly way of life. The goddess embodied these qualities for her worshippers. She was commonly worshipped by imperial Roman soldiers, particularly those who lived on the borders of the Roman Empire; altars to her have been found in Britain and North Africa.

Her chief virtues were frugalitas, severitas and fidelis-frugality, sternness, and faithfulness. In worshipping Disciplina, a soldier became frugal in every way: with money, with energy, with actions. The virtue of severitas was shown in his focused, determined, not easily dissuaded, and decisive behavior. He was faithful to his unit, his army, the officers and the people of Rome.

100 Greenblatt Stocks, Last Eight Months, from Dr. Alex Castaldo

Thanks to John Tierney for providing a list of 100 stocks from Joel Greenblatt's website as of March 4, 2006. My remarks:

  1. Eight months is really too short a period for evaluation.
  2. There were no charlatan-type stocks priced at 0.05 initially, the lowest was price was 4.57. The average price was 26.38. If we eliminate all stocks priced below 10.00 (twelve of them) the overall results are not much changed.
  3. The total return (including dividends) was 3%, while the S&P and Wilshire were up about 6% (not including dividends)

As Vince Fulco said, "I am sure the debate will continue..."

Greenblatt Stocks as of 3/4/2006
                                        Buy     Sell
Orig                                    6-Mar   3-Nov
Ticker Name                 ID          Price   Price PrcFct   TotRet
-----  -------------------  -------     -----   ----- -------  ------ 
ANF    ABERCROMBIE & FITCH  ANF         57.26   72.57 1.26738   1.275
ALDA   ALDILA INC           ALDA        30.80   15.42 0.50065   0.510
AHCI   ALLIED HLTHCR INTL   TWH          4.57    2.06 0.45077   0.451
AMED   AMEDISYS INC         AMED        32.41   40.70 1.25579   1.256
AEOS   AMER EAGLE OUTFIT    AEOS        28.25   45.12 1.59717   1.611
ANIK   ANIKA THERAPEUTICS   ANIK        13.22   12.03 0.90998   0.910
ARDNA  ARDEN GROUP CL A     ARDN.A      87.36  130.06 1.48878   1.500
BBSI   BARRETT BUSINESS S   BBSI        24.20   21.30 0.88017   0.880
HARB   HARBOR FL BANCSHS    HARB        37.00   44.15 1.19324   1.217
BLT    BLOUNT INTL INC      BLT         15.51   11.10 0.71567   0.716
BMHC   BUILDING MATERIALS   BMHC        32.27   25.10 0.77781   0.786
CAMP   CALAMP CORP          CAMP        10.06    6.68 0.66402   0.664
CECO   CAREER EDUCATION     CECO        34.42   21.66 0.62929   0.629
POS    CATALINA MKTG CP     POS         23.01   24.46 1.06302   1.074
CATT   CATAPULT COMM CP     CATT        13.84    8.52 0.61561   0.616
CVCO   CAVCO INDS INC       CVCOV       44.27   33.05 0.74656   0.747
CDWC   CDW CORP             CDWC        56.80   63.99 1.12658   1.138
CHAR   CHAPPARRAL RES INC   CHAR         5.25    5.80 1.10476   1.105
CHKE   CHEROKEE INC         CHKE        39.00   39.64 1.01641   1.049
CVGI   COMMERCIAL VEHICLE G CVGI        18.19   20.07 1.10335   1.103
CMTL   COMTECH TELECOM CO   CMTL        33.02   34.91 1.05724   1.057
CSGS   CSG SYS INTL         CSGS        22.35   26.66 1.19284   1.193
DEBS   DEB SHOPS INC        DEBS        29.99   26.41 0.88063   0.893
DECK   DECKERS OUTDOOR CP   DECK        35.90   51.29 1.42869   1.429
DHB    DHB INDUSTRIES INC   DHBT         4.72    2.25 0.47669   0.477
DPZ    DOMINOS PIZZA INC    DPZ         26.33   25.98 0.98671   1.001
ELX    EMULEX CORP          EMLX        17.97   19.26 1.07179   1.072
ENDP   ENDO PHARM HLDGS I   ENDP        32.99   28.12 0.85238   0.852
FCX.B  FREEPORT MCMORAN CGB FCX         51.88   61.15 1.17868   1.248
RAIL   FREIGHTCAR AMERICA,  RAIL         9.80   11.90 1.21429   1.214
FTD    FTD GROUP, INC.      FTD         14.30   14.13 0.98811   1.032
GCI    GANNETT CO INC       GCI         61.56   58.02 0.94250   0.957
GPS    GAP INC              GPS         17.97   19.57 1.08904   1.103
GVHR   GEVITY HR INC        STFF        24.40   21.68 0.88852   0.898
GIXS   GLOBAL IMAGING SYS   GISX        17.98   21.23 1.18108   1.181
HNR    HARVEST NAT RES INC  BNO          9.61    9.92 1.03226   1.032
HAS    HASBRO INC           HAS         20.68   27.01 1.30609   1.329
HLF    HERBALIFE LTD.       HLF          7.90    7.87 0.99557   1.007
ITWO   I2 TECHNOLOGIES      ITWO        16.99   18.74 1.10300   1.103
INSP   INFOSPACE INC        INSP        23.84   19.85 0.83263   0.833
ISSC   INNOVATIVE SOL&SUP   ISSC        14.06   15.17 1.07895   1.079
IIIN   INSTEEL INDUSTRIES   III         20.94   17.13 0.81805   0.821
INTC   INTEL CP             INTC        20.30   20.51 1.01034   1.026
INTX   INTERSECTIONS, INC.  INTX         9.29   10.58 1.13837   1.138
IVII   INTERVIDEO INC       46114Y10    10.81  12.850 1.18871   1.189
JAKK   JAKKS PACIFIC INC    JAKK        25.20   21.44 0.85079   0.851
JOR    JORGENSEN EARLE M    JOR         14.22   15.15 1.06540   1.065
KSWS   K SWISS INC CL A     KSWS        27.93   34.75 1.24418   1.251
KCI    KINETIC CONCEPTS INC 49460W20    37.70   34.87 0.92493   0.925
KG     KING PHARMACEUTICALS KG          17.85   16.20 0.90756   0.908
KFY    KORN FERRY INTL      KFY         20.27   21.79 1.07499   1.075
KOSP   KOS PHARMACEUTCL     KOSP        44.41   50.09 1.12790   1.128
LRW    LABOR READY INC      LRW         23.94   17.70 0.73935   0.739
LII    LENNOX INTL INC      LII         31.55   27.31 0.86561   0.876
LXK    LEXMARK INTL INC     LXK         46.68   63.65 1.36354   1.364
LIZ    LIZ CLAIBORNE INC    LIZ         37.15   41.44 1.11548   1.119
LPX    LOUISIANA PACIFIC CP LPX         27.86   19.13 0.68665   0.696
MGLN   MAGELLAN HEALTH SERV MGLN        37.08   43.24 1.16613   1.166
MTEX   MANNATECH INC        MTEX        12.98   14.61 1.12558   1.144
MVL    MARVEL ENTERPRISES   MVL         18.19   25.05 1.37713   1.377
MAT    MATTEL INC           MAT         16.58   22.65 1.36610   1.366
MRX    MEDICIS PHARMA CP    MRX         28.86   35.42 1.22730   1.231
MSB    MESABI TRUST CTF BI  MSB         21.47   22.13 1.03074   1.093
MSTR   MICROSTRATEGY CL A   MSTR        98.56  118.91 1.20647   1.206
MTSC   MTS SYSTEMS CP       MTSC        38.96   33.47 0.85909   0.867
NCI    NAVIGANT CONSULT INC NCI         18.63   18.01 0.96672   0.967
NTGR   NETGEAR INC          NTGR        18.58   26.11 1.40527   1.405
NOOF   NEW FRONTIER MEDIA   NOOF         7.25    8.94 1.23310   1.233
NUS    NU SKIN ENT INC      NUS         17.62   18.33 1.04030   1.052
NUE    NUCOR CP             NUE         45.03   57.50 1.27707   1.316
OMC    OMNICOM GP INC       OMC         80.36  100.44 1.24988   1.260
OVTI   OMNIVISION TECH IN   OVTI        25.01   15.98 0.63894   0.639
PACR   PACER INTL INC       PACR        31.29   28.95 0.92522   0.939
PER    PEROT SYSTEMS CP     PER         15.07   14.77 0.98009   0.980
PNCL   PINNACLE AIRLINES    72344310    6.58    8.29 1.25988    1.260
PONR   PIONEER CO           PONR        31.69   26.46 0.83496   0.835
PLAY   PORTALPLAYER INC     PLAY        23.83   13.36 0.56064   0.561
PGI    PREMIERE GLOBAL SVCS PTEK         8.34    8.24 0.98801   0.988
PBH    PRESTIGE BRAND HLGS  PBH         10.91   11.29 1.03483   1.035
PWEI   PW EAGLE INC         PWEI        23.68   35.42 1.49578   1.508
NX     QUANEX CP            NX          42.32   33.49 0.79135   0.800
RHB    REHABCARE GROUP INC  RHB         20.51   12.16 0.59288   0.593
RIMG   RIMAGE CP            RIMG        22.18   23.69 1.06808   1.068
SVM    SERVICEMASTER CO COM SVM         12.55   10.86 0.86534   0.884
PCU    SOUTHERN COPPER CORP PCU         40.86   53.28 1.30412   1.368
SLNK   SPECTRALINK CP       SLNK        12.64    9.29 0.73497   0.735
SYNA   SYNAPTICS INC        SYNA        24.12   27.56 1.14262   1.143
SYNT   SYNTEL INC           SYNT        18.84   25.09 1.33174   1.421
TALK   TALK AMERICA HLDGS   TALK         8.92    7.99 0.89574   0.896
TPX    TEMPUR-PEDIC INTL    88023U10    12.06   18.95 1.57131   1.571
TBL    TIMBERLAND CO A      TBL         34.93   28.43 0.81391   0.814
TOD    TODD SHPYRDS CP      TOD         26.90   17.90 0.66543   0.766
UST    U S T INC            UST         40.80   53.12 1.30196   1.352
EGY    VAALCO ENERGY INC    VEIX         6.97    8.36 1.19943   1.199
VCI    VALASSIS COMMUN INC  VCI         28.46   15.12 0.53127   0.531
VTRU   VERTRUE INC          MBRS        44.81   40.80 0.91051   0.911
WDFC   WD 40 CO             WDFC        30.16   33.20 1.10080   1.123
WON    WESTWOOD ONE INC     WON         10.99    7.92 0.72066   0.739
WWE    WORLD WRESTLING ENT  WWF         16.13   16.20 1.00434   1.048
YCC    YANKEE CDLE CO INC   YCC         28.07   33.83 1.20520   1.210

