Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner


Oct. 1-15, 2006


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Ever-changing Cycles: Moneyball Edition, by John DePalma

From the WSJ last month:

[W]hile Moneyball emphasizes drafting college starters, who have logged substantial innings against quality opposition, Mr. Beane will sometimes violate that advice, especially after agents and rival GMs have gotten in on the secret ... A tenet of Moneyball is that on-base percentage is the game's essential offensive stat. So why are the A's seventh in the American League in OBP this year, down from third in 2001? Because other teams have seen Oakland's success and started paying big for players with high OBPs. The A's have instead focused on pure walks, ranking third in the majors in that undervalued category. Similarly, analysts know that pitchers with high strikeout rates hold up well (see Roger Clemens and Randy Johnson). So why does the A's staff rank 12th in the AL with 6.06 strikeouts per nine innings -- down from fourth in 2001? Because strikeouts are expensive. So Mr. Beane put a solid infield defense behind his effective but less-than-overpowering pitchers.

(Bacon analogy -- "The principle of ever-changing trends works to force quick and drastic changes of results sequences when the public happens to get wise to a winning idea.")

A look at last year's AL West standings gives the impression that the A's lost ground to the Angels ... But when Mr. Beane and his analysts looked at P-wins (a predicted winning percentage based on the ratio of runs scored to runs allowed), they saw that both the A's and Angels played like 93-win teams -- and realized that better luck would be as likely as reorganization to close the gap.

(Bacon analogy -- "Keep out of those switches")

From NYT earlier this month:

'The sort of team we put together is probably going to be dissimilar to others,' Beane said. 'When everyone else is zigging, we're going to zag.'

(Bacon-- "Copper the public's ideas.")

From The Sports Economist last month:

Sauer and Hakes turned to the data and asked if on-base-percentage was truly undervalued in baseball's labor market. Their paper reports that before Moneyball appeared, on-base-percentage was indeed undervalued. After this story became known, though, this advantage disappeared. In sum, baseball executives were able to adjust behavior in light of new information, a result standard economic theory would predict.

From the referenced "Journal of Economic Perspectives" paper:

Michael Lewis's book, Moneyball, is the story of an innovative manager who exploits an inefficiency in baseball's labor market over a prolonged period of time. We evaluate this claim by applying standard econometric procedures to data on player productivity and compensation from 1999 to 2004. These methods support Lewis's argument that the valuation of different skills was inefficient in the early part of this period, and that this was profitably exploited by managers with the ability to generate and interpret statistical knowledge. This knowledge became increasingly dispersed across baseball teams during this period. Consistent with Lewis's story and economic reasoning, the spread of this knowledge is associated with the market correcting the original mis-pricing ... The ideas in Moneyball, belying protestations from entrenched interests in the baseball world (Lewis, 2004), spread with sufficient speed that baseball's labor market no longer exhibits the 'Moneyball anomaly.'

The Critical Moment, by Victor Niederhoffer

There's always one moment during the week that is the key to what happened. I believe it was the plane crash on Wednesday that for one minute knocked all the stops from weak longs and then made the path of least resistance up.

I would recommend Christy Mathewson's Pitching in the Pinch (I've written about it before) for a beautiful discussion of that one critical moment in baseball where the pitcher has held something back and the crowd is tense, and the batter is particularly vigilant.

The question is how to define it, to quantify it in markets. I believe it came during Hurricane Katrina overnight, and the London Bombing's overnight. A good rule of thumb is that if it's down x points and bonds are up y points at time z , then it's the pinch. But I’d like to hear other erudites and tests on this.

Springy Markets, by Nat Stewart

The other day while otherwise occupied, I found myself straightening a paperclip and wrapping it in a coil pattern around a ball point pen. The end result was a small, impressive looking coil spring.

Pressing it in my fingers a few times, (ok, more than a few) I started thinking about why a coil spring seems able to bounce back from greater pressure than strait wire, or wire bent in other configurations. My thought was, the pressure is more evenly distributed over a larger area, which creates less stress on any specific area, allowing the coil to handle more pressure before permanently deforming. Regardless, this sent me to the internet curious about the mechanics of coil springs.

This leads to Hooke's law which states that the amount by which a material is linearly related to the force causing the deformation. According to Wikipedia:

Hooke's law only holds for some materials under certain loading conditions. Steel exhibits linear-elastic behavior in most engineering applications; Hooke's law is valid for it throughout its elastic range (i.e., for stresses below the yield strength). For some other materials, such as Aluminum, Hooke's law is only valid for a portion of the elastic range. For these materials a proportional limit stress is defined, below which the errors associated with the linear approximation are negligible. Materials such as rubber, for which Hooke's law is never valid, are known as "non-hookean". The stiffness of rubber is not only stress dependent, but is also very sensitive to temperature and loading rate.

What would be the market's elastic range or elastic limit, and how would it be defined? Relative short term highs and lows come to mind. Perhaps distance off a reference point, like the opening range concept, or opening of week, or month, or yesterday's close, or x periods ago. Would the elastic range for markets be different depending upon if the market is being stretched in the direction of long term drift, or in Abelson's direction?

Are the elastic properties of market prices more similar to (using above examples) steel, aluminum, or rubber? If they're like steel or aluminum, how could the useful range appropriate to reversal trading applications be defined? If like rubber, what would be the equivalent of temperature and loading rate? Perhaps interest rates (or change in rates) and a measure of rate of price change?

If one can identify or approximate the elastic range, where would be ideal buy/sell points? Too far out, and risk price exceeding the elastic limit. Too close, and one suffers though the trough of the elastic range, perhaps selling to soon out of relief, missing the upward spring. Never a perfect balance, however.

If the analogy is at all valid, are there different time scale coil springs in the market? For example, if a short term (small) coil has exhausted its elastic limit, but the intermediate range (large) coil is still within its elastic limit, would this have any impact on how to manage positions? Would such thinking risk, "turning that short term loser into a position trade" which all books say is a bad idea. Is it? If not, or if so, by what criteria?

If one turns the coil spring on its side and traces the up and down pattern, it makes a perfect cycle of highs and lows. If one were to pull the most recent coil beyond the elastic limit, the horizontal distance would increase, and the extremes would fail to meet the extremes of previous coils. Over specific durations of time, is there an expected periodicity between short term highs and lows based prior highs and lows? If such highs or lows have not been made within a calculated 'elastic range" does this anticipate a change in cycle, or an anticipated move beyond the recent elastic limit?

If one finds oneself in a trade that relative to intended time horizon has exceeded the expected elastic range, would shifting exit horizon or targets yield a better result?

Ryan Maelhorn responds:

If you stretch a coil spring too far it essentially becomes worthless. It turns back into mere wire. The 1999-2000 bubble could be seen as a ruining of the coil that took years to "fix." Price is what separates the elastic range of stocks. Stocks under $0.10 can gain or lose 500% in a single day, whereas the DJIA is said to have a huge rally if it climbs 3%. Also, if you pull the coil out somewhat and let it go, it will not only go back to its natural state, but compress slightly, and then stretch out just a tad before coming to rest. When penny stocks lose 50% or so from the open of the day, usually there will come a time during the day when they will bounce back slightly, perhaps as much as 20%, before continuing their decline. A move you wouldn't even see if you were only looking at daily price bars.

The Threat is Worse than the Execution, by Victor Niederhoffer

The thread on potential started by my partner of 40 years would benefit from quantification of the chess proverb, appropriate for this list since Dan's father was New York State number 2 and won a game from Alekhine which the Grandmaster reviewed, "The threat is worse than the execution". I would suggest that a double top is a threat, and it's bullish, and a double or x bottom is a threat and it's bearish. Also, a big move within the day which subsequently fails tends to be confirmed...and that companies tend to go up before a favorable earnings announcement (not after) and similarly show a tendency for going down before seeming bearish economic announcements. The threat of a political calamity is always bearish and when it happens it's bullish. Any accepted hypothesis that the market can't go up because of some such inanity as was populated by the bifurcated is another horse from the same garage and this can be quantified in Popperian terms as well as threat execution terms. a rich purview.

Jared Albert responds:

As a day trader, much of my method relies on a healthy mental state. So for me, often, the execution relieves the worries stemming from the perceived threats. Two example are:

Many times I have felt that I couldn't afford to take another loss; that the next loss would be career ending. And after trading the entire day and still losing money, I found that I was not wiped out, and that I could still come back the following day.

Another 'psychological' example is that I notice that my trading is often more defensive (make less, lose more) as the time for estimated tax payments approaches. Once I take the hit and draw my account down to pay, I'm back to normal.

In terms of market indicators, in the very short term, the threat can be a large block appearing in the order book. Initially, the price may move away from the block. But if the price starts moving toward the block then the large block is not a threat but an opportunity and it's appearance provides a great tell as to the strength of the move.

Dynamic Potential in Chess and Markets, by GM Nigel Davies

I've been thinking about the concept of 'dynamic potential' in chess and markets. From a chess point of view, when we execute a strong move we are simultaneously expending the energy contained within our position. It is important, therefore, to understand whether the damage inflicted is worth the energy expended. And also whether the potential has a 'sell by' date, i.e. that if we don't use it quickly it will fade into nothingness.

Generally speaking I'd say that weaker players have difficulty restraining themselves when they see a strong move, they just have to play it. Most Grandmasters, on the other hand, will show great restraint, waiting for the optimal moment to strike. Tigran Petrosian had this tendency to an exaggerated degree, as did Salo Flohr and Mikhail Botvinnik.

I believe that this concept is also deeply entwined with markets, but with certain new features which will make it difficult to measure. When someone takes a position they commit much of their own potential (trading capital). If the 'whole world' took a particular position then the 'whole world' would be committed.

But one of the problems with this as a model is that the 'whole world' is never involved, and market participation varies all the time, from relatively few players to vast numbers. The chess equivalent might be to have a variable number of pieces depending on the number of spectators watching the game at a particular time.

For this reason it's going to be a lot harder to assess the 'dynamic potential' of markets than it is with chess, and it's hard enough when there are just 64 squares to deal with! Attempts have been made to create models based on sentiment, but I suspect that there is a major flaw in these because of the above mentioned variable participation. The recent new high in the Dow, for example, may attract new participants and mess up any readings based on the assumption of a stable population. So although 'potential' appears to be at a low ebb, the pool of 'potential' can simultaneously be expanding.

Paxil on Trial, by Bo Keely

As an experiment, I swallowed a 10mg Paxil tablet a few days ago and now feel ready to report on this aspect of the demise of American society. I begged the little green pill off a manic-depressive to better understand him, his so-called anxiety, and the smiling Paxil faces'I see walking around the high school where I teach.

This is the most common prescription in the world for depression, anxiety, bipolar disease, my favorite post-traumatic stress, premature ejaculation, and gambling disorder.

One daily 40mg tab was my adult friend's starting dose that I cut in 1/4 for the trial. I took it with a glass of water on a half-filled stomach to dull the effect. I kept a pen and notebook in pocket to record the effects and went for a walk in his garden.

An initial mild euphoria took hold in twenty minutes as I continued to smell the roses. I sensed the medication's smooth absorption via the gastro-intestinal tract and insidious entry into the CNS. I hadn't tainted the results with prior research to self-administration. Everything felt free and easy, not a care on earth. Yet I could still make notes and identify plants.

The Paxil high got heavier an hour into the trip, with the thought: Are you anxious? Depressed? Obsessive? Uneasy with people? Then Paxil's the drug for you. One problem: You may never quit.

The absolute worst feeling I got from the drug, that is perhaps what most users embrace, was becoming an Eloi. The sensation was distinct and lasted for two hours. The Eloi are one of the two post-human races in H. G. Wells' 1895 novel The Time Machine. In the year AD 802,701, humanity has evolved into two sub-species: the Eloi and the Morlocks. The Eloi are the attractive upper crust living on the surface of the earth, while the Morlocks live underground, working and tending machinery that provide food, clothing and infrastructure for the Eloi. The Morlocks continue to support the world's infrastructure and serve the Eloi who have undergone drastic physical and mental deterioration. Having solved all problems that required strength, intellect and virtue, they have slowly become miscellaneous dingbats. It is revealed that the Morlocks are tending to the toiless Eloi's needs as a farmer tends cattle -- because the Eloi comprise most of the Morlock diet.

My next thought along the Paxil journey was to cry out. Just imagine a legion of Happy Faces drooling down the school sidewalks and into the SED (Severe Emotional Disorder) classroom that I once taught for Riverside County, Ca. Their so-called Paxil Faces are rounded, waxen with thickened lips and dreamy eyes reflecting a happy, soulless mind. I anguished at that stint before being dismissed for insubordination and arguing against kid drugging and withholding of my salary.

Finally, six hours after the first taste, I came down from my Paxil high. An annoying aftereffect was wanting more for the remainder of the day. Paxil Paxil Paxil. I took my notebook and feelings to my buddy who commiserated. He had tried to stop. He had twice tried to stop and each time had felt so physically wretched that 'the continued addiction was preferable to the withdrawal'.

I would not have to withdraw from this small, experimental dose, but sense that it can be done with a charismatic physician's advice, at a bangup clinic, by geographic distancing from the drug, or best of all with the support of a recovered peer. There should be a Paxil's Anonymous. It may take weeks, one milligram at a time, and with all that I've said, plus exercise, good diet and water, and plenty of work or hobbies, it shall be done.

One recovered from the Paxil habit should feel so accomplished that depression or anxiety is never an issue, just a bright future.

That's the short report of Paxil on trial. I've experimented similarly with a couple dozen other prescription drugs in the name of altruism. Paxil, and the stable of like SSRI (selective serotonin reuptake inhibitors) antidepressants, are hands down the most pathetic therapeutic craze I've witnessed since earning a Psych Tech Certificate two decades ago. By rendering a patient or citizen unwilling to make judgments and incapable of taking stands, there is no role for them other than in the vegetable garden of life.

It's the most amazing, most common prescription in the world. So many millions more could be dangerous if they get pointed in the wrong direction.

Ken Smith replies:

What are they in Denial about?

  1. That the same political class that has been in office for decades will ever change anything.
  2. That the ministers, rabbis, preachers, priests they listen to will ever tell them the truth about life; that religion is big business and nothing else.
  3. That they can save money by spending money.

Dr. Janice Dorn replies:

The worst lies are the lies we tell ourselves. We live in denial of what we do, even what we think. We do this because we are afraid - Richard Bach

Why do we run from the truth? What makes us close our eyes and bury our heads in the sand rather than face what appears to be a harsh reality? Why are we compelled to cling to dysfunctional relationships and losing stock positions in the midst of increasing drawdown of our mental, emotional, physical, financial and spiritual capital?

We act this way because we are driven by hope. We behave in a certain manner because we want to believe that, somehow, somewhere, sometime, things will get better. We refuse to cut losses in our personal lives and portfolios because it is an admission that we are wrong, that we can't make good decisions and we will have to say goodbye again. The final saying goodbye to someone or something for which we yearned, lusted and made our own is painful. We cherished this as a possession, believed that everything would be fine if we were a little more patient, held on just a little bit longer and kept doing everything we could to make it right while, every day, we were dying slowly inside.

People have been coming to me with "problems" for nearly 30 years. Bad jobs, hideous and abusive relationships, childhoods from hell, depression, self-destructive behaviors, addictions, compulsions, anxieties, phobias and the devastating consequences of undisciplined and massively risky trading. It's always about what's wrong. After all, why go to a shrink or a trading coach if things are wonderful? Why celebrate the positive aspects of one's life when there is so much misery and despair? Why bother to take personal responsibility when it is easier to remain in victim mode?

My monthly Trading Doctor Newsletter was born out of these experiences, strengths and hopes...both yours and mine. No matter what, we are always determined to "fix" the problem, to make the pain go away, to stay with the losing relationship or the underwater position because we "know" that everything is going to be fine if we just keep working on it. It will be OK. The person we love will change and the stock will come back. Forget about the fact that it is ruining our lives, that we can't eat, sleep or exercise properly and can't remember the last time we felt any semblance of serenity or joy. Just deny that the whole thing is happening and everything will, like some magic trick, turn out just fine. Won't it?