       Average                                        1.02007 1.02998

       S&P CASH INDEX       SPX_IDX   1278.26 1364.30 1.06731
       WILSHIRE INDEX       WLXX_IDX    12888   13648 1.05900

Robert Pinchuk replies:

I don't really understand the point of evaluating Greenblatt's simplistic ditty over 8-months. Is there some intended derision over his methodology? Some thoughts:

  1. Market Cap has been good for return in 2006: this means cap weighted indices will have in general performed better than equally weighted (and the Greenblatt strategy is an exceptional subset of an equally weighted strategy). Note how OEX has outperformed SPX by about what the Greenblatt portfolio is missing vs. either the SPX or the Wilshire. Try Windsorizing the the cap weighted S&P (5% by Cap? and see what this does).
  2. High EBITDA/EV decile (cheap stock proxy) has done rather poorly in 2006, yet over time this has undoubtedly been the most rewarding naive valuation measure. At present there is little reason (except for the Greenblatt formula's notoriety itself) to expect this will change, since it strikes at the physics of finance for intermediate term holding periods.
  3. High Decile ROE (or CFROI or EVA) or other profitability factors have been contributing rather poorly but the factors' cross-sectional returns have been dismal to despite cross-sectional efficacy. Why has the high decile performed poorly, historically for short-frame holding periods? Most likely, valuation, since people chasing "the best & most profitable companies" typically overpay, at least over the one-month timeframe.
  4. I reckon most of the excess return comes from the "valuation side" if one were doing an attribution, and the long vs. short return trumpeted comes more from the short side (of expensive & less-profitable stocks) than the long side where higher profitability tends to be highly prized. In any event, Greenblatt is the Cliffs Notes version, and Bob Haugen is the one who's taken the systematic multi-factor approach to more interesting (and intelligent) levels.

Barron's Abridged, by Prof. Gordon Haave

Live from Baton Rouge, it's Barron's abridged:

Abelson: It is a great challenge being a worrywart right now. There are so many things to worry about, that it is hard to figure out what to worry about the most. An actual bull was lose in Newark and was lassoed, this is a bad omen for the stock market. Corporate Fat Cats set up a committee to undermine regulation and lawsuits that they don't like. Growth stocks can be overpriced because there is career safety for money managers in buying well known names, says Jeremy Grantham. The sky is falling.

Page 18-20: Walmart not doing so hot, investors should apply a nice discount to shares. SWS group is a buy. The movie Saw 3 is so good that Lions Gate might do well.

Page 22: Evercore partners is overpriced, it is also risky since a lot of its revenue comes from a few clients.

Page 24: Adidas, which owns Reebok now, is looking pretty good because it is big in the world of soccer, a sport that is apparently big around the world. A guy from Evergreen thinks it can go up 30%.

M3: In case you have been in Spitsbergen all week, the Dow slipped below 12,000 at one point. Unemployment came in at 4.4%. Investors are worried about inflation. Guy from Banc of America says that is is going to be hard to make the case that inflation will be less than 3% for the next three years. In other news, no human character traits were observed in any of the well known indicies.

M4: CIT group could go up if it spins off its aircraft leasing business.

M5: Canada has proposed changing the way it taxes royalty trusts.

M6: Far Eastern stocks are cheap, and have been doing well, even though there is all sorts of crazy stuff going on over there. Goldman likes Daewoo Shipbuilding, and CSFB likes United Microelectronics. Thai banks could be a good short term play.

M9: UBS is pricey, this could be troubling because the more risk they take trading the more money they seem to lose. Plus, they are dependent on a large financial advisor force, which is expensive.

M10: Le-Nature filed for bankruptcy, which could be the start of a bad season for junk bonds and leveraged loans

M11: To hedge the election, buy DJX strangles.

M12: Orange juice prices are up due to a small crop. This affects KO and PEP. Randolph and Mortimer Duke unavailable for comment.

M18: Possibility of democratic win leading options players to hedge their prescription drug co. positions. CSFB says sell large cap health care and buy biotech - since the dems like throwing money at their favorite biotech fads. Overall risk perception in the broad market is low.

Page 29: The Big Money poll says that the Dow is going to 13,000 Democrats will gain in congress, rates will fall.

Page 36: Despite the fact that the world is, as a whole, the best fed it has ever been, Barron's thinks that the population boom means people are going to starve in the future. It will take a lot of fertilizer to avoid that, so buy Potash.

Page 37: GPS stocks have been up lately.GPS devices are powered by chips made by SIRF Technology, buy it. Paul Wick looked like a fool telling people in Barron's to short APCC, it got bought out right after publication. Logitech Z-10 interactive 2.0 speaker system if pretty good.

Page 38: We told you a few weeks ago that Oracle might go out and buy stuff, they are already at it. They bought Stellant, and it is a good fit for Oracle. Red Hat is up the creek without a paddle.

Page 39: Annuities can be a big ripoff, so if you are going to buy one do some research. ...some good websites.

Page 41: There are more and more long-short mutual funds, so hedge funds better watch out.

Page 43: Technology mutual funds are very volatile, sometimes they are up big, sometimes they are down big. MFS Technology fund is no exception.

Page 44: ASV stock is down big, and should go lower. Nobody noticed that their mini bulldozers were piling up in inventory until the CEO abruptly quit. Investors should have noticed this earlier, but didn't.

Page 45: Interview with Gary Greenberg, Muse Capital. He is a specialist in global investing. Unlike anyone else, he thinks renewable energy is a good long-term play. Naturally, he recommends a bunch of renewable energy stocks. He also likes CVS, the State bank of India, Lundin Mining, and British Airways.

Page 47: The stock and bond markets are giving divergent views on whether or not their will be a hard, soft, or no landing. Who knows?

Page 48: After ruining Lucent and HP, Carly Fiorina rights a mostly useless book, with no honest self-appraisal. See Dan Quayle's book. Didn't know he had one? That's the point.

Page 49: We told you to buy US Steel. You should have, it has raised its dividend payout by 50%. The Canadian Gov't is changing how it taxes royalty trusts. ACAS has been a great company for dividend owners, should continue to be. FCX and CHKE also raising payouts.

Page 50: You thought Brazil was an emerging market? Try Bulgaria. Emerging Emerging markets are now called Frontier markets. They key to not getting burned is to buy a good mutual fund that invests in these markets. If you want to invest in Africa, you should check out this site.Vietnam is already looking overbought.

Page 54: Politics needs more speech, not less. As it turns out, the Canadian politicians can't be trusted either when it comes to stable tax policy

Some Numerical Queries, by Victor Niederhoffer

The recent S&P moves relative to open, high, and low cry out for description and prediction.

S&P Futs    Day   Open    High    Low     Close
20-Oct-06   Fri   1374.5  1375.5  1369.8  1374.9
23-Oct-06   Mon   1371.6  1384.2  1370.1  1380.7
24-Oct-06   Tue   1379.0  1385.3  1378.2  1384.8
25-Oct-06   Wed   1383.0  1389.5  1381.4  1389.2
26-Oct-06   Thr   1392.0  1395.2  1385.0  1392.9
27-Oct-06   Fri   1391.0  1392.2  1381.2  1384.8
30-Oct-06   Mon   1381.3  1386.8  1378.9  1383.2
31-Oct-06   Tue   1385.3  1387.1  1377.1  1383.2
01-Nov-06   Wed   1386.1  1386.9  1370.9  1372.9
02-Nov-06   Thr   1368.8  1373.5  1367.3  1371.3
03-Nov-06   Fri   1375.8  1377.2  1365.6  1368.5
06-Nov-06   Mon   1372.8  1386.3  1372.6  1383.8
07-Nov-06   Tue   1385.0  1391.7  1383.3  1391.0
  1. A run of six lower lows in a row was broken on Monday.
  2. A run of six days without a rise was broken.
  3. The high on Monday was below but within 1 point of three highs of the previous week.
  4. The change at the open on Monday was within a quarter point of the change on the previous day.
  5. Two up opens in a row more than four occurred in conjunction.
  6. Hopes were dashed on Friday when a nice up open was followed by a move down of 12 points.
  7. Wednesday of the previous week the high-low range was 16 points and Friday the high-low range was 12 points but the other three days the range was below 10.
  8. A string of six weeks up in a row was broken last Friday with a down week, giving the bears hope.
  9. The volume on Tuesday end of month was 50% higher than the average for the other days in conjunction with an unchanged day.
  10. The low on Monday was just a quarter point below the open and the high last Friday was just 1 point below the open. Similar low maximum within day moves above open occurred on 10/27, 10/31, and 11/03.

Many queries as to randomness, predictability, and further observations and hypotheses arise.