Denial ain't just a river in Egypt - attributed to Mark Twain

Years ago, I bought many thousands of shares of a low-priced stock because I became convinced that it was the next best thing to sliced bread. I paid no attention to anything I read or heard because the stock was being touted by someone whose opinion I respected. It made no difference to me whatsoever that the company had less than competent management, massive debt, no revenues and one of the ugliest charts on the planet. For reasons which I will explain in more detail in The Trading Doctor Newsletter, I had grown, fostered and nourished a BELIEF that this was going to be the big win for me. I truly believed that I would get in on the ground floor and then watch with delight as Wall Street finally noticed what a groundbreaking product this company had and the stock would start going up and up. Visions of a ten or twenty bagger infiltrated my brain and made themselves perfectly at home in my limbic system. I started having personal feelings about this four letter stock.

I loved it, knew it was going to live up to every expectation I had about it, read every piece of news I could about it, told friends that this was the next biggest and best winner and it was only a matter of time before everyone would see the beauty and power that I knew. I was there first, so no worries at all. My belief system was so skewed and distorted that I could not see the truth. I did not want to read or hear anything negative about the stock since I was now in love with it to the tune of tens of thousands of dollars. I owned it. It was my prize possession and I felt like, in some way, I needed to defend it against all naysayers. Kind of like a marriage or a new relationship, I didn't want to hear anything bad about it. My brain was filled with the neurochemistry of new love and attachment, so please don't bother me with reality. Just like every other new relationship, stocks are entered on hope.

Please let me know if any of you can relate to the following quasi-delusional stinking thinking and denial of reality that took place in my brain over a period of two excruciatingly painful years. Please share with me if you can identify with the panoply of thoughts and feelings that ran through me day after day. Please tell me if you have ever felt like this, if your mood for the entire day was dependent on what was going on with one or more of your holdings. Please talk to me about this type of vertiginous, tortuous, torturous, neurotic brain scramble and how that is working for you:

Oops! What is going on? Almost immediately after I bought the stock, it started to go down. This can't be happening. I don't want to believe that it is going down even though I see it right in front of me. There must be something wrong. OK. This is just a teeny temporary correction and it will come back soon. Hmmm. I have a little loss here, maybe I made a mistake and should get out and watch it or read some more. No. That's not possible. I am smart and educated and this company is the next big winner, so I'll hold on and it will come back. What's up with this? It keeps going down every day and I can't sell now because I will be taking too much of a loss, so I have to hold on. Anyway, I know that the minute I sell, it will turn around and start going up. It happens to me all the time. I just know it. It's the market, and everything is being sold, not just my beloved four letters. I am a highly intelligent woman and I have made the right decision. I am not a loser and won't be a loser. I really want to win and this stock is going to come through for me.

As soon as the market gets a bid, it will come back. Anyway, I have decided that I am not going to trade it. I will just hold it for the long haul since the story is developing, good news is supposed to be coming next month, they are going on the road to get sponsorship and analysts will start recommending it. The chart now looks like death, but that doesn't matter because a lot of charts look like that and many have just turned themselves around into big winners. Maybe now that it's down 30% from where I bought it, I should buy more so that I can lower my cost basis. It wouldn't be that much money since the stock is cheap and just think how much I will gain once the Street "gets it right." But my rule says never add to a losing position. Maybe I should break the rule, just this once. Let me think about it and sleep on it and see how it acts tomorrow. WOW! It went up today. It went up 10% in one day, so things are starting to improve. Too bad I didn't buy more yesterday because I would have had that extra cushion and lower basis. Oh well. Not to worry, things are really perking up now and I was right not to take the small loss and even more right not to take the large loss.

Now I am back at break even and all I can say is "good for you for holding through". All that worry for months was worth it, and the market is now going to reward me for my excellent stock selection, patience and loyalty. Now that I am at break even, I no longer feel complacent, fearful or despondent. In fact, I am now a little anxious because I have to figure out how to sell the stock when it really starts to take off. Do I take a partial after it runs up another point or two, do I sell it all, do I just hold on to it as I see it run up even further? What if I sell it all and it keeps going? Ugh. That would really be a bummer, especially when I have waited so long for the breakout. Yes-it looks like it's breaking out, so I could actually add to it since it is now a winner---well, sort of a winner because it's just a little over break even. I know about buying breakouts because I read how so many people do it successfully and this looks like the time to buy more. But I already have enough and I am starting to feel increasingly uneasy since it is just a little over breakeven. Interesting how I didn't experience this when the stock was losing and I was down so much (on paper, of course). In fact, when I had the losing position it was easier because I didn't have to do anything. I just sat and waited and knew it would come back. And it did. Now I am starting to get really scared because I have a teeny profit and maybe I should take it. But--what if I sell it and it keeps going up? I won't do anything. I will just watch it and see what happens tomorrow. I'm a winner on paper so it is ok now.

There is the risk you cannot afford to take, and there is the risk you cannot afford to not take - Peter Drucker.

But it wasn't okay. The next week I sat in disbelief as the stock lost nearly 30% of its value. That was it. I simply could not take it any more. I was sick and tired of being sick and tired. I refused to endure one more minute of this. I was too good to suffer any more. I could no longer sit in misery and despair and wait for the market to throw me a bone so that I could get all excited and happy again. It was just simply too much torment and I was no longer taking responsibility. I was letting the markets dictate to me how I would feel that day. I was allowing the markets to exploit every aspect of my personality that would cause me to be weak, tricked and off balance. I had to get my head out of the sand, get out of denial and sell. Tens of thousands of dollars vanished into the market abyss. Two years of mental machinations and emotions which covered the entire range of any "feelings" chart I had ever seen. I bought with hopes and dreams and sold with despair and defeat. I ran screaming into the other room and then suddenly, I felt a sense of utter calm and tranquility. I was free from the daily suffering, the agony of thinking I knew something when it was really about how much I did not know. I was no longer a prisoner of brain scramble, endless tormenting of self and depletion of personal energy. By taking action I stripped through the denial and magical thinking. I took personal responsibility, empowered myself and gained great courage. Yes, I have scars and wounds which I cherish because they are there to remind me of hard fought times and lessons learned. It is idiocy to hold and hope, and bravery to admit you are wrong and get out before it's just gone too far. This experience is etched in my brain and written on my soul. I shall never forget so as not to repeat it.

I committed every one of the "Ten Biggest Blunders Investors and Traders Will Make in 2006-2007". I drove myself into a state of almost complete mental, emotional, physical and spiritual drawdown. I broke my cardinal rule of Don't Lose Money. I held on because for some reason I could not get myself out of denial. It was only when the denial lifted that I felt both courageous and free. I faced the truth and got out of hope and fear. Through this brutal experience I learned lessons which I teach to others daily. I know what it feels like because I have been there. I know what courage it takes to play this great game and to rid yourself of false evidence, stop playing ostrich and deal with the absolute truth which is staring you in the face.

In the markets, as in life, the only way to grow and preserve yourself is to get rid of what is not working for you. It doesn't matter if it's your relationship, your house, your pet or your position in the markets. If you do not have the courage to cut your losses, they will fester and take you down with them. To see and know in your heart what is right and not to do it is complete lack of courage. To be courageous is to do, in the face of seemingly overwhelming obstacles, what must be done. Courage is getting out of denial, admitting you made a mistake and taking personal responsibility. Courage is freeing yourself from the shackles of lies, hopes, dreams and white picket fences which are built on shifting sands. Courage is listening to the voice inside of you and following your heart which never lies to you. Only in knowing what is false does one come closer to the truth. Courage is the eternal and heroic struggle to find and face your authentic self, look it squarely in the eyes, and know that you are now becoming the person you want to be.

Many of you spend your entire life running from the mistaken belief that you cannot bear the pain. But you have already borne the pain. What you have not done is feel and see everything you are beyond that pain - Kahlil Gibran

The Fed's Monetary Base Numbers, by Dr. William Rafter

The Fed's Monetary Base numbers just released (through October 11, 2006) show that the Fed continues to have a restrictive policy. Specifically, at this time the Monetary Base is over 4 percent below the long term fit of that data (since inception in 1984. Here's a picture.

The Average in Humans and Stocks, by Victor Niederhoffer

The average is something that we all would like to know so that we can learn what makes the world go round. Since more people are near the average than anywhere else, knowing about them is a key to success in business whether considering who you're going to sell to, buy from or employ. I like to study average people by reading the magazines they read the most, such as the National Enquirer, or seeing them in representative settings such as ballgames, church, car dealerships, or homes. It's an article of faith to me that the more I know about the average, the better an investor I'll be.

Thus, it was with great eagerness that I read The Average American by Kevin O’ Keefe, a successful married intellectual Democrat fund raising executive, championship runner, and friend of Jimmy Rogers. The book describes his quest to find the one “most average” American through a series of interviews with people whose eponym or business is average or normal.

The book starts with a visit to the Census Bureau, where he interviews statistician Greg Robinson and finds source material for the communities that he will canvas to find his average American. He then interviews a magician named Myklar the Ordinary, a track steward of a Land Rover club who awards a prize for an average finish, smoke-gun owners in Elko, Nevada, a director of noxious weeds in Dickinson County, Kansas, a postman in Maui, Hawaii, a presidential candidate for the Average Joe Party in Pennsylvania, an alderman running for office on the Average American ticket, the pollster George Gallup pollster, the president of the Little League in Williamette, Oregon, a golfing husband and wife in Florida whose business is selling products to the average golfer, and a person whose last name is Average. Eventually he finds the average American based on a checklist of 140 of their characteristics such as age, charity, community, education, employment, faith, family, geography, health, income, hobbies, home, physical characteristics and political convictions. The average person has all 140 of the positive attributes of averageness and it's Bob Burns in Windham, Connecticut . In the only beautiful part of the book, O’Keefe tells Burns that the average American is unique and glorious, not mediocre, and that he's the Average American. Burns says "What an honor!" and invites Keefe to go fishing next year. "What an honor!", O’Keefe says and he means it.

The list of average American qualities is instructive and includes:

Regrettably, the book is marred by the author's complete ignorance of statistics. He uses community criteria to exclude individuals, then tries to find the average by including each of 140 criteria that he randomly picks up from interviews with people whose businesses or names have something to do with averageness, or sparked by reading of popular magazines, movies, and books about average things. It's interesting to see how many average things he discovers and how many matches different people might have to them. But there is no validity or even justification for the goal of the book, which is to find the most average person. Instead what he comes up with is a person unique in fulfilling each of 140 criteria that each have, say, a one-third probability of failure. That indeed is a unique person, not an average person. In addition the author's persona is displeasing. He's the typical intellectual who is unsure of his position and status in life, and tries to find himself through exposure to common people.

In an effort to find the average stock, I am brainstorming about different approaches. One such approach comes from ecology where they consider such things as plant hardiness zones where in each zone conditions are more similar than growing conditions across two zones; this  reminds me of the industry classifications that one usually uses to divide up an average. A nice approach to this is contained here.  What is the average stock? the most representative stock? The problem is that it is different based on which of the multiple variables that can be used. Should it be classified by market value, price, profit margins, kind of business, kind of CEO, or a distance measure based on combining all of these. Here are some names of companies that Mike Pomada and I came up with in preliminary efforts to find the representative stock:


The above stocks are in the middle of the average rank (i.e., rank each category, then average the ranking -- on an equal weighted basis -- and then rank the average rank) of the following 4 categories:

Stefan Jovanovich adds:

"The typical intellectual who is unsure of his position and status in life, and tries to find himself through exposure to common people" is a beautiful expression of an important truth. It reminds me of what happened to Milovan Djilas had after was released from prison by Marshal Tito and allowed to came to the United States.

Dad had my brother Peter drive Djilas around the Northeast so he could meet American intellectuals. One excursion was to Princeton. Peter remembers overhearing a member of the faculty asking Djilas what the other prisoners were like. "Ordinary criminals," Djilas replied. "Not political prisoners." "But, they were good guys, right?" asked the intellectual. "No," replied Djilas, "ordinary criminals -- murderers and rapists and thieves."

Rick Foust offers:

I too enjoy watching the average man. And living in a state with no great claim to fame other than being in the center of the US gives me plenty of opportunities to do just that. And when I travel, I insist on passing through the poor areas (to my wife's discomfort). When others might go to the tourist traps, I go to a county fair, or an auction, or even a flea market. My favorite way to travel is to spend months away from home as part of a job. That gives me time to become immersed in and gain an appreciation for the locals.

As I revealed previously, my best stock market indicators are the average 401K feeding guys at work. When I take time off from work, it is like going blindfolded with regard to the stock market.

The average man is of value as an indicator because he is an outlier from the Wall Street community. He knows nothing of how the stock market works. He thinks the Dow represents all stocks except those in the Nasdaq. His only involvement with the stock market is what he puts in his 401K and what he hears on the news. Both of these activities are on automatic and largely ignored because his focus is in on his family and his hobbies. He puts money in his 401K because his company matches his contribution. He puts his 401K in stocks because he has been told that stocks are the best investment over the long term. The average man does not trade, but instead buys stocks because he has faith in the system. His environment that has taught him that it is easier to work within the system than without it. He stays with the herd.

So how could watching the average man be of any use in trading? He is a filter. He ignores the noise and alerts at the extremes. If you have ever watched a herd of animals you may have noticed that they are oblivious to random and regular noises about them. But try sneaking up on them. They will pick you out of the noise every time. It is an instinctive skill honed since the dawn of time.

Dr. William Rafter responds:

One of our strategies ranks about 1000 stocks and selects 40 at a given time for further review. We then apply some different ranking methods to build a portfolio with the sort of qualities most investors would choose, like lower volatility. But for the most part, the 40 are our "stars", and most investors would be relatively indifferent as to holding one over the other. When we run the statistics we find that over long periods of time (say 10 years), out of the 1000 stocks we wind up owning 950 of them. That is, almost every one is a star at some point. Or put another way, it's quite average to be a star.

The smaller you make the list, the more it occurs. We also rank and rotate 20 International Indices and the 24 S&P Industry Groups. We have even researched this on markets we cannot yet trade, like the 14 DJ Blue Chip China Sectors. And over long periods of time we find that we were at some point long every one of the above.

The ranking process is a fairly complicated combination of linear and non-linear methods, so there are a few "hoops" the assets have to jump through. That is, we have deliberately made it difficult for these assets to be the stars, but yet they manage to do so.

Wouldn't the law of ever changing cycles dictate this very outcome?

Steve Ellison replies:

This idea is congruent with my intuitive reaction to this discussion. There is no such thing as an average person. In our advanced economy in which specialization is the norm, just about everybody has some unique talents. A person is only average when viewed through somebody else's filter--usually based on one measure, or at most a few.

Russell Sears replies:

One of my first jobs was helping building an extension onto Fairview Hatchery in Remington, Indiana. At the hatchery,  millions of chicks are hatched on trays stacked on top of trays. These are wheeled around on rack after rack in incubators to processing and then to shipping.

For the most part, the thousands of chicks looked exactly the same. If a chick looked different or showed weakness, the others would gang-up on it and peck it to death. The processors would then take the damaged defective chick and pitch into a bucket. There these damaged tortured chicks would continue to peck at each other. They were left in a hopeless, oppressed condition, where rage was the only thing left to give them hope. They would attack each other until they all died.

You look at the violence going on today, and you find the political oppressor, feeding the rage, rather than the benevolence. They do this by making the "average guy" see wealth and betterment as a closed system. The only way to get ahead is "steal theirs". It is "us" against "them".

Its not just that the average is good or benevolent. The average is powerful.

Here are some ways in which this power is turned to benevolence or the greatest good:

  1. Freedom and Liberty.
  2. Legal system that encourages competition.
  3. Transfer of wealth not limited. (property rights)
  4. Democracy (giving power to the "average") and checks and balances limits power.