Ant Trails in the Market Trends, by Bo Keely

I awoke with the rising sun and stretched in my hollowed Contour. Then I took a long walk through the desert north of Blythe, Ca. and discovered an old foundation with the rusting legs of a chair. I returned to the car and drove a track though 120 beehives tossing thousands of honeybees that dissuade anyone from tracking me. A letter at the post office from my father told of his new hip replacement and cane, and of the memory of putting a horsehair mat in our Idaho Falls basement and teaching me to wrestle. Then I ambled to the Kitchen and was intercepted by two snapping dogs at the a-keely's tendons, but I leapt lightly and kicked one in the ribs with the right foot and the other in the teeth with the left. I haven't kicked a dog in years and called 'Sorry' over my back. At the Kitchen I ate four barbeques knowing it would make me sick later for an hour but it's free. A man walked in the door as I exited and a child dashed up hugging his leg and shouting joy, 'Daddy!', and he responded, 'Who?' Apparently delighted, a black man called the pastor jigged on the linoleum exclaiming, 'It's the light!' I left and drove to the college with sand stretching in every direction under the hot November sun, and strolling to the library met a thick line of black ants passing ten feet from their hump nest to a Palo Verde tree. I jumped it and was suddenly struck by my last brush with technical analysis, plus an illumination.

I knew then that an uptrend tends to continue and a downtrend tends to fall, however if the pivot for either could be exacted and its mechanism understood then I could get rich. Subsequently, I poured over the daily market and a few dozen stock charts for six months before yielding and thinking, if only I can find a model that fits the market reversal then maybe I can get famous. I studied the ocean surf breaking on the beach, dominos falling, elementary calculus, bird wings, train cars, fluid and gas movements, light, and so forth before acquiescing and taking up racquetball. Today on alighting on the far side of the ant line, I wheeled and sat to observe. There seems more than a vague resemblance to a market move. Of course, a market waves and ants line_ or do they? The tip of the market wave is a line and the ant column has a fluctuating width, and so I sat a little longer. A trend of short duration meets small resistance and breaks, and so does an ant column, but a longer trend creates stability and similarly the ant column actually wears a trench that causes greater resistance to change. There are outside influences in both cases. But the intrinsic key between the ant model and all the others- surf, dominos, wings, cars, fluids and gas, and light- is that there is individual as well as group intelligence in the elements only of the ant line and market movement- the ants and the investors. I sprung, brushed them off, and turn the idea over to others better versed to qualify and quantify the parallel influences including intelligence of market and ant trends. Further clarification is in The Ants that won the Pulitzer Prize (science) for authors Bert Hölldobler and Edward O. Wilson. It's a starter anyhow, I could get print, and in any case today's trend in Blythe is up and fierce.

A Market Observation on Election Day, by Allen Gillespie

An incredible run. The Dow made a new high today 79 days since its last 14 day low, and it has covered just of 14% during this move. Given that there are only 8 rallies in history that have carried on as long and as far without a correction to the three week low, one must be impressed that it happens on election day.

Old Blue Eyes, by Bo Keely

Anyone who has moments of feeling sorry for himself should read the uplifting Narrative of the Life of Frederick Douglass, An American Slave: Written by Himself. It must be opened slowly and read like a healing sore. As with any autobiography, I advise to bypass the introduction and go straight to the 100-page narrative. Douglass had a black mother and white father, lost both, slept in a gunny sack and grew familiar with both northern city and southern field slavery. The oft touch of the whip isn't part of my anecdotal review and must be experienced first hand through the book. Fredrick Douglass rose through labor, education and sheer will up and out of slavery and, following an exciting 1838 escape by sea to New York, became the Lion Abolitionist. He is the best known of the fugitive slave autobiographers and this is the first of three memoirs that he wrote after the escape. I feel this narrative is the only one you need to read because it covers his twenty years as a slave while the sequels are the gravy of his victories.

The sole drawing of Douglass at the time of this narative's publication shows a square jaw, heavy brow and tight curls, and the close-set eyes that are hard to gaze into even after 150 years. So I dim the computer screen to see my reflection and wonder how I can think myself suffering in this mayhem. This spanking new Palo Verde College Library in Blythe, California, the 'jewel of the desert' opens doors each 8am and the meager students- public welcomed!- weave a hundred signs, Quiet Zone, No Cell Phones, No Food, No Chat, No Porn, to the 12-computer carousel.

Chat and porn account for half the overall computer time. Cell phones are continually in use and someone's always crunching chips next to a radio. The assistant librarians assist them, but the head librarian is apart, a grand dame and import from Yuma, Arizona a year ago. She, now graying and fifty pounds heavier, seemingly has thrown in the towel from her office to ponder my first day's warning (having suffered a like fate as the night supervisor of the tutoring center for one term), 'Dolly, there's an indirect correlation between longevity and competence at this job, and I'm afraid you'll last a year.'

There are three exceptions to the library bedlam, duffer authors who live independently out of their vehicles. The sci-fi man types around a two-foot bead and lives in a '70's camper in the parking lot; the bald Oklahoman is 230 single-spaced pages into his second Christian book and parks a battered van in a nearby BLM campground, and I type snips like this and crash nights in a hallowed Ford when away from my Sand Valley home.

My reverie is broken by a handicapped student twirling his cane overhead at a phantom and screaming, 'I'll flatten the bas___!', even as I wonder if my peers too incorporate it into their works. The assistant librarian asks me, as functioning reference librarian until the real one arrives at 4pm, 'What is an Almanac?' I show her, and the Oklahoman confers for the proper capitalization of pseudo-Christian. I find it, and a behemoth adult student with a tattoo necklace of chains takes #12 with the smaller screen (to discourage pornography) and scowls across at me as usual. Ironwood and Chuckwalla Prisons lie across the desert from Palo Verde College. When he does that I reflect back to a morning a few months ago_

A blue eyeball appeared in my computer toolbar. Odd, I thought, and at noon picked a hematite from my private collection and slipped it into the mailbox of a computer technician who carries stones in his picket to polish for good luck. That evening he whispered over my shoulder, 'They're watching you,' and quickly summarized that the eye means remote monitoring by one of the techs. The necklaced giant, he said, ratted me to administration claiming, 'He sits from 8 to 8 daily and must be looking at girls.' Disquieted, I moved to another monitor where the blue orb blinked on periodically wherever I sat for three days, and finally disappeared.

A far more serious incident a few years ago cost me a snowflake obsidian and trip to NYC to visit the Chair. For one month in 2002, many others thought I was going crazy with the stress of daily writings at the college but I knew that someone was breaking into my Email account. The hack reordered my list of addressees, greeted me from my own address with, 'This is your morning cup of coffee', and one time typed my password while my fingers floated above the keys. A couple friends got Emails from my address that I didn't send and I received ones that they didn't mail. The meddler caused no real harm but I sweat at the screen and cast sideways glances about the library until one day realizing that the pirate was probably too clever and charming to be operating from Blythe, and I began to look outside. Moreover dismayed that the invader could be affecting the moneyed people of the SpecList, I drove to Phoenix and flew to New York to settle the matter.

I climbed the outside stairs leading up to the trading office where day and night I knew I would find the Chair trading, studying or running in place next to the computer, and silently entered the screen door. His head was bowed before the screen and though we hadn't seen each other in many years his blue eyes only flicked up and then down. I sat at a computer across from him and wrote an Email, 'Vic, how are you?' He immediately replied, 'Fine. You're looking well.' I responded, 'There's an issue.' He smiled typing, 'Let's meet on the outdoor court at midnight.' I left and unpacked in a downstairs room, and in a few hours went out to the racquetball court to hit. Soon he burst under the sodium-vapor lights and embraced me crying, 'Show me your new backhand, and then tell me why you're nuts.'

The upshot is that without really saying so the Chair didn't believe there was an invader inside my Email account, and felt there was no danger to the Speclist. After an otherwise pleasant week's visit I returned home to the Sonora desert and Palo Verde College. Maybe I really was going mad; I finally thought to slip the prized obsidian into my friend's mailbox and that evening he materialized behind me at the library computer. 'They caught a disgruntled computer tech hacking the college systems and staff's Emails. He generated your Email password with a special program, but has gotten fired and you're safe. ' Then he walked off with the stones polishing in his pocket.

And today, months after the blue eyes and years after the visit to New York, I glance up from the screen where I occasionally escape and look around at the same troublesome library. I'm not going to read this drivel any more and feel sorry, and I suggest you cut your losses short too. I'm going to break away and read the last chapter of the Narrative of the Life of Frederick Douglass and then go for a hike.

A Half Dozen Random Questions on Growth vs. Value Debate, by Russell Sears

First, whenever you logon to Yahoo-Finance, Google-Finance, MSN-Money or other mass investor website and read a stock picking columnist, any columnist, and they all say the same thing "value beats growth". Indeed to even be invited to the table, you must pledge allegiance to Buffett. How far off can the regime change be?

Second, will the regime change be as big as 2000 and 2001, when the shoe was on the other foot in 1999?

Third, rather assuming it must remain the same because of 17 years of data. Why is this number of years chosen? Does it have to do with difficulty in determining "point in time"? What does this say about the accuracy of the data?

Fourth, what is special about 1,000 stocks? Does this method work for top 30, top 100, top 500 or top 5,000? Does size matter in this debate?

Fifth, when Buffett, the master of value investing, underperforms three years in a row, even as the chants grow louder insisting he is the guru to listen to, what does this say about value investing?

What effect does both 4 and 5 have on the "Average Joe" small potatoes stock picking value investor? And what effect does 4 and 5 have on the mega fund value camp?

Sixth, does Soros's principal of "when someone tells me how honest he is...." apply to a value investor's telling you how pure as snow his data are?

Data Shenanigans, by George Zachar

Rewriting History by Alexander P. Ljungqvist (Stern School of Business, NYU), Christopher Malloy (London Business School) and Felicia Marston (University of Virginia) provides evidence that nearly 20,000 records in I/B/E/S, a database of research analyst recommendations owned by Thomson Financial and widely used by investment professionals and academics, were manipulated between September 2002 and May 2004. This took the form of selective, ex post removal of analyst's names from some of their historical recommendations. These were not random; they were concentrated among the worst performing recommendations.