Some thoughts (most need testing) on how to apply this to stocks and investing:

  1. Invest in countries where freedom is high and is growing.
  2. Invest in companies where union votes against striking or to end a strike without concessions.
  3. Invest in companies where options grants are widespread, not just privileged few.
  4. I believe the Olympic marathon is a event open to everyone, the average guy. Invest in countries that have become more competitive in the Olympic marathon or other "average guy" sports.
  5. Other sports such as equestrian, are more political, more elitist, rather than personal merit. Invest in countries that have the most "average guy" in the elitist sports.
  6. Invest in countries whose athletes become wealthiest through other endeavors, after winning the Olympics.
  7. Invest in companies with an open door policy: that is access to the top is encouraged.
  8. Invest in companies with highest bonus pay to the "average guy".
  9. Invest in companies who "oust" the option back daters after they settle.

Jekyll, Hyde and Animal Attacks, by GM Nigel Davies

Noting the market's Jekyll and Hyde behaviour (Master Hyde making his last appearance in May) I wonder how one might sense that Jekyll is about to change into Hyde and attack. I tried googling for 'animal attack warnings' and came up with the following interesting snippets.

"Dogs in some cases respond to that fear, and if somebody was to start screaming or crying, you can often get an almost primal response in the dog," he said.

"Most attacks happen in shallow water (just like in the movies), near a sandbar or between sandbars where sharks feed and can get trapped at low tide. Areas with steep dropoffs are also common attack places."

The Power of Potential, by Dan Grossman

To me the most significant lesson of recent international military undertakings has been how a country's taking action risks sacrificing what that country previously enjoyed in the power, reputation and deterrence of potential action.

For example, going back to the 1967 and 1973 wars, the Israeli military had the reputation of being unbeatable by its Arab neighbors. This gave Israel very valuable deterrent protection against its hostile, far more populous enemies.

But when Israel launched a major attack on Hezbollah in Lebanon and was unsuccessful in that Hezbollah was able to fight it to a draw, major damage was done to Israel's military reputation and deterrent power. Israel is now far more vulnerable to attack by hostile neighbors and by major terrorist organizations. With the benefit of hindsight, Israel should never have risked its reputation and deterrent power in a voluntary war unless it was virtually certain of prevailing and thus keeping its reputation for invulnerability and deterrence in effect.

Similarly, after the First Gulf War, the bombing campaign in Bosnia and the impressive early destruction of the Taliban in Afghanistan, the US had an awesome reputation of being the world's sole superpower, with virtually unlimited high tech military power several orders of magnitude above that of any other country.

But for the US to undertake a major invasion of Iraq that turns out unsuccessful, to become bogged down in a losing war against militarily unimpressive enemies, has done incalculable damage to the US's ability to cow hostile nations with its military potential. Again with the benefit of hindsight, the US should have thought long and hard about risking the unparalled military reputation and deterrent strength it enjoyed.

Now that the US's perceived military strength and ability to deter is far less, Iran can do what it wants in developing nuclear weapons and funding/arming Hezbollah, and even North Korea can feel pretty safe in its provocations. The degraded military reputation of the US also gives it far less ability to influence Russia and China to help with Iran and North Korea. And Russia can also feel free to strongarm our ally Georgia (the country, not the state) with little or no complaint from the US.

(I am not dealing here with the question, moral or libertarian, of whether the US should be attempting to deter or influence other countries. Only with the question that if it wants to, whether it has the power to do so.)

Finally, the relevance to investing of giving up the power of potential is, I believe, tenuous. It is true that when one moves from cash to a committed investment not easy to sell, one loses the potential to invest in other things or to remain in cash. But there is no reputation or deterrent value that one is giving up, since stocks and other investments are not capable of being threatened or deterred. (Except perhaps in rare cases where an extraordinarily rich investor like Icahn or Kirkorian is threatening to buy a massive amount of a company's stock if the company refuses to do what he wants.)

Prof. Marion Dreyfus replies:

A deterrent power that is never invoked, on the other hand, becomes a straw man, and ankle-biters will proceed to a series of provocations to test the level of tolerance of that so-called massive deterrent potential. Israel had been repeatedly provoked by thousands of Kassams and Katyushas against northern cities, and precisely how many thousands of incursions it can sustain is not an exact science. Nor is it in her interests to permit little gangrenous groups to pick off her soldiers and murder them at will.

This leaves out the concomitant scandalousness of the unpreparedness of the IDF. Both in terms of tank platoons and soldiers guarding the perimeter, there was a feebleness of deployment that stuns most of us familiar with the power of the IDF. A major contributor to the lack of overwhelming force and the triumph of the IDF, too, was the constant effort to save civilians, which is no way to win a war against soulless automata. had the Israelis conducted the war in the way most nations would and do, it would have won inside of a week.

Craig Cuyler replies:

These points could also be related directly to proper means of speculation, ballyhoo deflation and scientific method in trading. The US government has ignored almost every rule of proper speculation and here are just a few off the top of my head:

As Dan says, the situation has weakened America's military position and standing in the global community and the direct beneficiaries are the Iranian Mullahs and psycho's like Kim Jong Ill who are now emboldened to develop their own nuclear arsenals. This is similar to when hedge funds like Amaranth get themselves into trouble and the market knows that it can press its advantage until the protagonist capitulates - this is what Iran, Jordan, Hezbollah, Taliban, North Korea and others will do. When an investor or a speculator puts on a trade for the above reasons there can be only one outcome - failure!

Stefan Jovanovich responds:

The 1973 war (what the Israelis call the "Yom Kippur War" and their opponents call the "Ramadan" or "October" War) was the worst crisis in Israeli military history. Within the first week the Egyptians crossed the Suez Canal and breached the Bar-Lev fortifications in what was probably the greatest feat of Moslem arms since the Turkish defense at Gallipoli. The Bar-Lev fortifications had cost $500 Million (in today's dollars roughly 1/3rd of the 2007 Israeli defense budget) but they were breached with water cannons, rubber rafts and hand-carried weapons and the battalion holding them was effectively wiped out. There are other details of the war that match the failure of the Bar-Lev line, but it is enough to note that, immediately after the war was over, a special commission headed by Chief Justice Shimon Agranat of the Israeli Supreme Court was appointed to investigate "why Israel had been caught by surprise and why so much had gone wrong during the war itself". The commission's report, completed in January 1975, was highly critical of the performance of the IDF on several levels, including intelligence gathering, discipline within the ranks, and the mobilization of reserves. Among the facts in the report was the disclosure that the IDF needed the emergency airlift of $1 billion of ammunition (in 1973 dollars) from the United States to avoid literally running out of bullets. To gain a proper sense of the scale of this potential disaster, it is useful to know that the entire cost of the war for the Israelis was $5 billion. (One of the bitter reflections that we Viet Nam veterans try to avoid considering is whether the 1975 Democratic Congress would failed to fund the reinforcement of the IDF as cavalierly as they refused to resupply the ARVN.) The Yom Kippur War ended the political future of Moshe Dayan. Ariel Sharon was lucky enough to have retired as commander of the Southern front 3 months before the war began. Had he remained in command, he, too, would have seen the end of his career as a figure in Israeli politics.

The tactical difficulties the IDF experienced against Hezbollah have a great deal in common with the mistakes of the Yom Kippur war. The Israelis badly underestimated the usefulness of anti-tank weapons against infantry (most of the IDF casualties were from blast and shrapnel, not bullet wounds) just as the IDF underestimated the lethality of Sagger missiles.

As for American bombing in Bosnia (sic) (the air strikes were in Serbia proper), the American after-action reports are almost sarcastic in their assessments. The Serbs, displaying their native criminal ingenuity, managed to shoot down an F-15 using cell phones and 1970s-era Soviet missiles. The USAF was unable to even "bounce the rubble" since most of the "targets" destroyed in Kosovo turned out to have been decoys. The U.S. Army had to wait a month to cross the Danube while the combat engineers (not under fire) rebuilt the bridges. When they finally made it across, they discovered (surprise, surprise) that their M1A1s were too heavy for the roads. The war ended General Wesley Walker's military career and began his political one.

Fortunately, both the IDF and the U.S. armed forces have learned from their mistakes and will continue to do so. The wars being fought in Iraq and Lebanon (yes, it is still going on) have taught both militaries that tactical intelligence can no longer sit even at the brigade level; it has to be down at battalion and even company level. Both militaries have also learned that they have to have the ability to jam enemy electronic signals not just in the air but at the street corner level. These are revolutions in military affairs comparable to the development of armor and automatic weapons.

To conclude  that "US's (and, I presume, Israel's) perceived military strength and ability to deter is far less" is to go against all the known facts of what those countries' enemies are actually doing. Both the Russians and Chinese are working as fast as they can to abolish conscription and reduce overall troop strengths. Both have effectively conceded to the Americans permanent air and space superiority by ending their next generation fighter programs. The field strength of Hezbollah, Al Qaeda, Taliban and the Baathists has been reduced to the level of banditry and local thuggery, and their internal documents speak of reduced levels of financial and military support and, in some cases, of outright despair. Their only hope is to win the battle of CNN.

I can go on, but what would be the point. That the New York Times and Washington Post and CNN remain unaware of what is actually going on in the Middle East and East Asia is hardly surprising, given the fact that their correspondents no longer spent any time in the field but leave that to their native stringers. That members of the list continue to retail the daily "everyone knows" historicisms of the "authoritative press" is disappointing.

Laurence Glazier replies:

More than 20 years ago, I remember reading media assessments that Israel was unlikely to survive more than a few years. I think this is still a good case to be contrarian. Other things being equal, Israel is and will even more so be one of the economic powerhouses of the present century.

There are -- as ever -- challenges.

Aumann may shine in game theory and bible code analysis but Buffett gets the nod in buy and hold.

J. Klein replies:

It was not only media assessment. 30 years ago I bought land in Israel, and all my friends advised against it, Israel couldnt last, too much risk, what a meshugge thing to do. It turned out to be a hit, by far.

Israel government has announced that it is planning a second wave of settlement erradication. The idea is to cut ourself free from our turbulent, violent, suicidal, no-good neighbors by a good fence. It is only expectable that Prof. Aumann, a believer, would argument against it, since we are giving up land aka Promised Real Estate.Nobel Prize does not make him a prophet, and less so in his hometown.

Gymnasiums and Trading, by Steve Leslie

I used to be a member of the largest athletic club here in my city. One thing I noticed is that the greatest attendance at the club was unquestionably on Monday. I suspect this was due to the couch potatoes after a long weekend in front of their TV screens watching sports and consuming large quantities of alcohol and trans fat laden foods, venturing out and cramming a weeks workout into an hour and a half. As the week progressed attendance would drop consistently until Friday came when there was but a few diehards left who were working out. If Friday was the last workday before a 3 day weekend forget it the gym looked like a ghost town. Also the peak hours of workout were from 5pm to 7pm. The aerobics classes were completely full and it was elbow to elbow. If you wanted to lift weights you had to share your bench with another. Furthermore, January was the highest attendance month and December the weakest. Naturally the Summer months June to August were thin.

When I was a broker, we did most of our commissions on Monday as much as 60 percent and by Friday noon our work week had effectively ended. Plus most of our commissions were generated in the morning rather than the afternoon.

I see similar phenomenon at work in the U.S. Stock markets. Whereas Monday mornings are the most hectic and Friday afternoon the most benign. 9:30am until 10:45 am are the most active, 12pm to 2:30pm appear to be listless until the lunch bunch returns to balance their books for the day.

I am sure there are fundamental reasons for this. As a speculator and swing trader, I would be very interested in hearing from the list their comments and observations, methods they use to exploit this and perhaps an article or paper that would support this thesis. It would seem to me that timing as to purchases and sales or securities would then be taken into consideration as to when one would consider and consummate them.

One theory in particular is to buy the S&P near the end of the month and hold it for the following 4 trading days. Are there others?

Jeff Sasmor responds:

I use NY Sports club in NY. Trainers there have commented to me that they see a lot of new members in January because of New Year's resolutions. They usually attend for a while then stop coming -- they generally have signed up for long-term contracts because they in good faith felt that they would keep going for their own good.

Perhaps daily-ness in the stock market is similarly tied to emotions. Maybe a lot of people sign into their Ameritrade and Schwab accounts on Sunday and place buy and sell orders to execute in a vast swath at 9:30 AM on Monday. This isn't exploitable. Unless you work at one of these brokerages...

But to depend on such patterns could be fallacious as they (in my limited experience) seem to shift, advance, and precess. One doubts that the oft-related scheme of buying near the end of the month and holding a few days is reliable (I am sure someone will tell me I haven't tested this but I think that this has been previously debunked on the spec-list).

There are definitely intra-day patterns, lulls, rushes, and so on but these are of no use to you unless you want to day trade (and Dr. LACK will probably try to talk you out of it).

Getting back to gym-going: at our gym each machine has a little LCD TV hooked up to cable TV. I have found that if I am watching Bloomberg or CNBC (yes, I know) then people will come up to you and ask your opinion of the market. Yep. I have only one answer for them.

Ryan Carlson replies:

A lesson I learned early on at the Merc is that pretty much the only ones trading on Friday afternoons are guys who lost money and are trying to make it back. Anyone that's had a good day is gone by lunch and at either the gym, playing golf or the CME Merc Club drinking. Sure, it applies to most other days as well but especially Fridays.

Perhaps it's easier to gun at other's bad positions on a Friday afternoon but the killer instinct in most is generally gone after 4 1/2 days of trading.

Itchy and the Most Wanted, by Bo Keely

A few years ago, I got hungry on the trail and pulled into a convenience store at a remote road crossing that didn't even offer a stop sign. I dropped my backpack at the entrance and abruptly heard, as if an echo, ''He's the most dangerous man I've ever seen. Yes sir, Sheriff, I'm looking at the killer on the poster." I gazed up and through the glass of a phone booth yards away where a young man in a sports coat peeked uneasily at me. I grinned and he gulped, "I got to go, Sheriff. He's got a bead on me."

I didn't feel like a desperado. I had just walked twenty-five miles a day for a month on the Pacific Crest Trail through the Sierra Nevada. I had an empty stomach.

The young man screeched off in a pickup, and I figured a twenty minutes response time before the constable arrived at this far flung crossing.

Yet the big badged Sheriff strode up as I exited, and ordered, "Don't move!" He rushed past into the shop imaginably to find the cash register open and bloodied by a dead clerk. The officer exited in five minutes presumably wondering why The Most Wanted bought only cat food. His hand hovered above his holstered gun, the strap back, and his trigger finger twitched.

How should I explain that after inspecting the junk food shelves that Puss n' Boots Chicken, and another can of Liver, were the most nutritious and economical buys?

Finger twitching, he asked for identification and took my license to his patrol car to call in. When he returned five minutes later with the license in a calmer gun hand and passed it over, I knew my short glory as The Most Wanted was over.

"Don't worry about us Bears out here," the Sheriff grinned, ''but keep an eye out for the Big Cats." The mountains aren't for a man nor beast who can't take a joke, so I shouldered my pack and hightailed it into the Sierras.

Obama Haiku, a New Series, by George Zachar

New Obama book is personal, political view
2006-10-12 10:46 (New York)

CHICAGO, Oct. 12 (UPI) -- U.S. Sen. Barack Obama, D-Ill., outlines a lofty political view in his new book and laments an "empathy deficit" in the United States, a Chicago report says.

Obama laments
the "empathy deficit".
I cannot relate.

Truckin', from Stefan Jovanovich

Academic resumes -- itemizations of where you went to school, your grades and (even) your test scores -- became common only after World War II. Before that time the questions on any job interview were about what jobs had you worked who you knew. My Dad attributed the change to the GI Bill, and he wisely anticipated that the change would lead to a dependence on standardized testing not only for schools, colleges and universities, but also for all licensed occupations. However, the rule that he followed as an extremely smart student and a future textbook publisher was not "parrot the textbook." He was shrewd enough to know that every teacher prided himself on being smarter than the textbook. The key to straight As was to attend every lecture, take copious notes and "parrot" exactly what the teacher said. Following that rule and working at it industriously each day earned him a Phi Beta Kappa key just as it has earned his granddaughter one. "Thinking for yourself" is fun and has its own rewards, but it is guaranteed to get you a 2.7 GPA. That has been the state of American education for over half a century. It is the reason the "rednecks", among others, have lost their faith in "education". They see it as an extended exercise in obsequiousness. They are right, of course. They are also right to be skeptical about the benefits of academic certifications. Getting a Class 4 license has proven a much more profitable investment over the past decade than completing a graduate degree. In my limited travels here in Northern California I see any number of signs for "Truck Drivers Wanted". I have yet to see a single advertisement reading "PhD in (Gender Studies, etc.) wanted; Steady Pay; Great Benefits". Instead, I see the poor grad students trudging to their classes at the local universities like so many helots marching to the silver mines.

Prof. Charles Pennington responds:

I guess Stefan is using hyperbole, but just in case: PhDs do not do all that badly out there, and better than truck drivers. I had a high school friend who became a truck driver for a while, and he confirms that it's quite stressful and boring and not really all that well paid.

The students who got PhDs in my group have jobs at Pfizer, Intel, University of Hawaii (Associate Professor, not post-doc!), Varian, the Mayo Clinic, Keithley Corp., and Intermagnetics. I don't know exact salaries, but I think they're probably centered around $100K. They do interesting work, too. Most of them are doing things with magnetic resonance imaging, including "functional" magnetic resonance imaging where you literally watch what's happening in someone's brain while he's thinking some designated thought.

I agree though, sort of, on the topic of how to get As from professors. The most efficient way to get As is to attend all the lectures, and, as a first priority, write down everything that's said out loud and written on the chalkboard. If you can understand it in real time, fine, but if you can't, review your notes as soon as possible after the lecture, and try to figure out what was being said. You might figure out 90% of it then and there. Later you'll still have to cram for the test, but you'll be miles ahead.

Professors always feel like they're trying to give everything away, leading the horses to water and begging them to drink. I always tried to design my tests so that a student could get 80% of the answers through diligence alone, though it did require above-average diligence. 15% required some thinking, some creativity, and some aptitude, and maybe 5% could be answered by only the top one or two students in the class.

Sure, there's a lot of alcohol and 420 consumption at universities, but if you looked around at the students at Ohio State, you would find much to admire (insert Professor/coed joke here). Many, many students there had jobs working 20 or more hours per week along with their full course loads, and the curricula, at least in science and engineering, were not designed with that in mind. Plenty of students really do develop their minds and abilities more than they ever thought possible going in, and they experience much satisfaction from that. It is much better to go to college than to become a truck driver.

Stefan Jovanovich responds:

For those lucky and skilled enough to be in your rather select group, the rewards of serious scientific academic study are unquestionable. The point I thought I was making was that for "ordinary" people the traditional academic game is proving to be an increasingly bad bet. For those for whom the choice is "education" in the generic sense of survey courses, breadth requirements and a non-rigorous major vs. a Class 4 license, the Class 4 license is currently looking to be a better deal. That is clearly the conclusion of the masses who are voting with their feet in favor of junior colleges and trade schools. I apologize if I am stepping on someone's rice bowl, but I doubt very much that the current relative values of a certification to operate heavy machinery vs. a B.A. in Anthropology can be questioned, given their respective acquisition costs and likely future incomes.

The utility of formal education must be measured in more than monetary terms, but for the people taking out student loans (whose repayment, under the new bankruptcy laws, cannot be so easily ignored) the question of what a degree is worth and what it costs is hardly academic. As you acknowledge, "the curricula, at least in science and engineering, (are) not designed" for students who have to work to pay their way through school. That is a change for the worse and testimony that the land grant public universities no longer offer genuine opportunities to the poor, bright student. My Dad bussed dishes at the dining hall to make it through the University of Colorado, and my father-in-law slung hash in the kitchen of a fraternity to earn his undergraduate and masters degrees in geology at Texas and Oklahoma. I have never been either as poor or as smart as Dad or Buster; but, if I had not worked a job serving process, I would not have been able to afford to make it through law school at Cal (and the world would have been spared one more tax attorney).

One of my father's very few serious regrets at the end of his life was that in the early 1980s he could not persuade the directors of the public company that he ran to go into the for-profit education business and offer "trade school" educations. The directors feared that the public school teachers would rise up in anger and boycott their textbooks. Dad thought the risk was worth taking since he saw the profit margins in the textbook business evaporating before the advance of high-speed copiers, readers and used book resellers. The capital markets have proven him to be right. The upstart University of Phoenix and its cohort of U.S. for-profit publicly-traded educational companies - which were just being started 3 decades ago - now have a greater market capitalization than all of the world's textbook publishers.

J. T. Holley replies:

My father was a truck driver for 25 years. Boring it's not (regular change of scenery), and the pay is great compared to other jobs in rural areas. But I'll grant it's stressful due to the other drivers on the road. For a young man in the rural U.S. to leave and go to the "U", he must ask a deep deep question: "do I leave my family?". It's easy for those raised in the city or town that the "U" is in, but those living in towns like Grundy, Damascus or Martinsville in Virginia don't make that decision as fast. Being a truck driver allows them the opportunity to "get out" and come back weekly and be around the family. This is usually one of the highest paying jobs in the area if it exists. Now, I'd rather be the "dumb human than the smart pig" as Plato proposed, but in rural redneck America the smart pig might be the better option. In a small town, having a PhD might get you a loan from the bank to start a business, but that's about it. I had a kid from Kansas on my ship in the Navy. He couldn't swim. He asked me why I joined the Navy and I gave him the usual "college money" reply. Feeling a sense of obligation I then asked him why he joined. He said "to see the ocean". Seeing the seriousness on his face I asked him if he'd ever heard of a vacation. He said "It just doesn't work that way up in the Smoky Hills".

Russell Sears responds:

Perhaps I misread the post. But as the good teacher, Adam Robinson says in his book, the smart student learns to parrot the textbook. After all its generally the teacher ego that picks one book over another. Perhaps it has not quite sunk into this "quant" that in the real world you need to think for yourself. That this was an exercise in peer review, not textbook writer worship.

If I am right what is sad, is the state of education at MU. Perhaps, a word of "real world experience" could change this youths direction.

GM Nigel Davies adds:

Consider the incentives in education. What is taught in the classrooms is not necessarily what is required by the world at large, but rather the interpretation thereof by people who are elected and/or appointed to decide such matters. The students have an incentive to toe the line and will be unified in saying that the system/their qualifications are good because it gives them an edge in the jobs market. And the establishment has an incentive in making the system look good in order to maintain funding. Who's going to question its value? Looks like it's only Ken Smith, some truck drivers and maybe a Grandmaster or two.

Greg Rehmke responds:

Whether driving a truck or pursuing a PhD, I suspect results turn on what people read, discuss, and write. Audio tapes from Books-on-Tape, The Teaching Company, and Knowledge Products can provide both truck drivers and commuters a wide-ranging education. I especially recommended is the "Giants of Political Thought" series available from Knowledge Products.

As truck-drivers relax after meals or before sleep, what they read shapes what they understand and how they think about the world. If they read, for example, William Easterly's recent book White Man's Burden, or Rodney Stark's The Victory of Reason, they will better understand why the western world prospered while Africa and Latin America are still stuck with poverty. If, instead, they read the New York Times and watch the evening news, and if they listen to talk radio and NPR instead of thoughtful audiotapes, their minds will be full of some combination of things that aren't true and things that don't matter. (I listen to NPR sometimes because I enjoy it, so I end up with a fair number of not true/doesn't matter items bouncing around my head.)

Graduate work can expand understanding and insight, as well as research and writing skills. But most Masters programs in the social "sciences" waste time, money, and minds. I remember a stand-up comic telling of a professor encouraging him to pursue a Political Science Ph.D. after finishing his undergraduate degree. "What do Political Science PhDs do?" he asked. "They teach other students about political science" was the answer. "What do they do with their political science degrees?" he continued. "They teach still others" was the reply. The comic concluded that political science was a giant Ponzi scheme. And so, unfortunately, are many of the social "sciences."

I am enrolled in the Masters program in Economics at San Jose State University. Classes are in the evenings and most masters students work full-time. At least a dozen SJSU economics profs are accomplish market-oriented scholars (Jeffrey Hummel, Mark Brady, Ed Stringham, Ben Powell, Lydia Ortega, Edward Lopez, and others, many with Austrian/Public Choice educations from George Mason University). Each semester hundreds of undergraduates learn economics, but also learn Austrian and public choice insights that usually remain hidden from students at higher-ranked universities.

In the end we each choose whether we pursue our own course to wisdom and understanding, or just float along in the media mainstream. We could spend a decade in college, as thousands do, but learn little either true or useful. Or we could spend a decade crossing the country by truck accompanied by the greatest thinkers in world history.

Misty Watercolor Memories, from Cliff Humbert

My high school electronics club would visit neat destinations on weekends: SLAC at Stanford, or Lawrence Berkeley National Laboratory at Strawberry Canyon, or help work on the MOOG synthesizer at SF State, or hear Tom Dolby talk about audio frequency shaping...

One Saturday, our trip was to "an electronic hobbyist" and we found ourselves in a garage filled with a tangle of wires, instruments, tiered bench shelves, and a cleared open space on which sat a box connected to what looked like a video terminal..

Soon the Woz came from the house and were shown the precursor to the very first Apple.

Bayesian Forecasting of Option Prices, by Prof. Tony Corso

An interesting paper is downloadable here. The gist of the paper is that combining 30 days of historic data with implied volatility gives a better forecast of option prices than simple implied volatility. They demonstrate this by calculating the usual stats (root mean squared error of the forecast, etc.) and by running a 'trading contest'. They describe 5 rules (they call them agents) that, at the simplest, used 30 days of returns to generate a forecast of the stocks distribution, and at its most complex, used Bayes rule to combine 30 days of returns data with implied volatility data to make a forecast of the stocks distribution. They then sell (overnight) ''over priced'' options and buy ''under priced'' options. Naturally, the simple rule makes very little money and the sophisticated Bayes rule makes a ton of money

Some things I would have liked to have known that weren't mentioned:

  1. They aren't buying and selling straddles, but individual options (i.e. the simulation isn't delta hedged)... and they do not differentiate between how much of their profit is do to a favorable move in the underlying, and how much of the profit/loss is due to correctly predicting the implied volatility.
  2. They do not breakdown how many profitable trades were shorting options, and how many were going long options...it makes a difference to me if I make money while I'm long gamma rather than short gamma

One thing that strikes me as making this hard to try to replicate in other markets is the time structure of volatility problem  It may be okay to take 30 days of OEX/S&P futures (or spot) data and use it when deciding about options that expire quarterly, but I'm leery of trying that with options that expire monthly.  Lets say its Feb 1, and you are looking at options expiring March 1. For stock indexes, the prior January's data will not have any, err, ''structural reason'' to be terribly different from the index future performance data from Feb 1 thru March 1.  Not so with say, oil. During January, the prompt futures contract is February. The January data is using data from Jan 1 (a 30 day forward price against the February contract) through Jan 30 (a one day forward price against the February contract). If you believe (as I do) that things get more volatile as one approaches spot, the January data is a biased representation of what one expects the market to do from Feb 1 to Feb 2  (the overnight trading part of the simulation). The January historic data is a blending of variances of 30 day forwards (Jan 1's vs Jan2's observation) and overnight forward prices (Jan 30's vs. Jan31's observation), but we want to ''overnight trade'' an option on a 28 day forward contract (the March option expiring March 1) -- the variances don't ''match up''.

Do any statwise people have an idea as to how I might get around this time structure of volatility problem in trying to reconstruct this simulation using oil prices? (Let's leave the seasonality problems alone for the moment).

N.B. Oil savvy specs will realize I've fudged the expiration cycle/dates a little for the sake of clarity

Dr. Alex Castaldo replies:

Academically it is an interesting paper. They were able to derive extremely messy mathematical expressions for the posterior distribution that are new to the option literature as far as I know. (Bayesian stats sounds good until you try to do the math... often you just hit a brick wall and can't get anywhere).

From a practical point of view I share Prof. Corso's concerns. There are a number of real life issues (like term structure, skew, etc) that are left out.

Also I am bothered that they use (page 17) the "mean of the implied volatilities over the 30 days preceding" and the 30 day realized volatility in their Bayesian estimator. The standard opinion in the industry is that the latest implied volatility is the best estimator and that is one of the estimators they claim they can beat.

Bayesian Methods, by James Sogi

The debate on the relative merits of classical predictive statistical analysis and the application of Bayesian analysis when applied to markets when you have a prior probability computed for a given time frame is whether it is better to exit at the optimal time given at the time of entry of the trade or to alter your probabilities and trade based on the arrival of new information, new ticks and new changes in price, news, or announcements while the trade is pending. The classical statistical theory asserts that you have to trade the probabilities and to alter course creates the danger of Bacon's "switches" and diminishing the favorable edge. The prior distribution has ups and downs in the returns but overall the sum probabilities will be positive over the long run and to try short run this distribution reduces the overall return. The application of the Bayesian theory argues that adjusting the position during the trade to the arrival of the new information and can increase the probabilities and returns and avoid the "switches". In practice the former seems to be beating the latter but this may be due to lurking variables in execution. This could be tested easily enough on historical data. The problem in testing is which parameters to use for the posterior criteria.

Thomas Leonard and John Hsu's book Bayesian Methods, from the Cambridge Series in Statistical and Probabilistic Mathematics, has understandable definitions of the concepts for the practitioner and the theoretician. The Bayesian paradigm investigates the inductive modeling process where inductive thought and data analysis are needed to develop and check plausible models. Indeed, one of the the main reason for the spec list is inductive thought to develop models and their testing. Mathematics and deductive reasoning are then used to test those models. Too much concentration on deduction can reduce insight, and too much concentration on induction can reduce focus. An iterative inductive/deductive modeling process has been suggested. Bayes' Theorem states generally that Posterior information equals prior information plus sampling information.

The Expected Utility Hypothesis (EUH) microeconomic procedure helps make rational decisions about money and might be used as a model to quantify decision making and risk as an addition or alternative to Dr. McDonnell's risk formula by considering the choices of the trader or client relative to the statistics to determine whether the amount at risk and the decision frame work being used is rational or will lead to losses or lower return for given probabilities. This work parallels the work of Tversky and Kahneman, but is quantified in Bayesian terms. The basic idea is that people place a premium on certainty which leads to irrational decisions about risk and leads to more losses than is right. This is a good quantification of the gambler vs speculator distinction just discussed, as the gambler's probability expectation is negative while the speculator's probability expectation is positive. Using as examples such as the St. Petersburg Paradox, Allais' Paradox, and the risk aversion paradox, the EUH can be used to make better decisions. Some seek the premium for certainty and fall into the trap known as the "Dutch Book" resulting in certain losses over a series of iterations. This is the distinction between a gambler and a speculator. Formally, does your choice satisfy the utility function U(r) such that for any P1 and P2 P1 <= P2 if and only if:

E(U(X) | P1) < = E(U(X) | P2)

The EUH measures whether you choose a positive but more random expectation over more certain but lesser return. The St. Petersburg paradox is a good example. A fair coin is tossed repeatedly until a head is obtained for the first time. If the first head is obtained after n tosses, you receive a reward of 2^n dollars. What certain reward reward would you accept as an equivalent to the random reward? The paradox occurs because the expected winnings are infinite, but most people would accept 6 or 8 dollars. The EUH can quantify an individual's utility function. This might be a good way to allocate money among funds or risk profiles using an elicitation process and creating utility curve for allocating either clients or moneys among funds or accounts with varying risk profiles and expectations or leverage.