Eighty to One Hundred, by Steve Leslie

Years back I read a comment from Tom Dorsey of Dorsey Wright who stated that it is easier for a stock to go from $80 to $100 than from $15 to $20.

Is there an optimal price of a stock to purchase? $30 or above?

If one bought a basket of stocks at $80 at the beginning of the year, and held it for one year, what would be the performance of the basket and would it outperform the S&P index? What would the standard deviation be?

What price should an investor avoid? Below $12 or below $5? What are the reasons for doing so?

James Sogi adds:

Aside from the high/low price issue,

> 20/80

[1] 0.25

> 5/15

[1] 0.33

So it's about 8% easier.

John Bollinger recalls:

I think the first to dip his toe in this pond was Frederick Macaulay, later of 'duration' fame, writing in the Wall Street Annalist -- a NYT publication -- in the 1930s, the exact date eludes me.

Martin Lindquiskt elaborates:

Ahh... the square root theory. Norman Fosback has a little discussion in Stock Market Logic. The square root theory says the the magnitude of the stocks price move is directly related to the price of the stock. Specifically, for a given market advance, all stocks should change in price based on their square root. So the $15 stock (square root is 3.873) would advance to 24 (3.873+1 squared) and the $80 stock should at the same market advance go to 99 (8.944+1 squared). Or so according to the theory. The gist in any case is that in during an advance it pays to have the lower priced stock which should be more volatile.

Fred Macaulay originated the theory in the Annalist, March 13, 1931. William Dunnigan's New Blueprints for Gains in Grains from 1956 also has a discussion.

Gibbons Burke replies:

These lines from the first of the Quartets, Burnt Norton, resonate with philosophical thoughts on the nature of the markets, and the study of market history....

   Time present and time past
   Are both perhaps present in time future,
   And time future contained in time past.
   If all time is eternally present
   All time is unredeemable.
   What might have been is an abstraction
   Remaining a perpetual possibility
   Only in a world of speculation.
   What might have been and what has been
   Point to one end, which is always present.
   Footfalls echo in the memory
   Down the passage which we did not take
   Towards the door we never opened
   Into the rose-garden...

A Primer on Correlation and Regression, by Victor Niederhoffer

Applying Regression and Correlation, by Jeremy Miles of the RAND Corporation and Mark Shevlin of the University of Ulster, illustrates the proper and pitfall-laden path that lead to the many beautiful and illuminating things that correlation and regression can accomplish . The book is written for psychology students without any training in calculus, and it contains simple examples and extensive commentary on the regression output from standard statistical programs such as SPSS. However, the applications for psychology are almost identical to those that would be used in markets, with such variables as industries substituted for classes and companies for individuals.

And what a wonderful array of applications and extensions this book contains. I found myself augmenting my knowledge or learning something new on almost every page, and I have read many dozens of books on this subject. There are great sections on how to code your data so that you can do categorical regression, categorical covariance , structural equation analysis. There is a very good section on how to go through all the steps of logistic regression with simple examples and calculations to show how the maximum likelihood solution is computed. There is a very fine discussion of the reasons that you should never use stepwise regression and why hierarchical regression is much better. There is a complete chapter on all the computational methods of measuring the individual contributions to the prediction and the influence of each independent variable and each observation in the regression.

One of the main themes of the book that hold everything together is that everything that can be done with the usual analysis of variance techniques can be done with regression, but that regression does so much more. While I had read this before, I had never seen such a clear exposition of how to code the data so that you can actually accomplish the transformation and always come up with the more complete and useful regression solutions to such problems.

Chapters in the book cover simple model building with regressions and correlation, multiple regression, categorical regression, assumptions in regression, issues in regression, nonlinear and logistic regression, moderator and mediator analysis, and multilevel modeling and structural equation modeling. Its amazing that after reading this book, one comes always with a good appreciation of how to accomplish all the bells and whistles that a researcher might wish to accomplish in all these fields. The chapter on multilevel modeling is particularly useful as it fits in naturally with the simple approach and groundwork of the previous chapters, and by the time you come to these not-often-used techniques, you have a feel for the extra information and utility and practicalities of actually employing such techniques. The discussion of power that the author gives as an aid to determining the proper sample size for one, two and multi variable regressions, with helpful and easily understandable charts was also crystal clear and highly illuminating.

I found at every stage of the book that I was thinking that regression should be used much more often in market work. The residuals that are routinely examined in regression -- checked for such things as outliers, skew, kurtosis, autocorrelation, changes in variance, degrees of predictability at various stages of the analysis, clustering, influence of individual observations -- should be subjected to exactly the same scrutiny by anomaly and system researchers that psychologists would examine in determining the appropriateness of their own sample and conclusions. The influences of path and intervening variables that the psychologist studies to find the true causes should be considered by any market researcher as he strives to get to the roots of any intermarket relation, or study of the influence of economic events on markets. The same necessity that leads social science investigators to use multilevel analysis, i.e. that individuals are clustered into classes, groups, areas or sexes are the same reasons that market researchers should use this analysis for companies which are clustered into industry groups, P/E groups, periods when the market went down or up. Indeed, once you read a book like this which tries to boil down all the advanced techniques of regression into a form designed to perform practical research, you'll be seeing applications everywhere, hierarchies galore in seasons, years, interest rate environments, sentiment levels, differences in the recent correlation of consecutive observations, indirect effects that should be taken into consideration, methods of reducing the number of variables, ways of measuring the improvement that adding variables to a prediction would provide, problems of multiple comparisons, methods for removing data points which lack independence, methods for handling differential mortality of companies that go bankrupt or merge, or were retrospective added or deleted.

It's a bonanza and a cornucopia. The authors style and personas in this book is that of two rather average scholars who have struggled with and solved by hard work many problems and opportunities that a student might have in dealing with regressions and correlations, and how they would guide others of a similar mind . While many good things devolve from this framework, they do leave the student a bit up in the air for some of the references and mathematics behind more sophisticated extensions of regression. Topics like the regression bias, validity shrinkage, reliability, alternate correlation measures, range restrictions, distribution theory, prediction intervals are well covered in a book by an expert statistician Philip Bobko in the book Correlation and Regression, which we'll review shortly.

Intrepid Jinxed by Hoodoos, noticed by George Zachar

The Carrier Intrepid Runs Aground In Hudson's Muddy Bottom
By JILL GARDINER, Staff Reporter of the Sun, November 7, 2006

A panel of politicians, including senators Schumer and Clinton, spoke at a bon voyage ceremony for the ship early yesterday morning, and mayors Koch and Dinkins cast aside the yellow mooring lines.

From the Jaws of Victory, by Victor Niederhoffer

Yesterday's dramatic finish between Dallas and Washington with a blocked field goal, a run back, a penalty, and another field goal kick to the opposite side, all with six seconds remaining, reminds me of the closes that often happen in markets where until the last moment you're winning and then a 1 in a billion event occurs to snatch defeat out of the jaws.

Russell Sears replies:

When you are tired, some frustrating and very unexpected things can happen.

This is what makes racing the marathon such a love/hate relationship for me.

You can train and train, be physically ready. When exhaustion hits you, you can out think it, with mental toughness. But you only get a few brief seconds to decide if you really are ready. You must be both physically ready and mentally looking for it. Even then, it can take you by surprise, with a moments mental lapse. Then expect it to turn ugly and the unexpected.

But when you are on, it is powerfully exquisite.

This is a very hard painful lesson to learn and most marathoners, never do. They either give up on the marathon, or give up on doing them for times.

Ask Lance about this.

I suspect when people are on a team, or a large group of speculators, people often rely too much on the others. At that critical moment you are exhausted but needed most. Some will step-up, some will drop the ball.

J. T. Holley responds:

This was felt by Joe Gibbs if you watched the game and heard him speak immediately afterwards. During the Cowboy field goal attempt he had his head up watching his own defeat happen right in front of him, but when Novak (1 for 5 in attempts this year) miraculously got an attempt to win the game in the above mentioned 1 in a billion, coach Gibbs had his head down unable to watch the outcome. Afterwards he simply replied "that doesn't happen a lot".

My Hokies had a similar but not the same time frame outcome against Miami on Saturday night. They too blocked a kick that led to their victory. The relevant counting part is something I heard spoken by Coach Frank Beamer some years ago at an alumni function. When questioned in regards to his "Beamer Ball" style i.e. blocked kicks, blocked punt, he -- being also the special teams coach utilizing the best athletes on the team instead of reserves -- responded with, "one out of every eight plays in a game is a kicking play, that's where we can make a difference".

Steve Leslie adds:

In 1999 Jean Van de Velde, France's greatest golfer of all time, had an opportunity to be the first Frenchman to win the British Open since 1907. He came to the last tee with a three stroke lead, needing only to double bogey the last hole and win the tournament. After hitting the fairway with his driver, Van de Velde hits his next shot far to the right careens of the grandstands and into the rough. He flubs a wedge into the water, takes an unplayable lie, hits his next shot into a bunker, and hits out of the bunker and sinks the putt for an unimaginable seven. He then goes into a four hole playoff where he loses to another improbable winner in Paul Lawrie.

Perhaps the most amazing finish in golf history.

John DePalma replies:

ProTrade.com calculates "win probability." These calculations have become popular in baseball. Conditional upon home/visitor status, inning, # of outs, runners on base, and score differential, a team's probability of winning is derived based upon what has happened historically. For football ProTrade describes "Win Probability" as "a percentage that states a team's chance of winning at any given point in a game." The probability reflects "score, clock time, field position, home-field advantage, available timeouts and many other factors." Before Dallas attempted the field goal with 6 seconds left, the team's probability of winning was roughly 91%. After the field goal was blocked Dallas' odds dropped to 43%. The odds fell incrementally to 19% on the runback and penalty. And of course the odds dropped to 0% on Washington's field goal. (See http://tinyurl.com/y6u8y2)

As an aside, it's interesting to note that at least with respect to the baseball calculator, there is no path dependency. Momentum is assumed away. (Momentum and "hot hands" as mostly a statistical illusion.