Back to the original point. Let's say you are in a trade that says the optimum expectation is tomorrow. What if the market goes up big today in a big rush all of a sudden. Do you wait it out because the system says so or do you take the gift. The odds have changed on the expectation due to today's rise. What if the twin towers are bombed. Do you bail or ride the original trade? The answer to these is simple, but as shades go, it is not so clear. The criteria for judging the posterior probability seems to be the crux of the issue, but should follow a rational method.

Dr. Phil McDonnell responds:

The origins of Expected Utility Theory go back to The Theory of Games and Economic Behavior by Morgenstern and Von Neumann (1944). They asserted that the expected utility is given by:

E(u(x)) = sum( p(i) * u( x(i) ) summed over all outcomes i

where: p(i) is the probability of outcome x(i) occurring. u(x) is presumed to be an unknown but monotonic increasing utility function which may be unique to each individual. Note that the expectation is a sum over all outcomes.

In their paper Kahneman and Tversky (KT) on Prospect Theory a prospect is essentially a set of outcomes as above, in which the sum of the probabilities is 1. The latter constraint simply means that all outcomes are included. In the first page of KT they say "To simplify notation, we omit null outcomes". Null outcomes comes from two sources. One is a probability of zero which is innocuous because the zeros would not be included in the sum of all the probabilities adding to 1 in any case. KT makes the unsupported assumption about the nature of the utility function in the following two cryptic remarks from p.266.

,with u(0)=0, (p.266)
set u(0)=0

In both cases they are making an assumption about the utility function which neither supported nor even explained. In addition the paper is using what may be the wrong zero point.

Daniel Bernoulli made a very insightful analysis of the St. Petersburg Paradox mentioned by Jim Sogi. His key understanding was that the utility of money is logarithmic with the natural log ln() being the convenient choice. The compounded value of a dollar is given by (1+r)^t where r is the rate and t is time. This is simply a series of multiplications of (1+r) by itself t times. We know that multiplication can be replaced by sums of logarithms. After which we take the anti log to restore the final answer. So if our goal in a sequence of investments or even prospects (bets) is to maximize our long term compounded net worth we should look to the ln() function as our rational utility of a given outcome with respect to our current wealth level w. In particular, for a risk indifferent investor, a given outcome x would be worth:

u(x) = ln( (1+r) * w )

This thinking is the basis for the optimal money management formulas and for what could be called a Rational Theory of Utility. Note that the formula only depends on wealth. It is non linear and concave.

Thus it is reasonable to ask what was the average net worth of the individuals in the Israeli, Swedish, Allais and KT studies. For the most part they were students with some faculty. The average net worth of a student was probably about $100. A little beer and pizza night out was considered living high for most.

Using questions with numbers reduced in size from Allais, KT asked subjects to choose between:

A: 2500 with p= .33 B: 2400 with certainty 2400 with p= .66 0 with p= .01 For N=72 [18%] [82% chose this]

The expected log utility for these choices under rational utility is: E( u(x) ) = 3.1996 E( u(x) ) = 3.2189

Clearly the 3.2189 value chosen by 82% of the subjects was the better choice.

Looking at Problems 3 and 4, Choices A, B, C and D we find that the rational utility function agreed with the test subjects every time without exception. KT disagreed with both the rational utility function proposed herein and their test subjects. Based on this metric it would appear that the subjects are quite rational in their utility choices.

One can find the KT paper here.

Here is some R code to calculate the expected log utility for a rational investor for each of the referenced KT problems:

Jeremy Smith responds:

Note that there are at least 2 ways the distribution can change. It might change unpredictably, e.g. due to arrival of new information or it might change for example because of the approaching expiration of options. Even if Bayesian methods and Markov Models aren't good at the first kind of change, they ought to be useful for the 2nd kind.

Rethinking Recess, by Bo Keely

My comments on education, once again, are from the front lines of substitute teaching in Southern California middle and high school for two years. The difference between a sub and a full-time teacher is that I see every of 500 students in all the classrooms each two weeks, whereas regular teachers are cloistered in a single room with five classes of kids all year round.

I tell people that sub teaching is a combo of show business and running a dog kennel. The goal, at least in Southern California, is to keep the pupils from each other's throats, teach them freedom while maintaining respect for proper authority, and carry out the normal teacher's lesson plan which usually is showing a video, for example, 'The Nutty Professor', that I once viewed five times in one day.

It's a tough job, but also the best straight gig I ever had, so there are no complaints, only suggestions. I can tell you from the podium that the first line of defense in the classroom is the class seating chart that allows the profssor to identify and compliment achievers or send fecalcephalics to the office. The second line of defense is recess because, as anyone who has trained animals -- kids are little animals and we are big ones-- knows, first you wear them down and then you fill their minds with gold.

The omission of recess in school programs is a grave mistake because the kids must blow off steam during the long school day in order to absorb academics. A healthy mind follows a healthy body. Non-requirement of Phys. Ed. class, atop a lack of recess, is a sure recipe for disaster and the subsequent failure of the American society.

I'm willing to deal with the crash of broken mirrors and wastebasket fires in the locker room if you'll vote yes on recess and Phys. Ed. in our public schools.

Very Good in One Role and Very Bad in Another, by Victor Niederhoffer

Just as books like The Godfather teach us that an individual in his different roles can be very good or bad, like the Don's being so good with the grandchildren, but willing to kill you for a dime without a trial, the rednecks can be very good in one role and very bad in another. I know of a man whose views on things are as bigoted as those of the rednecks -- yet he is a very good fisherman, always willing to share his catch with you, and would give you his views on the market without any charge or a hamburger for free if you were hungry and drove to his store. I found the same kind of people as the rednecks on the juries I have had the displeasure of facing. They all have relatives who are policeman or firemen, and you can't ever expect them to decide against the authority of the police. At a more fundamental level, the average person, the average G-d fearing, quarter acre owning, two child parent, high school educated, 40 years old, earning $40,000, has more common sense and compassion than the average prince of Wall Street because he has participated in a series of voluntary mutually beneficial transactions that have taught him that life is benevolent.

Craig Cuyler replies:

Your point reminds me of something I read once that said "the qualities that make you a good businessman are the same that make you a bad human being and vice versa."

Through various friends of mine and work I have come into contact (as am sure most of you have) with quite a few people worth in the hundreds of millions of dollars and the one common trait that they seem to share is their lack of real friends. I've often been to these people's homes for birthdays, New Years, Christmas parties, etc. and they don't seem to have a close circle of friends other than the ones that they have become acquainted with in the last year or two. Most of the so-called average people that I know have large circles of close friends that they have known for years. I don't know if your experiences are the same but is something that my friends and I have often commented on.

Dr. Kim Zussman responds:

To borrow from another scientist, true friendship is an asymptote. The best illustration of this was my friend Mr. Clean (the tarantula), who died without ever issuing a nasty bite with his quarter inch fangs.

Another relation is |F(T)| = 1/$. The absolute value of true friends is inversely proportionate to your net worth (hasten to note this conclusion from too little n, but in that depicted net can be easily conned, you can test the affected sycophancy).

J. T. Holley responds:

My PaPa passed away in 1995 at the age of 98. He lived in a house that he built himself. The only running water was the kitchen sink. The outhouse was conveniently downhill 50 yards from the house and downstream from the creek that ran beside it. He had a Barn that had twelve bear hides on its outside with turkey claws hanging from the tin roof and had every tool known to man inside for survival. There was a cellar underneath the house that had a blacksnake named "Jake" that guarded canned goods and potatoes from rats, mice and men. He didn't have a high school education and never possessed a driver's license in his life. This aside he was probably the closest thing to a true scientist and empiricist that I've met in my life thus far with his handwritten notes, journals, calendars and such. He taught me to trap, hunt, fish and have a love and passion for NASCAR, football, John Deere, Remington, Buck knives and that life wasn't fair and you have to be tough, callous, persistent, and independent in all endeavors to succeed. Knowing my rural upbringing I feel qualified in making a few points about rednecks:

  1. There's a lot more of them than you and it's easier for them to become like you than for you to become like them.
  2. They really don't care for your opinion or how you do things.

At the same time my PaPa passed away I was ironically knee deep in textbooks teaching me of Plato's "allegory of the cave", Kierkegaard's "stages of life's way", Sartre's "existence precedes essence", Thoreau's "men live lives of quiet desperation", Plato's "mixed metals", and Heidegger's concept of throwness (pure choice except parents and death). Having that deep rooted upbringing and the benefit of a liberal arts education I can tell you the following:

"You are outside the cave, not everyone is. Just because you've chosen to advance your life along the way doesn't mean everyone else has and remain still inside the cave. They like being aesthetes and have not seen the need for logic, ethics, religion, and empiricism at the levels you choose. In their bliss they don't understand that they are suffering just like you are, and realized that they can choose like you choose and decide on a daily basis. For some reason we are all different but yet the same. The fact remains that we are here and that eventually we aren't going to be here anymore at some point. This bothers you more than them and you create value and meaning to cope and deal with your existence just as they strongly hold on to their essence, but this doesn't necessarily make you better than those in the cave when it comes to survival."

One thing that I've learned is the fact that nobody cares about your new found skills of countin' except a handful of people on this List. My wife doesn't care about "normal distributions", my Dad doesn't ever want me to utter the word "heteroskedasticity" in another conversation while playing checkers, while sitting watching football with friends don't ever mention that West Coast offense's edge is being "arb'd away" due to the "law of everchangin' and the adaptation of Defensive Coordinators, "randomness" is something that most people use as a creed, but the most, most, most ever importance is make sure that you and your Mom are on the same page when the words "Fat Tail" come rolling off your lips.

For those wishing to further their understandings on the topic of rednecks, simpletons, the "common man" located predominately in the South or at least having roots traced there, I would strongly suggest reading every single book in the Foxfire trilogy. These books are both educational and give tons of insights into the world of Speculation.

The other important thing is that rednecks or Southerners have a great "dumb act"; Vic conveniently pointed this out to me when I first gave him an "Awe shucks" comment. This is something I can't shake and to even "appear intelligent" is that which makes me feel naked and nauseated. Deception comes in all shapes and sizes.

Briefly Speaking, by Victor Niederhoffer

A good measure of stability, or uncertainty, is the distribution of S&P futures opens relative to closes. Right now, I note five down opens in a row, each succeeded by a up open to close -- the average open about -1 point, and four levels of close to close within a 2.5 point range, with the average absolute variation among them 1.7, and nary a big decline since September 6. If only these signals could be unraveled predictively, like those 2000 per game in baseball described in The Hidden Language of Baseball. There are certain coaches in baseball who are expert at reading signs, and are hired mainly for that purpose, and I would like to know of such personages in the markets.

   DATE       O         H         L         C
10/9/2006   1357.3    1361.8    1355.1    1359.2
10/6/2006   1358.4    1360.0    1352.7    1358.8
10/5/2006   1357.8    1363.2    1356.5    1360.8
10/4/2006   1341.2    1359.0    1339.8    1358.3
10/3/2006   1338.6    1347.8    1336.0    1343.2
10/2/2006   1345.7    1348.1    1339.3    1340.4
9/29/2006   1348.2    1349.5    1345.0    1345.4
9/28/2006   1347.5    1350.3    1343.1    1347.3
9/27/2006   1345.3    1350.2    1343.2    1347.7
9/26/2006   1336.0    1347.1    1335.0    1346.7
9/25/2006   1328.3    1340.0    1321.6    1335.7

Rick Foust responds:

I have no related credentials to hang on the wall, but I have studied this very question at length and I have a definite opinion. I have not seen this question answered elsewhere and no one seemed willing to touch it here. So, I will offer my opinion, for whatever it may be worth.

Examples of such talent exist in every walk of life. I notice this talent most often in athletes, coaches, children, mothers, animals and animal trainers. An off the wall example that never fails to amuse me is the ease with which some taxi drivers negotiate city traffic. I have found the talent to be independent of intelligence or education. The best market reader I have encountered was a grandmother in Texas that day traded options as she worked around the house (folding clothes, etc). For other examples, think of some of the great quarterbacks that were known for being able to read defenses while being cool under pressure (e.g., Joe Montana). I recently received a video of a guy that I think is outstanding. Here is a link. The file is large, so please be patient if you have a slow connection. Just in case you wonder if you got the wrong file, it really is about a guy and a dog.

In my opinion, the essential ingredients are; a willingness to accept life as it comes, perseverance and attentiveness. Experience is a great help.

The ability to accept life as it comes is the most rare of the three ingredients. I generally have difficulty explaining this concept because it is so easily confused with being Pollyannaish or lackadaisical or reckless. It is none of those things. A wise woman once told me that love is unconditional acceptance. So, unconditional acceptance of life means loving life. Accepting life removes the filters that cloud perception and also relieves the tensions that inhibit decisions. And of course, if you love life, it will love you back. (I know that sounds corny and sappy.)

Perseverance is common. But a strong combination of acceptance and perseverance is very rare. All too often, those with high levels of perseverance are just stubborn, doggedly refusing to accept reality. I mean perseverance in the sense of having the courage to do one's best even though down 12 points. (No, I am not a football nut.)

Attentiveness seems common, but I am talking about a special kind. I apologize, but I don't know how to explain it other than by using myself as an example. Although I have always been able to get good grades without much effort, I have never liked school. So I rarely scored the best in any class. Early in my career, I was in some fairly intense training to qualify as a Shift Technical Advisor to reactor operating crews. And true to form, I scored third highest in the class without much effort. What disturbed me was that the top scorer exerted even less effort than I did. I was used to being outscored by the studious. But not this. I watched him in class, trying to figure it out. All I can say is that he just sat there, relaxed, soaking it up like a sponge. Years later I became involved in martial arts. At first, I had difficulty learning the movements and techniques, but it got easier with time. After a couple of years of martial arts training I had more job related training. To my amazement, I found I was able to sit and effortlessly soak in the information. And I was able to turn it on and off. And I got 100% on the tests and was typically first finished. I don't know what happened. My guess is that the martial arts training opened the resistance in some learning pathway.

On related topics: Attempting to profit on readings adds a degree of difficulty because it involves risk and timely decision making. The element of risk has the potential to emotionally disrupt the ability to read the signs. The element of timely decision-making is a problem in that by the time sufficient data has accumulated to enable statistic verification (if that is the correct terminology), the pattern is likely near the end of its useful life. (The exception would be patterns that are so obscure that they are not likely to be seen by many.) Therefore, in order to profit, the trader must be able to act in the face of uncertainty.

Another difficulty is that a black swan inevitably appears when things are otherwise going well. As patterns become evident to too many players, the patterns can no longer be sustained (similar to the cycles of rabbits and foxes). This has the advantage of perpetuating a game where one person cannot end up with all the marbles. If the trader is complacent and/or has not prepared a defense, the end result can be disastrous. In the markets it has cost me money. As a small plane pilot, it almost cost me my life. The misfortune that occurred to Siegfried and Roy is a well-known example.

An Amazing Example of Efficiency and Value, by Victor Niederhoffer

The local Stew Leonard's sells a 12 pack of 12 ounce canned Coke for $2.40. That's 20 cents a soda, about what I paid 40 or 50 years ago for a bottle. When one thinks of the many steps involved in getting that Coke to the customer, the cans, the filling, the packaging, the transportation, the printing, the sealing, the advertising, the warehousing, the refrigeration, that's an amazing example of efficiency and value showing many things, e.g. that there's incredible competition in the world, and that even the most branded and famous of all products, can't escape from substitutes and the inexorable decline of commodities and commodity type products and formulations to a Julian Simonesque 1% a year increase in price.

J. T. Holley replies:

Furthermore it's a testament to the traders/hedgers of KO who have been able to hedge the costs even when they vary from that normal 1% a year increase.

All to keep the price the same.

Mandelbrot, Fractals and Chaos Theory, by Dr. Phil McDonnell

In response to Professor Haave's query: "Mandelbrot does a good job attacking modern finance theory, and he does a good job explaining what the rest of us call "fat tails". But otherwise, well, is it the same merit as Elliot Waves?"