Kinesthesiology -- The Tao of the Markets, by James Sogi

Trading is a physical endeavor requiring stamina, quickness and alertness. Physical training benefits the trader as any sportsman. Long hours at the screen take a physical toll. There is no mind body duality, and the body affects the mind and emotions and decisions. There are many parallels between music theory and the markets and why not in the physical and mental aspects of playing music and the market.

I am studying voice and singing under the theory of The Tao and the Voice by Stephen Cheng. He suggests a series of Tai Chi warmup exercises for singing. His approach would be beneficial to trading warmups or breaks. I know I like to go sing a few songs with loud electric guitar and big amplifiers during breaks to get away from the screen. Gets the lungs to open up. Yoga helps too. The Japanese Salariman has a routine to stretch the up body from sitting hunched over a screen or desk too long which they all do together in the office. Chair likes to go an play tennis during his trading breaks as the quotes are called out the window, "New lows on the day!"

One of the exercises involves circling your hand in circles above the head. The effect of this is to integrate the left and right sides of the brain. Some of the difficulties in decision making on trades is in the left and right brain functions. Perhaps the experts could add on this subject. The motions physically cross signals in the two brain halves and get them working together better. When my kids were little they taught them at school to rub their ears and turn figure eights with either hand in front of their bodies across both sides saying," I love school". It became a joke, but it may have some good effects. Now all chant, "I love trading, I love trading".

Western philosophy and religion adopt the premise of the disembodiment of the spirit from the body in terms of soul and the ultimate. This leads to many issues which can be approached differently by integrating body and mind, the inside and outside, not as separate things, but as a unified process. We are after all part of the market and it is part of us.

The Melbourne Spring Racing Carnival, by Jan-Peter Janssen

Several days ago on this web site there was an article regarding The Melbourne Cup. I had to see it for myself so on Saturday I attended Derby Day. Here are a few thoughts I would like to share:

Happy but Out of Pocket
Before the Carnival, I guessed the services would be overpriced. So I budgeted by placing only one Australian $50 bill in my pocket. I promised myself that I would not place bets on horses as I know nothing about racing. I kept this promise. The price structure of the complementary goods of gambling and alcohol was impressive, or dangerous is probably a better word. Champagne was ridiculously overpriced, while beer was much more affordable. It is my opinion that the beer priced at $6 had two purposes: to get patrons intoxicated so they would gamble more and to squeeze the last coins out of the unlucky pockets of losers. The small plastic bottles of champagne sold for $30 were effective in reclaiming money from any lucky winners.

The Grace Equilibrium
Everyone puts on their most beautiful outfit for the races. For men it's simple. I only spent a minute donning my olive green Italian suit. Girls on the other hand, have been planning, shopping and using their creativity for weeks to come up with the most gorgeous dresses and graceful hair pieces they can find. I have never seen so many eye-catching combinations of colors, shapes, flowers and feathers. I wonder why hair decorations are so rare in today's daily society. Since almost no one wears them daily, an individual woman would feel silly sporting one. However, if women wore these decorations daily they would collectively be more graceful. Maybe a small spark (designers, stars, wake up!) is all that's needed? Tons of money could be made on decorations and designer hats if incorporated into daily fashion.

The Opposite Seasons
We are the first generation that can relatively easily cut down the four seasons in a year to just two. By having one home in each hemisphere, one can have twice as many friends and can experience the magic of spring and comforts of summer twice as often. For business this becomes a problem however. In most industries moving all staff members twice a year would be impractical. But I do see an opportunity here for some firms, especially small firms with young (childless) employees doing online business. Possibly a good way to attract the brightest minds without paying the highest salary? Offering a country swap and endless sun? I think this opportunity exists as long as there is an asymmetry between the number of firms operating this way and the fraction of people who would suit this unique lifestyle.

Craig Mee replies:

Just a quick reminder, Australia's biggest horse race, "The Melbourne Cup", is November 7. In 17 of the past 22 (and 11 of the last 11) years the Australian share market has closer high on the day. The average gain has been close to double the average loss. The effect on human emotion and share buying in the midst of one of the happiest days during the year in Australia cannot be under-estimated.

1421, by James Sogi

Those who enjoy Rule the Waves and the Master and Commander series will enjoy 1421: The Year China Discovered the World about Chinese voyages of discovery around the world in 1421, their navigation and ships. The conclusions are not quite as :"clear" and self evident as the author states but is a big improvement over the Chariot of the Gods thesis. It is interesting to compare European and Chinese voyaging. Here is an excerpt:

On the 8th of March, 1421, the largest fleet the world had ever seen sailed from its base in China. The ships, huge junks nearly five hundred feet long and built from the finest teak, were under the command of Emperor Zhu Di's loyal eunuch admirals. Their mission was 'to proceed all the way to the end of the earth to collect tribute from the barbarians beyond the seas' and unite the whole world in Confucian harmony. The journey would last over two years and circle the globe.
When they returned Zhu Di lost control and China was beginning its long, self-imposed isolation from the world it had so recently embraced. The great ships rotted at their moorings and the records of their journeys were destroyed. Lost was the knowledge that Chinese ships had reached America seventy years before Columbus and circumnavigated the globe a century before Magellan. They had also discovered Antarctica, reached Australia three hundred and fifty years before Cook and solved the problem of longitude three hundred years before the Europeans.

Meditations On Hunting By Peter Grieve

One of the best books on hunting is "Meditations on Hunting" by the Spanish philosopher Ortega y Gasset (he likes it, by the way).

One of his amusing points is that while people speak of "defenseless" animals, every hunter knows that every animal has a great defense, that of being elsewhere.

Hunting really doesn't fit into any categories. It's not nature, because there are rules. It's not a sport, because one of the participants doesn't want to play. It's not economic behavior (nowadays, anyway), and it's not relaxation.

My take is that it's a kind of controlled participation in Nature, where deeply primitive elements are combined with very noble goals.

An Ancient Chinese Story, from James Sogi

There is an ancient Chinese story about a peasant whose horse ran away. His neighbors extended their sympathies at the misfortune, he responded, "Maybe".

The next day the horse returned followed by six wild horses. The neighbors exclaimed at his good luck. He said , "Maybe".

The next day while trying to ride a wild horse his son broke his leg. "Too bad!", said the neighbors. He said, "Maybe".

The next day the government officers came by to conscript soldiers, but the son was excused for his injury. When the neighbors exclaimed how well it all worked out, he simply said, "Maybe".

This surely reminds me of my path to trading and each trade as well.

A-Rod and the Hedge Fund Manager, by Jason Shapiro

The key to success in just about any endeavor is to have a process that works over time, adjusting this process to changes in the environment, and not letting short term noise get in the way of the long term success. As a hedge fund manager this process gets clouded when we get paid quarterly, and get marked and overly scrutinized on a monthly basis. This has a tendency for the manger to get off the long-term track and do things like book a good month for marketing purposes or book a good quarter for incentive fee purposes. This may get in the way of the long-term success of the process, but it feels justified when short-term money is involved.

I believe a baseball hitter can go through this same psychology. A hitter may have a great swing, practice habits, and a coach that helps him make changes as necessary, and this process over 162 game season or even 1620 games over 10 years will lead to great success. This success of course says nothing about any individual one week or 10 game period of time. Come playoff time these long-term numbers get thrown out as the fans and media (the investors) want great performance when it counts most. The hitter is now in the same dilemma as the end of month hedge fund manager. He forgets the process and tightens us trying to ensure short-term success even though he may suffer a short-term setback in his long-term success. This thinking certainly affects the psych of the hitter and in fact makes matters worse than just the short-term randomness may indicate. I think this helps to explain the A-Rod scenario come playoff time as well as the performance difference in hedge funds.

Old Cats Home, by Bo Keely

I thought I was a lion tamer taking on the volunteer job of counseling in an old folks home. Armed with a veterinary degree and psych tech certificate, I made my daily rounds. The first room belonged to Gloria, bedridden with a bad bowel for two decades, who always screamed as I entered, 'Read to me of the coming of the Lord!' Dutifully I took up the King James Version from the bed stand and, holding it upside down as is my habit, read from Revelation 6, 'And I looked, and behold a pale horse and his name that sat on him was_' Through the narrow passages Gloria gradually calmed, turned her face to the sunny window, and fell asleep every time. I put the bible back and continued down the hall.

The next challenge was Mildred, fit to be tied to a hard stool, staring vacantly and silently for as long as any memory in the home. The general staff dare not broach a three-foot radius about her chair but each shift I spent ten minutes sitting closer and closer and staring off in her same way. After two weeks, I imagined a rapport and cautiously scooted my chair until our knees touched. A hand snaked out with claws that raked my face! In bloody retreat I speculated that that one required more training.

Down at the day room, Crying Annie presented a special peril of disheartening the entire population with sequential tearful outbursts. No one knew why she cried but it was said that she had never laughed. My single afternoon's ledger of her one minute mean bawl six times per hour related to various stimuli yielded zero correlation, however, it sparked an idea. 'Annie,' I opened cheerily, and as she burst into crocodile tears I yanked my curls and blurt, 'I will make you laugh or eat my hat!' Miraculously she subsided looking over my head. I explained how in school I had bent and picked a horse's hoof to clean and the animal had chomped my hair thinking it hay. 'Ever since, when I need a haircut_' Annie's explosive laughter shook all the old cats out of their rooms to ring us and laugh themselves silly until they cried. It was a circus and, ahead of the act, I bowed out.

Six months passed until the day I was rotated to the geriatric psychiatric ward where a codger stalked me to counsel, 'Get out of here; this ain't a dress rehearsal!' I lay the whip down and walked out.