There are several things wrong with Fractal and Chaos Theory:

  1. The world view is fundamentally and fatally pessimistic. Benoit Mandelbrot argues that the variance must be infinite. He drew that conclusion 40+ years ago based on the fact that cotton prices had changing volatilities over time. Based on that slim evidence he jumped to the conclusion that it must be infinite. I have yet to see a real world price of infinity. Despite the lack of even a single infinite data point, Mandelbrot completely dismisses the modern GARCH models as being too complex. In my opinion, dealing with the intractability of infinite variance is far more complicated.
  2. It is non-predictive. Generally speaking, randomly generated numbers (fractals) are produced and usually graphed. Then the pretty pictures are compared to real world phenomenon in the past. The pictures do seem to resemble some real world patterns to the human eye. In my opinion that is because the eye wants to see patterns in such things as snowflakes and turbulence swirls.
  3. Lack of rigorous definition. Admittedly there are some valid mathematical proofs which have come out of this area. However in general the field is completely devoid of basic metrics. For example how does one define "similar to" or "close to" for a fractal? This lack of basic metrics comes out of the fundamental pessimism in point 1. The philosophy is that the real world has infinite variance so there is no point in measuring how far we are from something because the next event could be infinitely far away.
  4. Lack of goodness of fit, statistics and feedback as to how well this theory fits the real world. You will never see a statistic of any kind in a paper on fractals or Chaos theory -- no estimate of probability, no R squared, nothing. In his book, Didier Sornette performs numerous non-linear fits of various market crashes and yet never presents a single probability estimate or R squared value. It is always presented as "see how nicely the chart of the model overlays onto the actual market chart".
  5. The theory is non-scientific. To be scientific a discipline must make testable falsifiable predictions. These theories are not predictive and therefore not testable nor falsifiable.

Chaos theory extends these fundamental issues one step further. Most mathematical definitions of a 'critical point' involve a term something like: 1 / ( t0 - t ) , where t is the current time and t0 (t zero) is the time of the critical event. At t approaches t0 the difference goes to zero. So at the critical juncture we are dividing by zero. The entire expression goes to infinity at that point. (Strictly speaking it is undefined not infinite). The point is that even if BM is wrong about infinite variance the models of Chaos Theory create their own asymptotic behavior which means these models do exhibit infinite variance even if the real world data does not!

About the only hope I have for these theories is that some of the older generation of thinkers will pass on and a new crop will come in and invent metrics and ways to measure goodness of fit which can turn this field into a predictive and testable science.

Russell Sears responds:

Could someone explain how theses theories lead to the doomsday scenario which Mandelbrot and the Derivatives Expert are so fond of? In my mind, I have worked out the following, tell me if I am on the right track:

First, the chaos part. You can often find "meltdowns" in markets. Points in time that markets "jump" and are discontinuous, or at least "non-normal" for brief periods. A butterfly flaps its wings and you have a thunderstorm, for 15 min. or perhaps even a hurricane for a couple days. Say a 13 sigma event for a day in Oct 87.

Second the fractals. The market is pattern that can be repeated, and scaled up simply by time, say perhaps by the square root of time. Combining these, if a 13 sigma event happened in the past for a day, it's only a matter of time until it happens for say a month, or a year. Likewise if we seen a 13 sigma, it is only a matter of time until we have a 1000 sigma event.

However, to "prove this" fractal they do the opposite. They take long periods of time and scale down. Of course these long time periods don't have the "chaos" pattern  yet.

The problem is: these longer distribution are pretty much continuous. Therefore, they follow a random walk pretty closely. Of course when you take a distribution that is stable, you see these "patterns". It is the same distribution after all.

The real assumption concerning fractals is the "energy" of the markets, i.e. that people can go infinitely into craziness, an unlimited nuclear chain reaction, fusion versus fission. They simply reject all evidence of extremes as being contained fission, by saying fusion will happen.

As you said, it's not science, but it uses a lot of math terms. It's a belief system.

Dr. Phil McDonnell responds:

News can cause jumps. This may induce something like the Merton jump diffusion model. The idea is that markets are generally lognormal but a few times a year some big news happens to cause a few outlier events per year. Also remember that if the market follows a jump diffusion model that the 1987 crash should be counted in the model.

The modern GARCH and EGARCH models are better because they take into account shifts in the volatility regime. The 1987 event was say a 13 sigma event taken over a 50 year average volatility. But when you look at it in the time frame of that week's actual volatility it was only about a three or four sigma event.

The concept of self similar behavior at both smaller scales and larger scales is probably one of the more interesting aspects of fractal theory. Lo has found that the square-root scaling of volatility over time does not quite hold but it is close. He derived his own test statistic specifically to test for this in markets in a non-parametric way.

How much time? There is considerable evidence that large negative jumps are mean reverting. This is a violation of the idea of self similar. As an aside even the normal distribution is self similar regardless of scale. The normal distribution for, say, 20 trading days can be decomposed into two periods of 10 days, four periods of five days, all of which are normal and scaled proportionally to the square root of the time. This has been known for something like 200 years.

Generally speaking a philosophy of pessimism pervades the study of fractals and chaos. I believe it is direct consequence of the assumption that the variance is infinite. This requires the ineluctable conclusion that the big one is out there -- hence the predilection for doomsday scenarios.

David Wren-Hardin adds:

I went to a talk Benny Mandelbrot gave at NYU, soon after his book came out. While it was interesting, it had very little relevance anyone trading on a daily basis to actually make money, or to value financial instruments. He was completely uninterested in questions of underlying mechanisms or market behaviors that might underlie his models. Attempts to get from him information on how to plug in actual market pricing into his models to give a predicted price were met by seemingly sincere shrugs of "the picture is enough, why make it more complicated?"

How Do You Feel About Being Called a Gambler? from Ryan Maelhorn

The American Heritage Dictionary lists the following four options for the definition of the word gamble:

1. To bet on an uncertain outcome, as of a contest.
2. To play a game of chance for stakes.
3. To take a risk in the hope of gaining an advantage or a benefit.
4. To engage in reckless or hazardous behavior: You are gambling with your health by continuing to smoke.

Certainly, according to definitions 1 and 3, and depending on your semantic leaning definition 2, we, as market participants seem to fit the bill of "gambler." It is the fourth definition listed above, however, that is really at the heart of this matter. Somewhere along the line, many centuries before any of us were born, the word "gambler," came not only to define one who takes on risk, possibly involving money, but one who does so in a crazed, irresponsible and, yes, reckless way. The image conjured by the word is always one of an old bum, living on the streets, who having been disowned by his family, and happens across a large monetary note, heads straight to the local casino or race track to lose it all. A helpless loser. A man or woman who could never raise a family or provide for anyone, even themselves. Gambling is seen as a type of disease, not unlike obsessive compulsive disorder, or alcoholism. There are twelve step programs and group therapies available. ! However this has never been the denotation of the word, but rather the connotation.

"Gambling is a serious addiction that undermines the family, dashes dreams, and frays the fabric of society." Thus spoke Bill Frist after the passing of his Unlawful Internet Gambling Enforcement Act this October second. The bill was due to be blocked for lack of parliamentary time, so Frist sneaked it into a Homeland Security bill, the "Port Security Improvement Act," which was guaranteed to pass based on its content. But can gambling only be done in a casino, online or otherwise? I wonder just how many people in the US have had their dreams dashed by online poker playing? Could it be more than 90% of those who play? That is the exact amount of new businesses that fail within their first year, an event that also dashes quite a bit of dreams, not to mention capital. Shouldn't First, according to his own logic, move to illegalize new business? Why is it that no one considers entrepreneurs gamblers?

A term usually approved of by more in our profession is that of "Speculator," which has the following strange definition:

A person who is willing to take large risks and sacrifice the safety of principal in return for potentially large gains. Certain decisions regarding securities clearly characterize a speculator. For example, purchasing a very volatile stock in hopes of making a half a point in profit is speculation, but buying a U.S. Treasury bond to hold for retirement is an investment. It must be added, however, that there is a big gray area in which speculation and investment are difficult to differentiate. Also called punter."

I wonder how this writer would characterize one who held a stock until retirement, or one who day traded bonds? Regardless, a speculator seems to be more respected than a mere gambler. No where does the word "reckless" appear in this definition, and indeed we start to see the immergence of respectability here. Even more respect is given to the "investor.":

1. A person who puts (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.
2. A person who purchases income-producing assets. An investor as opposed to a speculator usually considers safety of principal to be of primary importance. In addition, investors frequently purchase assets with the expectation of holding them for a longer period of time than speculators."

Here we have the penultimate description of the respectable way to wager. Now we are "putting money to use," "consider[ing] safety of principal to be of primary importance." The word "risk" is not mentioned even once, much less "chance," and certainly not "game." It is interesting to note that the Unlawful Internet Gambling Enforcement Act act had to have special langauge which permitted "any activity governed by the securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 for the purchase or sale of securities (as that term is defined in section 3(a)(10) of that Act)." It is also interesting to note the harsh 57% crash PartyGaming took on the London Stock Exchange after the US law was passed, a movement that was sure to reward many who were "gambling," and short the stock.

I just wondered what everyone else thought of these terms. Do they object to them? Do they feel offended when they are called as such? Do they prefer one over the other? My mind runs briskly to the top poker players in the world, how consistently they are at the top of the money lists, making hundreds of thousands of dollars each year. Any gambling book worth its salt informs the reader of how important it is to preserve capital, and of how much one must go out of their way to avoid gambler's ruin. It seems to me only logical to regard the top poker players as investors. In fact, maybe this is the crux. Could it be that one who takes chance and succeeds is an investor, while one who takes chance and fails is a gambler? Not unlike one who kills a household of people is regarded as a mass murderer, while one who kills the majority of the army of another nation is hailed as a conqueror?

Tom Ryan responds:

In the main, it seems to me that there are several distinct differences between gambling and speculating/investing, and this ties into the discussion on fractals and markets which has been dissected many times on the list before.

The first point is that diversification tends to help reduce risk in speculating but does little for you in gambling. Why? Because the pieces of paper we trade in the capital markets are actually legal claims on the economic engine of commerce, via either a rate of interest or a claim on future assets/profits/dividends. Provided that economic growth and health continues in the aggregate and nuclear winter is not coming, in the aggregate the value of these claims will rise over time, and therefore the more you diversify the higher the odds that you will participate in this rising tide. In gambling, playing more casinos, tracks, or playing different types of games does not increase your probability of success.

Secondly, in speculating/investing, one can usually reverse out of a position or decision…even though there is a cost to that, it is not 100%. In gambling you can't take a portion of your money back after the ball is in play on the wheel or the horses are on the back stretch. So in speculating there is far more potential to adapt to changing circumstances

Finally, increasing your significant time horizon helps reduce risk in speculating/investing but actually works against you in gambling as in the long run all gamblers go broke because of the combination of the odds and the vig that you pay to play. It has to be that way of course as the casinos have to take a net rake from the gambling public in the aggregate to have a business in the long run.

One of the issues with infinite variance is that it leads one to theologically consider that the game ending event could happen at any time, therefore the statements I made above about risk management would be false. However, one of the (many) problems with infinite variance in a social environment (capital market) is that it ignores the ability of people and groups of people, to learn, adjust, adapt, and evolve over time as circumstances change. For example, although we may not have the ability to avert a major disaster from a large asteroid hitting the earth today, we as a species are more aware of the danger today than 500 years ago, and 500 years from now maybe we will have the technology/capability to avert such a catastrophe. This adaptation and learning process is always ongoing in the markets due to competition. This is simply a long winded way of saying, markets are not snowflakes.

GM Nigel Davies Replies:

Perhaps one of the most interesting aspects of this question may be that those who object the most may be the ones who are most at risk. Life is inevitably a speculative game in which the line between calculated risk and gambling is often going to be quite blurred.

In any case it's better to know that you're playing a game. As a topical example I doubt that many people who take on large mortgages to buy property consider themselves to be 'speculators' (gamblers?) on property prices and interest rates, but that's exactly what they are.

Gibbons Burke responds:

Being called a gambler shouldn't bother a speculator one iota. He is not a gambler; being so called merely establishes the ignorance of the caller.

A gambler is one who willingly places his capital at risk in a game where the odds are ineluctably, mathematically or mechanically, set against the player by his counter-party, known as the 'house'. The house sets the odds to its own advantage, and, if, by some wrinkle of skill or fate the gambler wins consistently, the house will summarily eject him from the game as a cheat. The payoff for gamblers is not necessarily the win, because they inevitably lose, but the play - the rush of the occasional win, the diversion, the community of like minded others. For some, it is a desire to dispose of money in a socially acceptable way without incurring the obligations and responsibilities incurred by giving the money away to others. For some, having some "skin in the game" increases their enjoyment of the event. Sadly, for many, the variable reward on a variable schedule is a form of operant conditioning which reinforces a compulsive addiction to the game.

That said, there are many 'gamblers' who are really speculators, because they participate in games where they develop real edges based on skill, or inside knowledge, and they are not booted for winning. I would include in this number blackjack counters who get away with it, or poker games, where the pot is returned to the players in full, minus a fee to the house for its hospitality*.

Speculators risk their capital in bets with other speculators in a marketplace. The odds are not foreordained by formula or design - for the most part the speculator is in full control of his own destiny, and takes full responsibility for the inevitable losses and misfortunes which he may incur. Speculators pay a 'vig' to the market -- real work always involves friction. Someone must pay the light bill. The marketplace does not kick him out of the game for winning, though others may attempt to adapt to or adopt his winning strategies, and the game may change over time requiring the speculator to suss out new rules and regimes.

That said, there are many who are engaged in the pursuit of speculative profits who, by their own lack of skill are really gambling; they are knowingly trading without an identifiable edge. Like gamblers, their utility function is not necessarily to based on growth of their capital. They willingly lose their capital for many reasons, among them: they enjoy the diversion of trading, or the society of other traders, or perhaps they have a psychological need to get rid of lucre obtained by disreputable means.

Reduced to the bare elements: Gamblers are willing losers who occasionally win; speculators are willing winners who occasionally lose.

There is no shame in being called a gambler, either, unless one has succumbed to the play as a compulsion which becomes a destructive vice. Gambling serves a worthwhile function in society: it provides an efficient means to separate valuable capital from those who have no desire to steward it into the hands of those who do, and it often provides the player excellent entertainment and fun in exchange. It's a fair and voluntary trade.

*A sub-category of the speculative gambler: Playing poker with a corrupt official can be an untrace-able means to curry favor by "losing" bribes in a game of "chance." The 'loss' is really a stake in a position where the "gambler" is really seeking a payoff in a much bigger game, and the poker game is his means to a speculative edge. An example of this is Rhett Butler in "Gone with the Wind", who played cards with his jailers in order to obtain special privileges. Mayor Royce in "The Wire" is another literary example, but this may have been modeled the real-life bribe-taking tactics of former Louisiana Governor Edwin Edwards (whose 'house' is now Oakdale Federal Penitentiary - the Feds kicked him out of the game for winning too much.)

Carly Haiku, a Continuing Series, by George Zachar

Her book? "Tough choices".
But Carly's up to the task.
She takes the Gulfstream.

Title brainstorming:
both Profiles in Courage and
My Struggle were out.

And now, the late hit:
Amateruish? Immature?
Pot calls keetle black.

Catty CEO
bashes board member gossip.
Recursive woman.

A true infighter's
crisis management technique:
She shoots the wounded.

Gary Rogan adds:

The board never said why.
They did pay forty two mil.
The price of mystery.

She laid the ground work
But no good deed goes unpunished.
Tough choices indeed.

BA in medievil history.
Philosophy. But Perkins?
Byzantine indeed.

It's all about people,
Not numbers. I think.
Or is it the other way around?

Male dominated culture.
They gave her a hard time.
Female executive.

Change is difficult.
Choices are painful.
I feel your pain.

Prejudices that Taint our Success, by Scott Brooks

Lately, I've been contemplating the lessons that I've learned in my life, with special emphasis on the things that I learned, believed, and found out later were wrong.