Are Traders Backing the Wrong Horse in the Grain Markets?, by Stephan Bisse

Are traders backing the wrong horse in the grain markets? Corn and soybeans are rallying strongly in part because of expected extra demand coming from the production of bio-fuels. At the moment the main focus is on corn and the corn grain ethanol produced from it. However, a recent article in The Technology Review refers to research that shows that the net energy gain from corn grain ethanol after taking into account all the energy used in farming and processing corn is small. The net energy gain from biodiesel made from soybeans on the other hand is much greater and biodiesel produces less greenhouse gases to boot. A possible catalyst for the switch of attention from corn to soybeans could be an article mentioned today in the Fort Dodge Messenger about a local trucking company embarking on a two year study comparing biodiesel to normal diesel in every day commercial use. This and the increasing spread of soybean rust seems to augur well for continued soybean price strength in absolute and possibly relative terms.

Deep in the Heart of Texas, by Victor Niederhoffer

I recently visited the University of Texas Cooperative Book Store and bought the following books in an attempt to increase my knowledge. I find the regular forays that I take to college book stores one of the most useful activities I engage in as it keeps me up to date on current knowledge, lets me know the kind of things the current operatives in the field are exposed to, and serves as a beacon, spark, and warehouse of knowledge for my kids. My favorite book stores are ones at Texas, Penn, the Seminary book store at University of Chicago, the Barnes and Noble at 17th street connected with NYU. The range of subjects taught at all those schools is all encompassing.

Usually when I lug the baskets of books to the cashier on such forays, the cashier will say that I made the second largest purchase in their history, next to some Mideast customers who came in with a retinue of 5 that purchased two of everything in the bookstore for their library back home. I always answer that the reason I have to buy so many books is that I have so much to learn. I find that all older practitioners of investments have much to learn also, and are frequently wedded to ideas from the 1930's that it would be helpful for them to mix with current knowledge and theories and foundations and the lack of book knowledge is one of the reasons that so many senior writers and advisers are so out of touch with a proper foundation, which should always include the books of Brearley, Dimson, Damodaran, and Harris. I would recommend that all students and practitioners of finance buy the current texts in the field as it would help to give them a groundwork in what's known, especially in the field of regularities relating to risk and return.

I will read many of these book in the hopeful near future and share reviews of those that I can understand with you. Here's the current list:

Title                                               Author (Last Name)
Principles of Finance                               Besley, Brigham
Correlation & Regression                            Bobko
Microeconomics                                      Cameron, Triverdi
The Age of Migration                                Castler, Miller
Astronomy                                           Chaisson, McMillan
America- Past & Present                             Divine, Breen, Fredrickson
Modern Control Systems                              Dorf, Bishop
Telling Lies                                        Eckman
Hitting the Sweet Spot                              Fortini, Campbell
The Struggle for Democracy                          Greenberg, Page
Practicing Physics                                  Hewitt
Conceptual Physics                                  Hewitt
Biology Demystified                                 Layman
Applied Multivariate Research                       Meyers, Gamst, Guarino
Applying Regression & Correlation                   Miles, Shevlin
Schaum's Easy Outlines-Electric Circuits            Nahvi, Edminister
Human Learning                                      Ormond
Urban Economics                                     O'Sullivan
Introduction to Computer Systems                    Patt, Patel
Humanity                                            Peoples, Bailey
Images of the Past                                  Price, Feinman
Corporate Finance                                   Ross, Westerfield, Jaffe
Conformity & Conflict                               Spradley, McCurdy
Statistics for the Social Sciences                  Stevens
Financial Reporting, Financial Statement Analysis.. Stickney, Brown, Wahler
Teaching Students Centered Mathematics              Van De Walle, Lovin
Principles of Fraud Examination                     Wells
Frankensteins of Fraud                              Wells
Chemistry Demystified                               Williams

October Surprise, by George Zachar

4.4% "headline" unemployment

231k payrolls (w/revisions)

Earnings and workweek pop back to range tops

437k household jobs print

...But let's talk about that newly disgraced preacher in Colorado instead...

The Black Swan, by Andrew Moe

It seems the black swan is amorously engaged at present and thus unavailble for a repeat of the may meltdown. A fine desktop wallpaper for the day to serve as a reminder of the fickle nature of chance -- and love:

A black swan swims in front of a paddle boat on the Aasee lake in north-western city of Muenster November 2, 2006. When the black swan arrived at the lake in spring, it became a local attraction, after 'falling in love' with the plastic swan paddle boat available for hiring on the German lake. REUTERS/Ina Fassbender(GERMANY)

Market Queries From a Northern Neighbor, by John Burckett

I am a 27-yr old professional equity derivatives trader with several questions and comments for Dr. Niederhoffer and Ms. Kenner. I just read Practical Speculation. I had previously read Joel Greenblatt's The Little Book That Beats the Market. Needless to say, the two works propound extremely different views on the relative merits of growth versus value stocks and on the ideas of Benjamin Graham. I'm sure this is a debate that has been beaten to death before I was born, and I'm sure you are entirely sick of the whole thing, but please bear with me. I am interested in reconciling the ideas of the two authors. I would like your opinion on Mr. Greenblatt's work and his "system" for investing.

I wondered specifically what Dr. Niederhoffer and Ms. Kenner's response would be to the data cited in Greenblatt's book. Is this evidence entirely worthless due to statistical and sampling errors? Is it only since 1965 (the Value Line data in the book was for 1965-2002) that growth has overtaken value? What do Dr. Niederhoffer and Ms. Kenner think is the correct way to value a stock? Since it's difficult to precisely ascertain current or even past "real" earnings for a single stock, let alone the mkt, how can one hope to accurately predict the level of future earnings (as you must do for growth stocks). What valuation model should be used? What valuation model can be used that works for both "growth" and "value" stocks (it seems fairly silly to categorize all stocks into one of these two fairly arbitrary columns, but that's what seems to happen).

Anyone can go to Mr. Greenblatt's website and get a list of "value" stocks. He argues that his system (buy 20 or 30 of these value stocks and then sell them after a year and get new ones from an updated list on his website) will beat market returns over time. I am suspicious, but where is the logical flaw or statistical error in Mr. Greenblatt's book. Will his method really work, and if not, why ? Mr. Greenblatt posted excellent returns over many years (I believe 10 years of returns are necessary to eliminate luck as the explanation of a trader's returns) at his hedge fund. I'm sure he wasn't simply applying the method from his book, but he is clearly a "value" investor.

To me, the strength of "value" investing, especially as described by Mr. Greenblatt, is its seeming logic. Even though you can't buy a stock portfolio for 50% of its liquidation value as Graham suggested, the market and especially individual stocks can fluctuate fairly wildly even over short time frames, so clearly it is possible at times to buy good stocks or the whole market "cheaply." As I write this, AMD has a 52 week range of 16.90 - 42.70... with roughly 485 million shares outstanding, that means in terms of market value AMD was (according to the market) "worth" almost $21 billion in late January, and only $8 billion or so in late July. Maybe some of this move was due to new (bad) information, but in all probability (since the stock subsequently recovered- then dropped again) it was due to the overtrading and ridiculous focus on short-term results that Dr. Niederhoffer and Ms. Kenner lambaste in their book. Take a look at the way retail stocks move around on monthly same-store sales numbers or oil and gas move on weekly reserves numbers for further examples of ridiculous overtrading and short-term focus.

Nevertheless, to ignore volatility (which is how I make my living) and keep your eyes firmly on the long-term potential of a stock leads to two pitfalls. First, you miss out on opportunities when the stock swings around in the short run (for example, you could have sold some medium-dated calls in AMD in Jan, then used the proceeds to buy additional stock in July). Second, you are ignoring risk; in the short-run, you could see such severe swings that you go broke instead of getting your 1.5million % a century return. Volatility might be much higher than it "should" be, it might be due to overtrading, and it certainly is the result of a focus on meaningless short-term information, but it is a fact of life. In my opinion, it's better to take advantage of this fact than to ignore it.

One solution is to actually buy volatility itself. There are several studies showing that a portfolio containing a volatility component of 10% or so will outperform a similar portfolio with no volatility component (an example of a volatility component would be VIX futures or a similar instrument, essentially just a long option position). The general basis for this is that implied volatility in the options market usually increases when the market drops. You are diversifying your portfolio with a negatively correlated asset. Since the VIX hovers at a very cheap 10 or so these days, it seems like a great hedge.

Any reply or even a suggestion of further reading on the value/growth debate would be greatly appreciated. I have also emailed Mr. Greenblatt's website with similar questions (you can find that email below).

Doc Castaldo illuminates:

He has so many inter-related questions it is hard to know where to begin. The Tim Loughran article "Do Investors Capture the Value Premium?" which some Spec (Dr. Zussman perhaps?) sent to Steve Wisdom recently seems relevant, and I sent it to him (the answer Loughran gives is no). I believe Prof. Pennington and Mr. Dude reviewed the Greenblatt book and found it well done; though some of us have doubts as to how well the results will hold up going forward.

Steve Leslie adds:

I have studied this deeply and although impossible to adequately reconcile this argument, my reply is that there is enough room in the world for value investors and growth investors. One is more of a science and the other is more of an art. And that which works for one will not work for another. And they tend to be complementary, whereas when value investing is in favor growth is out of favor and vice versa.

Case in point late '90s. Nobody and I mean nobody wanted to be a value investor. At the time I was with a regional brokerage firm and we had one of the best value fund managers around, and he was never asked to speak anywhere. Everybody wanted growth and hard chargers. He told me directly that the worm would turn and that which one is hated will once again be loved. In 2001 and onward his style came back into vogue. His numbers became very good when the implosion of growth occurred and value turned to the good.

I feel that value investing is more of a quantitative approach to investing. It requires arcane methods and such as roe, price to sales, price to book. You can have value investors, deep value, vulture investors etc. And it is very important that with value investing that one be a patient investor with longer term time frames. I have referenced the Hennessy Funds as excellent quant funds. They have a very rigid stock selection process and rebalance their portfolio annually which they bought the rights to from James O'Shaughnessey who brought this methodology out in his book How to Retire Rich. Their long term track record is very good and they did very will since 2000 but this year for the most part the results have been flat. Martin Whitman is a deep value investor and his Third Avenue Fund has done very well over time. As has the Davis Funds. The First Eagle funds does excellent work with their global funds.