I wonder what I don't know now that is hurting me as a father, businessman, husband, etc.

For instance, I never bothered with counting. I relied solely on technical analysis and my ability (or what I perceived as my ability) to recognize patterns and tendencies. If this list has taught me anything (besides the necessity of counting), it is to test my premises and try to falsify.

Let me give you an example of something that happened to me over the 4th of July weekend.

My family went down to our lake house for the week. We went over to the Current River to sit on the shore and let the kids swim.

I absolutely hate doing that. I hate the intense heat coupled with the bugs. I hate sitting on a gravel beach. I hate getting grit in my swim trunks (it always seems to find its way into uncomfortable areas).

But what I hate most are the types of people that are there. Now before you judge me for what I'm about to say, please hear my confession to the end and my followup request for forgiveness.

I didn't like the people that frequent those gravel beaches. I don't like the way they act, the things they do and they way they behave. I don't like their lifestyle. I simply don't like much about them. Basically, they were the epitome of white trash.

I was sitting on the gravel beach, next to my dad, step mom, and 4 year old. My wife and older 3 kids went downstream about 200 yards to play on a rope swing (swing out from shore over the river and let go...lots of fun, if you're a kid).

The people on the upstream side of me were listening to some country music that I didn't like, were guzzling beer, and chain smoking (I hate the smell of smoke). The people on the down stream side of me were smoking and guzzling beer, and listening to some weird bluesy thing that I didn't like (please note, all these people drive their cars right to the shore line and turn on their stereos). The people on the sandbar behind me were listening to Lynrd Skynrd which I do enjoy, but couldn't hear too well because of the other idiots' loud music...but that didn't matter because the Skynrd crew was directly upwind of me, so I got to smell their smoke.

The conversations that were occurring around me were enough to make me want to jump and strangle them all. "My stupid boss was b!+ching at me again, for being late. But I was only 1 minute late, so I wanted to tell him to #$%#^$$ off" Basically I was surrounded by the inane conversations of low IQ, low personal drive, low self esteem, lazy, under educated, union mentality, entitlement mentality, tattoo adorned, chain smoking, alcoholic wife beaters, who's lifetime highlight was when they were on COPS! Yes, typical white trash.

At least that's what I was thinking. I know that's harsh. But it's what I was thinking.

I guess I'll confess right here that I have a hard spot in my heart for white trash because I grew up with them, played with them, fought with them (read: got my butt whupped), got stabbed by them 3 times, and was bored with their inane idiotic low IQ conversations.

Anyway, back to the story.

I decided to walk down stream to watch the kids swing.

As I got within 100 yards of the rope, I watched my 7 year old son, Hunter, take his turn for a swing. He walked way up the hill with the rope, ran down, kicked his legs up and started his swing out over the river. Unfortunately, he held the rope to low, so when the rope snapped taut, Hunter went crashing into the water right at the edge of the shore.

I watched him climb out of the water with a pained look on his face and could see him mouthing the words, "ouch, ouch", and holding his leg.

My 11 year old son David walked over to Hunter to see what was wrong. David's eye's got real big and he started screaming to his mom, "Mom, get over here, Hunter is hurt". At first Gwen didn't know what was going on, but when David yelled, "Mom, Hunter is cut bad, I can see his bone", Gwen sprang into action. She turned to yell for me to come over and help as she was running out in the water to get to the other side of the river (the rope swing was on the opposite from where we were).

I turned to one of the one of the people that I had classified as white trash and handed them my hat and sunglasses and asked them to "hold this". They did so without hesitation. As I ran out into the river, I was contemplating how to get Hunter back across. I saw a "white trash lady" with an inner tube. I was going to ask her for the inner tube, but I didn't have a chance to ask as, she was already running towards me with the tube saying, "Take this across to get the boy".

As I was swimming across, I noticed another man was ahead of me almost to the other side already. He ran up on the other shore where my wife, Gwen was already with Hunter. He ran up and said, "I'm an off duty police officer, let me help".

Now as a rule of thumb, when someone is hurt, you're supposed to stay calm and let them know everything is going to be ok. This "white trash off duty police officer" took one look at Hunter's leg, and dropped the F- Bomb, "Holy F###". But even with that faux pas, he took charge. He grabbed Hunter's leg, and applied pressure, got a wrap around it.

I finally made it to the shore, and saw that things were as under control as they could be with Hunter, so I started to strategize how to get him across the river.

At that moment, a group of "white trash canoeists" were coming across the river. A whole group of them!!!

The first one to make said, "Put him in here, put him in here, we'll get him across". So I picked up Hunter, cradling him in my arms, with the "white trash off duty cop" still applying pressure to his leg and waded out into the current.

When I got to the canoe, the "white trash lady" in the front jumped out and said, "get in here", helped us in, got Hunter and me situated so I could apply pressure to his leg, and her husband started paddling us across. I have no idea what happened to her, except that I could hear her yelling at her husband, "Paddle faster, paddle faster".

It was then that I noticed, as I'm paddling with my right hand, and holding Hunter's leg with my left hand what was happening in front of me, upstream.

A whole group of canoeist were coming downstream, but in front of them, blocking the way, was a whole bunch of "white trash people". They were directing them to the shore and out of our way. I heard several other "white trash people" yelling upstream to another group of WTP to bring down their power boat to get us upstream (actually it was the group of WTP that was smoking, beer guzzling, and listening to some weird bluesy music right next to where I was just sitting 5 minutes ago) that had the powerboat. They started coming down stream to help.

By this time, we were in shallow water (maybe thigh deep). All of a sudden, WTP started running out into the water, getting on both sides of the canoe, grabbing it, and pushing it up stream.

I was yelling up to my father, "Bring the Ranger down, Dad, unhook the dogs and bring the Ranger down" (we had my Polaris Ranger with us at the Gravel Beach). Unfortunately, my dad didn't hear me. However, that didn't matter. Some WTP ran up to him, told him what was happening while another WTP was unhooking the dogs from the Ranger.

My dad jumped into the Ranger and started coming towards us. As he's driving down the gravel beach, WTP are moving their chairs and coolers out of the way so he could get by.

When I saw him coming, I told everyone pushing the canoe upstream to get us to the shore, which they did. I jumped out and grabbed Hunter and started running up the gravel beach.

Just as my dad and I met, and I was putting Hunter into the Ranger, handing him to his mother (I have no idea how she got there), a WTP ran up to me and said, "Here you go buddy, good luck with the boy, the nearest hospital is in Ellington". The reason he said "here you go" was because he was running toward me to give me back my hat and glasses.

I have no idea what happened to that inner tube that fine lady shared with me. I have no idea what happened to that canoe, that off duty cop, the person who gave me my hat back, the people who pushed the canoe, the people who directed the canoe's toward the shore, the guy in the power boat who tried to get to us...I have no idea whatsoever. I don't think I would recognize any of those people if they walked up to me and said hello.

All I know is that the same people that I was just looking down upon as white trash with just short of disdain were the ones who had, without question, jumped up and helped me rescue my son from his precarious situation. They had given of themselves and helped me and my family!

I wonder, how many more blind spots do I have in my life? How could I have let myself get so blind so as to not see the goodness within people? How many other areas of my life am I missing out on opportunity because of preconceived erroneous notions?

How does this effect my trading? Where am I lacking wisdom, or worse yet, where am I ignorant and don't know that I'm ignorant?

I am on a mission to find those blind spots. I want to then falsify and remove them from my life.

In the meantime, I owe all those wonderful human beings on that gravel beach an apology.

Craig Mee replies:

I offer that, being in situations you are used to, (ie WTP having probably most holidays and weekend breaks in the same areas ) breeds familiarity and confidence and thus a solid framework, for moving into top gear and showing a professional evaluation of the circumstances when needed. Though bring others in with no knowledge of local condition ie, depths, drop offs, road access, and the like, and they will fail miserably , no matter how good the intentions. > > Maybe the old adage of , trade markets you know, and in a crisis where, most downside will be, you will surprise yourself, by how well you dealt with it.

The President of the Old Speculators' Club responds:

A friend of mine who reads this column asked me why I was writing a three-part series about "rednecks" when there are so many other things going on right now that are worth writing about. It's a worthy question. And there are many reasons why I consider the discussion of "redneck" America timely. Here are just a few:

  1. The slow transition of our economy from one fundamentally based on domestic manufacturing and production to one based on technology and services -- that imports its hard goods from other countries. This has implications for the future of such typical "redneck" (and largely unionized) vocations as factory work, trucking, mining, auto assembly, etc.
  2. The cultural shift that's challenging (some would say marginalizing) such historically mainstream American institutions as the practice of religion, heteros-xuality, opposite-s-x marriage, military service, citizenship, firearm ownership, private property rights -- and scholastic, athletic, or workplace achievement through competition. Many of these things are staples of "redneck" life.

  3. The fact that America is currently at war (or at least militarily engaged) on multiple foreign fronts. As you've just learned, this has major "redneck" ramifications.

Basically, my overarching point in devoting so much ink to "redneck" America is to show just how integral to the American fabric (and economy) these people are -- no matter how distasteful that fact may be to many who are now front and center in the mainstream media. And indeed, many Whiskey & Gunpowder readers who rendered feedback on the first two parts of this series wrote in with their own positive anecdotes and affirmations about the shunned, yet vital majority these pundits call "rednecks." But a few criticized me for not painting the whole picture of this huge segment of Americana.

A Small Step Beyond Conspiracy Theories, by GM Nigel Davies

I find it interesting that there are so many definitive declarations that markets are random. I would have thought that a more reasonable answer would take the form that the person being asked was unaware of any pockets of non-randomness.

Could it be that the insecurity that leads people to construct conspiracy theories is at work here also, and amongst people who should know better?

Just a Thought, from Craig Mee

Could markets' price action be directly related to their nations' overriding mindset? For example, German markets might be influenced by a society which:

  1. Performs duties meticulously but can go overboard.
  2. Has a degree of arrogance.
  3. Suffers somewhat from melancholy.

Could we have a set of adjectives which describe major countries e.g.. US, UK, Germany and Japan, and have them directly related to the distribution which occurs during a trading day. For example, could the German mindset above represent efficiency but a tendency of pushing markets to extremes?

Briefly Speaking, by Victor Niederhoffer

I have been reading one of the best books on baseball, The Hidden Language of Baseball: How Signs and Sign-Stealing have Influenced the Course of Our National Pastime by Paul Dickson, and I wish that I were one-tenth as insightful about the signs in our field as Dickson is in his.

I have found an author with a sense of history, the ability to bring off a hilarious set piece and knowledge of romance and economics comparable to Patrick O' Brian. He is Mark Helprin, and I highly recommend his imaginative recreation of the backdrop of the World War I, in A Soldier of the Great War. I would like to make a Baedeker of all the economic wisdom in O'Brian and Helprin and see if this is good training for market people.

It is scary to say that over the 40 years that I have content-analyzed his uniformly bearish columns, Alan Abelson is at a minimum -- for him -- in his bearishness. All he can say is that his forecasting has been off and that investors should enjoy the rally while it lasts: " ...and this bull move, coming as it did amid growing skepticism about the investment outlook, is a perfect example of the power of contagion in coaxing investors off the sideline and dissipating fear. Since our crystal ball is in the shop for repairs [my goodness, that's the understatement of financial history -- VN], we'd venture that since it's being propelled more by money than mind and more by emotion than fundamentals, it's not for long, let alone forever. So enjoy it while you can."

That scary thought reminds me of a 13th method employed by poseurs to appear important [see Russell Sears' list  below], which is to ridicule anybody who has lost money, implying that you were on the other side of their trades. "The Ameron disaster shows how trying to front-run the floor traders at their own game by such simple fixed rules as selling the near and buying the far will lead to disaster." This is so much better than the 14th method, used by Abelson, which is to explain that the market went up because of "contagion," as if one had actually predicted it instead of saying the exact opposite for 12 consecutive weeks while the market rallied and he trotted out one ridiculous reason after another for being bearish from his old cronies like Fred Hickey.

Which brings to mind the 15th method. Pretend that you're very honest by admitting a loss, but then go on to talk about your current forecast and past greatness as if it's that much more pertinent and honest. Uri Geller would say: "Don't even count that I caught your missing car key in my hand out of thin air as an example of ESP, because I wasn't even trying to do it." Here's Abelson's version of the Gelleresque propaganda technique: "Fred Hickey, apart from that fact that he's the smartest tech analyst... unhesitatingly owned up to having had a truly punk September (his put options went the wrong way) turning his best-ever year into more a good one." A comparable technique is to trumpet a hypothetical success you're boasting about by noting that you grew up in the school of hard knocks and losses, as is that would make your current hypothetical profit on 1/100 the capital more meaningful.

In any case, it got me very frightened that Abelson is bullish and the bears might be capitulating especially because the next options expiration falls on the 20th, far from the beginning of the month. I have always thought that the terrorist attacks and bear raids by investment banks are timed to fall on the expirations on the 21st of the month, i.e., where Friday is the last calendar day of the month, making Saturday the first, Sunday the second, and Monday the third, the first Friday the seventh and the third Friday of options expiration the furthest day, the 21st. And a little calculation shows that indeed that's very bearish, with the average decline in Friday-the-21st weeks being -3% with a t of -2 and taking into account the 15% decline of the Friday the Sept. 21 close of 9/11.

However, a little pencil-and-paper work shows that option expirations ending on ending the 20th, such as the coming one, are not that bearish at all, averaging 0.0 -- just a little bit less than the drift. I leave it as an exercise for the reader to generalize this point.

Drilling Down, from Prof. Charles Pennington

My dentist, angling to enhance the growth of her already quite successful practice, finds the secret from Jack Welch:

I started to listen to Jack Welch's book-on-cassette of Winning. Oh man, oh man. I'm barely into the first chapter, and I know the reason for his success -- his annoying voice! People probably just want to get away from him; and therefore, get things done quickly.

Handicapping the Nobels, from Prof. Mark McNabb

The US is six-for-six for the prize so farr, which means the Literature prize will go the the North Korean press release describing the "happiness caused by the bomb test."

Economics goes to "expectations-weighted Phillips Curve" dude. An odd choice, since a Phillips by any other name still a Phillips... Once you introduce expectations into economics you get its bastard child: finance!

Gregory van Kipnis replies:

The 'new' Phelps isn't like the one we remember, the 'old' Phelps, who wrongly theorized that inflation was inversely related to unemployment.

I especially like the way Phelps balances Rawlsian theories of social justice for the least advantaged with the injustice of depriving entrepreneurial types of their need for self-expression. Should a society be limited by serving the needs of the least at the expense of the best, or does it not follow that by bringing out the best from the best, all of society, including the least, benefit?

Prof. Adi Schnytzer adds:

Maybe the Nobel team will try to embarrass the Turks by giving the Literature prize to Elif Safak, but I'd like to see Ismail Kadare get it. Stalinist writers aren't appreciated enough any more!

Tax Data, from Dr. William Rafter

Many have commented about an apparent conflict between the current payroll data and payroll tax receipts. One analyst specifically used the phrase "Social Security receipts." However, Social Security receipts are not the same as Federal withholding tax receipts. The Social Security data have considerably different intrayear seasonality, and of course do not include the very high-end individuals.

We download the withholding tax data daily, and post a chart at the end of each week.

Apparently, Trimtabs looks at the annual growth rates in whichever data they are examining. We confirm that whether you look at monthly, quarterly or annual federal withholding, the current growth rates are accelerating on the downside. The annual growth rate however is not yet negative, whereas monthly and quarterly growth are actually negative. At the moment, the market is ignoring these data. Typically, effects of the daily data have a five-week lag, and we are now in the fifth week. However, we all trade the market, not the tax data!

We have encountered some problems in pursuit of knowledge down this alley.