Growth investing is more of an art. It requires timing. Growth investing such that William O'Neil supports can be very successful yet very volatile. Small cap growth investors many times requires a longer term time horizon as the swings in price can be quite hard to take. I have always liked Ralph Wanger (A Zebra in Lion Country) and Tom Marsico in this area.

It is very important that the style of investing one uses incorporates their financial education, character and personality among others. They most definitely require knowledge and different wiring.

As to the trading of that the chair employs, I will let him speak for himself but I am confident that he will say the methods that one uses for value investing and growth investing would never work for his methods of day trading or swing trading.

To use a poker analogy (alas it always comes down to poker) I liken value investors to people like Dan Harrington, Howard Lederer and Phil Hellmuth. They are percentage players very methodical. They wait for premium hands and play those. These are the tight players.

On the other side of the ledger are the growth investors such as Phil Ivey and Gus Hansen, aggressive sometimes to a fault and they play many hands and many times on feel.

Both styles and much more in between are effective and can bring one to the promised land, they just take different routes.

Dr. Phil McDonnell reminisces:

Many years ago I was engaged in fundamental research on stocks for a finance class at Berkeley. Upon showing my results to one of the rising young finance Professors in the Business School I had a rude awakening. He promptly but kindly pointed out to me the myriad of biases which enter into such a study.

It prompts one to paraphrase the poem poem by Elizabeth Barrett Browning:

"How Do I Confound Thee?" Let me count the ways in which fundamental stock data can confound:

  1. Stale Data. Data are not always reported on time. Some is late, but most studies do not account for this adequately.
  2. Retrospective Bias. Most fundamental databases use the current 'best' information believing that is what you want now. But for historical studies that means the data may have been retrospectively edited as much as several years after the fact. This is a form of knowledge of the future. If you analyzed Enron before its collapse the fundamentals looked good and the stock was too cheap. If you analyzed today with a retrospective database you know that the company had catastrophic losses. But the truth about the losses was not known at the time and the adjusted numbers only came out years later.
  3. Sample or Survivor Bias. Use of a current database often results in a sample bias due to the fact that only companies which continue to exist in the present will be included in the sample. In order to avoid this issue one must go to an historical source in existence at the time in order to manually select the sample for each month by hand. Many companies are delisted or otherwise stop trading. For these the data must be manually reconstructed from historically extant sources. Otherwise this bias translates into a strong bias in favor of value investing strategies. A strategy which buys out of favor, or high risk or near bankrupt companies will always do well with this bias. The bias guarantees that they will still be around years later because they are still in the database.
  4. Data Mining. There are many variables to choose from with fundamental data. There are countless more transformed ratios or composite variables which can be constructed. This leads to the ability to try many things. Thus the researcher may have inadvertently tried many hypotheses before coming to the one presented as the best. Because fundamental data are low frequency (quarterly at best) there are only 40 observations in a 10 year period. True statistical significance can quickly vanish in a study of many hypotheses.
  5. Data Mining by Proxy. Everyone reads the paper and keeps up with current trends in investments. Thus our thoughts are always influenced by findings of other researchers. Thus even if a researcher did a study which avoided the usual data mining bias it may be simply because he took someone else's results as a starting point. In effect he used their results as a form of data mining by proxy to rule out blind alleys.
  6. Fortuitous Events. In the 1990's F*** & Fr**** published papers about factor models to augment the Sharpe beta model. Their significant new factor was Price to Book ratio. In James O'Shaugnessy's book What Works on Wall Street one can see a sudden upward surge in value strategies in the early 1990's coincident with the publication of the F & F model. However the event was a single one time upward valuation of value models in the 1990's. Before and after that, the effect vanishes.
  7. Post Publication Blues. After publication of any academic paper or book the money making method usually stops working. Sometimes it is due to data mining or some flaw in the study and the putative phenomenon was never really there. The market is efficient. If everyone knows something it will usually stop working even if the original study was valid.

Prof. Greenblatt's book is a fun read and remarkably brief. In fact if someone wanted to just get the gist of it, each chapter ends with a very clear summary of the key points in that chapter. It would be possible to get all the main points in about 10 minutes simply by reading the summaries. Let me say that if one were to use a fundamentally oriented strategy then the profit margin and Book to Price are probably the first two on the list. To be fair to the author, reciting one's efforts to avoid sample biases in a book intended for a popular audience probably would not help sales. Such discussion is usually reserved for academic papers but nevertheless its absence does not give reassurance that all possible bias was eliminated.

The best way to test this strategy is not to go to the library and do all the work yourself. Rather one could simply go to the web site and copy down all the stocks recommended. Then in 6 months and 12 months revisit them to see how they have done and to see if the performance was statistically significant.

Ever since those Berkeley days more than 30 years ago I have always been distrustful of fundamental studies. That lesson from then Prof. Niederhoffer has helped shape my market studies in many ways. The bias of fundamental data is yet another way the market can confound the research oriented trader.

Jaim Klein replies:

Let's simplify. The market universe is large and diverse enough to accommodate different successful strategies. One catches fish with net, another with bait. Regarding the value of anything, no such. The value of a thing is the price it can fetch in a certain moment and place. At 27 I was also confused. Experience is the best (probably the only) teacher. He has to do his own work and reach his own conclusions. It is time consuming, but I know no other way. He can also observe what successful people is doing and try to copy them till he can do it too.

Prof. Charles Pennington rebuts:

Dr. Phil lists 7 things that can go wrong in research on stock performance and its relation to fundamentals. Oddly enough, the Greenblatt book itself also lists exactly 7 such reasons on page 146! They're not exactly the same ones, but there is plenty of overlap. I'll list Greenblatt's 7 with my own paraphrasing:

  1. Data weren't available at the time (look-ahead bias)
  2. Data "cleaned up", bankruptcies, etc., removed (survivorship bias)
  3. Study included stocks too small to buy
  4. Study neglected transaction costs, which would have been significant
  5. Stocks outperformed because they were riskier than the market
  6. Data mining
  7. Data mining by proxy

Greenblatt: "Luckily the magic formula study doesn't appear to have had any of these problems. A newly released database from Standard and Poor's Compustat, called 'Point in Time', was used. This database contains the exact information that was available to Compustat customers on each date tested during the study period. The database goes back 17 years, the time period selected for the magic formula study. By using only this special database, it was possible to ensure that no look-ahead or survivorship bias took place."

To all the biases that we consider, I'll add the "not invented here" bias. It's too easy to assume that no one else out there can do rigorous research. I think Greenblatt's is fine.

(He didn't however do any original results on jokes. His jokes are all out of the Buffett/value-school jokebook. Fondly recall "There are two rules of investing. 1. Don't lose money. 2. Don't forget rule number 1." That one's there along with all your other favorites.)

Dr. Phil McDonnell replies:

The way we all remember the late 1990s is the dot com bubble. It was the front page mega meme. The stealth meme was the value stock idea.

Rather than think of it as a single paper consider the paper as the seminal idea of a meme. From the original paper there were follow on papers by various academics as well as FF. From there the meme spread to the index publishers who always want a new 'product' to generate marketing excitement. Naturally the index guys sold it to the funds and money mangers who promptly started new funds and rejiggered old funds along the lines of the new meme. The money management industry always wants new products but also each firm needs to act defensively as well. For example Vanguard cannot eschew the new fad and leave the playing field open for Fidelity. As with all memes it grows slowly and diffuses through society.

In all fairness one can never 'prove' cause but only correlation using statistics. But it is clear to me that something happened which caused the value part (really just Magic Formula) of the market to triple during those years albeit with only negligible public awareness early on.

For the sake of argument assume that the cause was not the FF paper and its impact on the value meme. Then what was Dr. Zussman's 'unseen factor(s)' which caused a triple in value? Which factor or factors are more plausible?

My prediction for the end of the next meme is the collapse of the Adventurer's bubble. To play it one needs to sell. But I would guess that it is only a one to three year collapse.

Dr. Kim Zussman responds:

Then in Franklinian spirit (in that popular literature anomalies contain sustainable alpha), here are top all-time SSRN papers with tradable strategies:

Rank  Downloads  Paper Title
1  55133  Market Efficiency, Long-Term Returns, and Behavioral Finance
Eugene F. Fama,
University of Chicago - Graduate School of Business,
Date posted to database: April 30, 1997
5  30740  A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation
Theodore Sougiannis, Stephen H. Penman,
University of Illinois at Urbana-Champaign - Department of
Accountancy, Columbia University - Department of Accounting,
Date posted to database: March 31, 1997
7  23835  Value Based Management: Economic Value Added or Cash Value Added?
Fredrik Weissenrieder, Weissenrieder Consulting AB,
Date posted to database: April 5, 1999
8  22921  Value Versus Growth: The International Evidence
Eugene F. Fama, Kenneth R. French,
University of Chicago - Graduate School of Business, Dartmouth College
- Tuck School of Business,
Date posted to database: May 1, 1997
9  20446  Taxes, Financing Decisions, and Firm Value
Eugene F. Fama, Kenneth R. French,
University of Chicago - Graduate School of Business, Dartmouth College
- Tuck School of Business,
Date posted to database: February 1, 1997
10  19467  Optimal Capital Allocation Using RAROC and EVA
Neal Stoughton, Josef Zechner,
University of Calgary, University of Vienna,
Date posted to database: September 11, 1998
And this near top of recent download popularity pile:
2  939  Dissecting Anomalies
Eugene F. Fama, Kenneth R. French,
University of Chicago - Graduate School of Business, Dartmouth College
- Tuck School of Business,
Date posted to database: June 26, 2006

Mojave Crossing Parallel, by Bo Keely

I read last night the first two chapters of L'Amour's Mojave Crossing to reconnoiter my upcoming parallel adventure. Tell Sackett stops at every landmark in my memory along the trail including Fort Mojave, Piute Range, the Old Government Road, and Rock Springs. Sackett hasn't spoken yet of the weather that would be first off his lips if the summer furnace or winter chill, so the crossing must have been at this time of year. He carried 32-lbs. of gold in his saddlebag but I'll take his weighty story deep in my backpack to compare our views. Of course, there's the danged black-eyed girl that L'Amour atypically opens this tale with. I nearly threw the book down in Carl Jr.'s as my favorite author always presents a flash of fists or guns with a heavy puzzle, but I held the reins of L'Amour's grand storytelling and then looked up and around the burger joint. Black-eyed girls are not common in these parts just south of where the novel opens, though nowadays they're unilateral with an equal number of black-eyed men. She was being tailed! To better sense Tell's carrying a treasure and thus encumbered across the vast desert, I'm hiring such a girl whom I used to date who now has a third-degree karate black belt and a new mate. I requested this morning, -- But she must be a black-eyed girl -- do you have black eyes?'  If all goes well, we'll be hot on the trail from the Colorado River to retrace Tell Sackett across the Mojave.

The Joke Revisited by Vic Niederhoffer

There has been some discussion of the jokeful nature of the market, how improbable things happen when you are set up completely for the probable. Nothing better illustrates this then the moves on this first of November. It's invariably the most bullish time of the month, and this month the most bullish of all. No declines of 10 points or more in stocks had occurred in 2-3 months (8/9 -17 pts, 9/6 -11.9 pts), and this was the largest 1 day decline on the first day in a month since 2004 (7/1/04 -14.7 pts).

Making it even more improbable was the backdrop of support with bonds setting a 8 month high at 113-05 on the December future. It occurred after 3 down days, and to thoroughly confuse, yesterday was completely unchanged on the official settlement leaving all counters without a rudder.

A few called me at the beginning of the day. This is such a perfect setup that I'm just going to leave the screen, go out of the office, and count my winning at the end of the day, so I won't be tempted to extricate with just a small profit.

As Berlioz said to Lasseur after he had heard the fifth and said "music like that should never be composed again". "...There's no danger of that..."

It's a Trap!, by GM Nigel Davies

The words "It's a Trap!" have occurred countless times in movies. They happen in chess too, suddenly yelled by your inner voice.

When does the inner voice speak? A common time used to be when you wrote your move down prior to playing it, the act of doing so being a kind of announcement, a phase shift. I say 'used to be' because FIDE outlawed the practice of writing down the move first, saying that it was 'relying on notes'.

There are other times too, when, for example you find a tiny inconsistency, a departure from the usual script. In the movies it might be that there's something not quite right about a uniform, perhaps that the butler's shoes are inappropriate or a coat is buttoned the wrong way.

With regards to yesterday the chair noted the unusual rally on the last day of October, strength when usually there was weakness. And then the higher gap open sold off very quickly, not at all like one of those days which start high and then feature a crescendo of buying as the day wears on. Not much to go on but there was a brief chance to escape. In retrospect. And it was a reminder of Tartakover's saying, "obvious therefore dubious, dubious therefore playable".

A Halloween Thought by Bo Keeley

I aim to quickly describe my thought process that may differ from yours. I willfully filter information at the sensory gate before allowing it to enter the mind. You walk into a bar and see everything but quickly cancel the things that don't deserve notice; then you focus an instant, one by one, on pertinent items or spaces and allow the ones you desire to engrain in short term memory. Then you pick from among those-even while moving and seeing the whole bar afresh- the few things that you want to ponder. Then you ponder.

Females and kids don't usually perceive in this way, but instead flash from one big picture or thought to the next, and feel each. That's wasteful. Athletes move gracefully about canceling undesired thoughts by their physical movement while zeroing in on what they do want, yet jocks in general are passive thinkers. That's molasses. Scientists stop-frame one item after another and further process- compare each and to their life memories- to infer conclusions. They are 'good' scientists if everything in the universe has equal value. Religious people believing in an outside control show the blank but eager faces of bulldogs never having gotten the bone. The insane have a motion picture of perception without being able to stop and frame a single item. City people unconsciously run every thought through a template of people representations from their pasts. That's pollution. Speculators to succeed must train themselves toward a checkers mentality of the repetitive three-steps of over-sweep, breakdown into subgroups, comparison, and all the while trying to keep the present, past and future separate. Chess is a more powerful game of survivors where the thought arena is constricted and the variables fewer with those individual pieces having wide-swinging strengths that must be controlled. That's sublime. Dogs are able to mull over only what they have repeated in experience while they overlook all else in the field until something odd pops up. That's happiness. Cats, with the slightest hint of thought, make the greatest mental leap and physical moves on earth, and are dangerous to a person like me. Who knows how frogs think?

These certainly are quick off-the-cuff generalities on the way I think as self-studied in the nightly laboratory of bars around the country for nearly 10,000 consecutive nights. I never drank, only thank. I believe in bio-psychology, the biological factors of thought and behavior. The mechanics of seeing the world every waking second as a chess player and dancer, the supreme thinker and mover, truly racks the mind and body. When I was a heavier thinker, my facial and brain vascular musculature tightened so that at the end of some days I fell into bed feeling like Officer Bill MacCarthy after pounding his head to ask a string of suspects if any wanted to resist arrest. However, 99% of the thinking population is passive users of the mind allowing the fruitful unconscious rather than the more controllable conscious to steer their choices. That's sad, but there's help. One may improve his perception, acuity and stamina by exercising the mechanical process via reading books, reading people, and just plain thinking. Beware that you can overthink and become entrapped a la the bulging body builder who doesn't know when to stop. For example, after writing from October 1 to Halloween, I feel with one hand my tight face and within the thoughts that come either too swiftly or stay too long. On the other hand, it's a short time before the green rattlesnakes clear and the moon rises full over the Mojave Crossing and I take a long hike to get better.

Russell Sears Reviews Stalking the Riemann Hypothesis

Dan Rockmore's book Stalking the Riemann Hypothesis, written for the recreational mathematician, brought forth in me the profound emotions. Reading it seemed quite similar to my enlightenment in reading my first Calculus book. The book completely avoided the messy math and stuck to the core concepts behind the math. And what a mathematical journey is was. Starting with the early history of pure math, with the Greeks, to modern day theories. It seems that search to prove Riemann's hypothesis has lead to many the leading edge of science. Chaos theory, Fractals, the edge of probability theory, Random infinite matrices and more.

Besides the beautiful ideas it goes introduces you to many of the great minds that have worked on this problem, and are working on this problems. Two quotes that just floored me:

Eugene Wigner: "The unreasonable effectiveness of mathematics" (sounds like a counter to me)

And for those convinced they can't ever get through the math. Polya in his book "How to Solve It"

"If you cannot solve a problem then there is an easier problem that you can solve. Find it."

These alone make it worth the read. You find all sorts, much like you would in our field. The magician turned mathematician. The hungry kid getting a break. Each story is inspiring. Some you probably are familiar with but, Dan writes very interesting facts on each.

But beyond this, it has a profound impact due to the underlying philosophical impact. The hope that we are beginning to understand the meaning to randomness, and through this perhaps a light showing hidden secrets of our universe, in the infinite and infinitesimal.

For those of you not familiar with the Riemann Hypothesis, it is one of the most studied areas in pure math, due to its relevance to the prime numbers. Before Riemann expanded it through analytic continuation to the complex plane, Euler expressed it as for any S > 1 as = 1/(1^s)+ 1/(2^s) + 1/(3^s) + 1/(4^s)+ 1/(5^s).... The relationship to the primes can be seen by its equivalence to Product of 1/(1-p^-s). Though not in the book, this proof is quite beautiful and can be seen sieving out the primes.  The hypothesis is that the Reimann zeta function, the expansion to the complex plane, only has non-trivial zeros on the real line 1/2. (The trivial zeros are multiples of -2). With a little imagination and idea of what the Fourier transform does, the Fourier waves turn at the prime to give a estimate for any number how many prime their are before it. The math is beautiful, the writing is great, and the spirit is uplifting.

Vincent Andres responds:

Concerning didactic books and Fourier waves, a very didactic and commendable book is The World According to Wavelets, by Barbara Burke Hubbard.  The title of the book is about wavelets, but in fact half of the book is about Fourier, in a very didactic way.

Quote of the Day, By George Zachar

"Without the Constitution, we remain in a market economy, while with it, we adopt the social market economy, which is a social step forward."
--former French President and chief author of the EU Constitution Valéry Giscard d'Estaing

Australian Stock Returns & The Melbourne Cup, By Andrew McCauley

In Australia the press dub The Melbourne Cup as the race that stops a nation. It is one of those rare events where almost everyone, gamblers & non-gamblers alike, have a punt on the outcome of Australia's most famous thoroughbred race. Sadly, like a large percentage of the population, I tend to walk away from the day, happy but out of pocket.

It is truly one of the social events of the year & the mood of the nation tends to be exceedingly upbeat. It is also a very positive period for Australian stocks. Recording all 4 Day % returns including the 1st Tuesday of November (Melbourne Cup Day) from 1992 to 2005, I found that the S&P ASX 200 had a tendency to produce inordinate gains with an average move of 1.78%.

Returns on Melbourne Cup day also tend to be positive.

I posit whether mood is the major influence on these returns, not unlike the better than average returns that accompany stocks at Christmas & New Year. It is probably an area that deserves further study. Other factors may be the perceived investor relief that October is over, 1st week of the month positive bias, November through to the end of January marking the beginning of an historically positive period and thin markets around Melbourne Cup Day.

I hope the markets remain compliant, and if I'm very lucky, I may walk away from Melbourne Cup Day happy and not out of pocket.