The Treasury reports its data differently on its Daily Treasury Statement and its Monthly Treasury Statement. Attempted communication with the group responsible within the Treasury has been unsuccessful, making it nearly impossible for us to reconcile the differences in the reported figures. By differences I refer to the fact that monthly total of the figures reported in the Daily Treasury Statement does not agree with the data reported in the Monthly Treasury Statement.

The Treasury reports its data differently on its Daily Treasury Statement and its Monthly Treasury Statement. Attempted communication with the group responsible within the Treasury has been unsuccessful, making it nearly impossible for us to reconcile the differences in the reported figures. By differences I refer to the fact that monthly total of the figures reported in the Daily Treasury Statement does not agree with the data reported in the Monthly Treasury Statement.

Also, the figures are reported not seasonally adjusted. That makes it difficult for the average researcher to draw any conclusions. Seasonal adjustment of data is not difficult to do, if one has the data. That also presents a problem because the older archived data are in .pdf form rather than .txt. Conspiracy theorists thus have considerable grist for the mill. However, as H. L. Mencken said, "Never attribute to deviousness that which can easily be explained by stupidity." We have managed to overcome those problems and build a dataset of the Daily Treasury Statement going back to 1997, and seasonally adjust it. With application, most others can also. The Daily Treasury Statement series also contains Corporate Tax receipts data, which may be of interest to some.

Can the Da Vinci Code Help us Unlock the Secrets of the Markets? by GM Nigel Davies

Can the Da Vinci code help us unlock the secrets of the markets? I'm not talking about the content of the book, more its popularity. The world loves conspiracy theories and it is a huge business. Why do they love them? Because the human mind wants to embellish and create storylines around random events. Is this starting to sound familiar?

The problem with most bullish thinking is that it lacks a conspiratorial element. How much more interesting it is to consider that what we see is just a facade and that there are agents of various different types undermining the fabric of civilisation. The spec-list has been presented with a few conspiracy theories in its time such as the deliberate manipulation of government economic numbers or undermining of the moral fabric of civilisation by assorted minority groups.

In this light, Abelson and his ilk might be seen as conspiracy theorists, titillating the public with thoughts that something in the woodwork is rotten. And our minds seem all too willing to go along with it.

Roger Arnold replies:

The equity bulls have an entire economic system that caters to bullish conspiracy theories and realities. Capitalism as an economic system may be considered a conspiracy theory; i.e. Gordon Gekko's "Greed is Good". The Greenspan/Bernanke Put may be viewed as a bullish conspiracy to steal from future generations a la moral hazard. The drift the Chair speaks of so fondly may be considered to be the reflection of that moral hazard. How many bears to do you see in the media? In a capitalist system the collective voice must be bullish and even Pollyana-ish by design. Advertisers do not pay for reality, they pay for promotion. That's why the bears have so few outlets are left frustrated; the bulls have conspired against them and reality itself. A big deal was made last week about the Dow record. But nobody mentioned that that was only in nominal terms. In real terms the Dow is now 17% below its record high -- but that doesn't sell. And speaking of that upward drift in real terms, and keeping survivorship bias in mind, equities have for the most part kept up with inflation / dollar depreciation for most of the past 100 years, but not much better. So, by and large being invested broadly in US equities ensures that your wealth grows with the cost of living. But that's about it. But that's ok! Because the cost of not investing is that you sink like a rock! So, the key to wealth is not simply to save and invest; at best all that can do is keep you afloat. You must specialize and excel. That's the key to the capitalist system.

A Few More Excuses, by Gary Rogan

While the most important "skill" in the prediction game is not to make any outright predictions that can be disputed, it's important to know how to weasel out of anything that can be interpreted as an actual prediction gone wrong. While listening to a nationally syndicated market analysis show on the radio while driving this morning, I noted a few used with great finesse:

  1. Blame unexpected behavior of the stock market on the price of oil. While a prediction was made on the same show two weeks ago that both oil prices and the stock market would fall dramatically, they still found it possible to blame the rise of the stock market on the boost given by the falling oil prices.
  2. Emphasize with an air of sophistication that one should never be "all in" or "all out". While some poor sucker called in to complain about the results of shorting market futures based on the shows advice, he was reminding that those who advocate being all in or all out are "poker brokers", whatever that means, and that one should hedge and cut back only a little when feeling bearish. Generalize to not behaving like the unnamed practitioners of whatever technique is currently not working.
  3. Stress that while the prediction was generally sound "the timing" was off.
  4. Stress that while the previously mentioned Elliot wave practitioner who shared his vision of doom and gloom is the best in the business, the general direction of markets is up.
  5. Never apologize or admit you were wrong in so many words.
  6. Don't ever be shy in stressing how important it is to be in the market during the expected move up, when just recently all you were saying how important it is to be cautious when the markets are poised for a downfall.
  7. Even after saying the above, never skimp on emphasizing caution.

This was all heard during a 15 minute drive.

On the Study of Business Models, by Dr. Kim Zussman

The paper Do Some Business Models Perform Better than Others? looks at matrix of type of rights being sold (creator, distributor, landlord, broker) by type of asset (physical, financial, intangible, human) for about 10,000 Compustat firms:

They find differences in various performance metrics, including FF alpha (a suspect measure of stock performance against size and book returns). The alpha for entrepreneur companies was significantly negative, and significantly positive for physical brokers.

Here is definition of entrepreneur:

An Entrepreneur creates and sells financial assets often creating and selling firms. Examples: serial entrepreneurs, "incubator" firms, other active investors in very early stage firms like Kleiner,Perkins, Caufield & Byers. We do not include in this business model entrepreneurs who never sell the firms they create."

and physical broker:

(14) A Physical broker matches buyers and sellers of physical assets. Examples: eBay, Century 21

Extreme Values, from Victor Niederhoffer

Extreme values are often useful to study, as they are unusual and often spring from, or trigger, major effects. They arise often in engineering, where faults from unusual events can cause disaster. They crop up often in insurance work, where the extreme event causes liabilities and risk to skyrocket; in traffic, networks, highways and utilities, where an overload can cause disaster; and in materials manufacturing. We all saw them in the flood control statistics that came into play with Hurricane Katrina.

Extreme values crop up everywhere in markets -- for example, in options, where the extreme value is the main thing that causes the skew, or the opportunity to make a killing, as experts buy the options that increase inordinately. They also come into play in the simple distribution of returns, where extreme values are the things that give you the full return or loss, and where avoidance of the extreme losses is key to survival or gain.

Most work on extreme values places heavy emphasis on thresholds, the large values beyond which the extreme analysis is conducted. For example, in a repeated series of measurement of the probability of defects of 10 parts, if the probability of defect is distributed uniformly from 0 to 1, the probability of finding a threshold probability above 0.90 is 0.10.

A good discussion of extreme value statistics is in "An Introduction to Statistical Modeling of Extreme Values," by Stuart Coles.

In my study of threshold work on extreme values, I have come across three good studies that have extensive and fruitful applications to markets. The papers are:

The Adya paper is about automatic methods of forecasting, and has many useful ideas about forecasting markets -- for example, the proximity to a new high.

The Cross paper shows how you can derive attributes of prices that fit with actual moves by simulation if you assume investors have two simple emotions: cowardice and fear of inaction. It's a nice attempt to show how two actual attributes of investors might lead to price movements with various parameters fitted to individual stocks and investors.

The Vesilind paper provides a nice review of yield curve regularities and time expectation theory and shows how you can build sets of inefficiencies based on these regularities into a retrospective model that yields profits in currencies and long-only fixed-income strategies.

These papers and their extensions have raised my threshold of awareness on the use of extreme value modeling and may elicit similar augmentations in yours.

How to Act Smart in Front of Your Friends, by Russell Sears and Victor Niederhoffer

  1. Study the dumbest guy you know who has everyone believing he is  an investor -- Russ
  2. Always state your predictions in a manner that cannot be refuted: "1320 is the number" or "October 15th is a critical day" -- Vic
  3. Study cubist paintings. It matters not that you really offer any advice, but show all sides. Do this for many things, in a confusing arrangement. But make your presentation have style. And imply your choice of random objects and presentation have meaning. Clearly any smart person would understand their implications -- Russ
  4. Remember to transfer the greatness of others to yourself at all times: "The Harvard conference is only for the elite but I can say that they stopped their laughter when I pointed out that the freighters were empty", or "They met me with five Rolls Royces, quite against my wishes"-- Vic
  5. Always act off of someone's else's recommendation. That way any successes can be credited to you, and failures blamed on the analyst -- Russ
  6. When you have a profit, imply that it is so wound up in illiquid instruments sure to double, that it would be impossible to treat your partner to anything expensive right at this moment, although in the future it is certain -- Vic
  7. Invest more time and money in golf, than in math and studying books. Talk of Tiger Woods like a friend you admire. Build your political clout on and off the links through golf. Never do a solitary sport like running or cycling -- Russ
  8. Use big words from fields that you know nothing about, like Paretian, exponential, fractal, leptokurtic, hysteretic, Engel Curve and Bertrand's Postulate -- Vic
  9. Avoid people who actually know what they are doing. Especially, try not to talk to them in front of your friend. And use all of your political clout to undercut them, behind their backs -- Russ
  10. Take any earnings announcements that came out after the close, and smile with a quiet satisfaction about how your buying or selling near the close was not wholly unconnected with its underlying implications. Do the same for any economic announcements, because your own surveys are so much more accurate than the governments and you always adjust them with the same seasonal adjustment programs that they use -- Vic
  11. Always imply that you are connected. Read the latest news on investments. Always file that latest analyst recommendation, ready to e-mail off at first hint someone's interested. And imply you are in tight with these guys. But never develop an opinion on the issue. Always offer a rave review on your source, no matter how untrustworthy they have been in the past. Also stress how timely their question is because you just got this piece. People love serendipity -- Russ
  12. Above all, be sure to memorialize that you saw Soros within the last 12 hours at one of his homes or a private conference at the CFR. and that he looked surprisingly fit, or if you are me, that his backhand is really improving -- Vic

A BBQ Review, from Steve Wisdom

Daisy May's BBQ USA | 623 11th Ave | At 46th St

Daisy May's is, according to Zagat's (as quoted by the restaurant) the "Best BBQ in New York City," and proprietor Adam Perry Lang has appeared on Oprah, in the NY Times, etc. He originally sold BBQ from a pushcart, and, in the spirit of a Yiddish folktale, did well enough to open his own store!

We stumbled on it by serendipity, but would have sought it out anyway, "had I known" it had such a pedigree.

The food is good, in general, but expensive'ish. Mr. Lang eyeballed my family and graciously selected about the right amount of food for the four of us, saving my having to order item-by-item.

The brisket was excellent, and the chicken was good, though the pulled-pork sandwich was loaded with slaw that blended with the pork into a sloppy, and not so appealing, amalgamation. The sides were the strongest point, creative and well-prepared.

But I am not sure about the whole Gestalt. In my NYC years, BBQ was about kitsch. I think of places like the divey Brothers BBQ in Greenwich Village (before it moved to a bigger, airier space) where the food was an afterthought. BBQ is an immigrant cuisine in NYC: comfort food for homesick "immigrants" from the heartland who have come to the Big City to grab their main chance. It that sense, it is like Indian or Korean or Puerto Rican food.

But Daisy May is earnest, not kitsch. Mr. Lang is proudly a "Daniel Boulud-trained chef" (!?) and uses ingredients like sel-de-mer (?!) in his cooking. And given his earnestness, the food should somehow, maybe, be better than it is.

The atmosphere was picnic tables in a high-ceilinged room with big-screen TVs overhead tuned to Country Music Television -- the night I visited, a NASCAR retrospective. But NASCAR on the TV is no substitute for real NASCAR chatter in the dining room, and there was none among the grab bag of hipsters, families, tourists in attendance. Ersatz, yes, but not kitsch. Somewhere in no man's land.

J.T. Holley adds:

My family has a pet hermit crab and we utilize sel-de-mer for its sustainability. Flip upside down its shell, fill it with water, mix in a little sea salt and it is like cat nip for the old Pincher. It is good to use near and after the molting process.

Also, I forgot the name of the establishment but the BBQ was fair to middling at some joint near Broadway. The cornbread was made with a touch of sour cream, which is one of my favorites.

Cryonics for the Healthy, from GM Nigel Davies

I have been mulling this over since hearing an advert for cooperative funerals (buy now, die in 20 yrs, etc). So far cryonics has only been seen as an option for people near death, but what if the process were to become more reliable? Some interesting dynamics from a spec point of view, i.e. odds of being revived vs. the performance of one's NASDAQ tracker over the next 30, 40, 100 years ...

Of course this is not an attractive option for screen watchers and what if a future world were to be unbearably politically correct? Revived citizens might also be seen as nothing more than museum pieces, there again if the sperm count continues to fall in males, perhaps there will be a use for oldies after all!? Hee hee.

Interestingly there is a conference taking place right now -- The Alcor Life Extension Foundation

Why Google Has Already Passed its Peak, by Matthew Lynn, noticed by Max Alexander

Google has turned into a corporate monster in the blink of an eye. The pace of its evolution has been bewildering, both for the company and for its investors. Many people still think of it as a cool start-up, when in fact it is already a Shell or a Volkswagen - a lumbering corporate beast, with little sign of intelligence left, but with enough muscle to ensure its own survival.
In the past few months, Google's own share price suggests the market has grown uneasy about it. The shares peaked at $471 in January, and have fallen back to $400 since then. Have the Google founders or directors been into the market to snap them up at those bargain prices? Funnily enough, they haven't. Since restrictions on stock sales were lifted in February, Google's directors have sold $7.4 billion of stock.
Google isn't about to disappear. It remains a formidable search and advertising machine. And who knows, one of its dozens of new products might turn out to be a hit. But world domination? Forget it. In truth, the company has already peaked. [read more (requires log-in)]

Briefly Speaking, from Victor Niederhoffer

A printed note on the clothes I receive from my local laundry says "We Love Our Customers!" It makes me think of the general question of consumer sovereignty, and the motto of South African company Pick n' Pay, which is "treat the customer as a queen and you will become a king." How could the importance and efficacy of the attention paid to consumer sovereignty by a company be measured, and what is the best way to measure its effect on returns? Also how do our friends devolve so often from our ongoing business contacts, and how does this relate to the economic analysis of friendship as a utility maximizing activity? Are there intangible assets of consequence on a company's balance sheet, related to reputation and brand name and repeat purchase likelihood, that might help us to value value companies? One wonders how to test such things and what your thoughts on the importance of consumer sovereignty for investments and life might be?

Steve Leslie adds:

A great place to start with this thought is at your local church, synagogue or temple. In an environment where one is expected to give personal money and private time to have the religious organization thrive, it is critical that the needs of the members and guests are attended to. Plus when you look at it on a large scale, competition is fierce, as all denominations and independent groups are essentially preaching the same or similar message, and it is available 24/7 through cable and Internet, so continually seeking out new members is vital. Take a look at the most successful ones -- what are their defining characteristics?

A feeling of importance, convenience, and involvement are critical components for success, in my church especially. I am a member of the largest Southern Baptist church in my city. We have a very organized Sunday School that thrives, due in a large part to a very active Minister of Studies.

Each Sunday, we hold two Sunday School sessions. Members are strongly encouraged to attend. There are a large variety of classes to choose among.

Classes are offered with respect to ethnicity, age, marital status, race, language, time and almost any other variable you might think of. For example we have a Caribbean class where discussions are held in French.

The goal is to afford every member and guest an opportunity to meet with others who have something in common. From there, bonds are created, relationships are forged and ministries are built.

We also have a nursery, day care and youth facility to meet those needs.

Our church understands that a thriving Sunday School flows into greater attendance in the Services and thus the offerings are more generous. It all begins by getting the individual involved in more than just coming to worship service for one hour and leaving.

Plus, from there other outgrowth ministries are developed. For example, We have a wonderful hurricane relief group that is mobilized on demand whenever we have a disaster.

It is a platform that works very well, and when running at peak efficiency is a wonder to behold.

Similar events can be observed in the secular world with the mega auto dealerships in vogue today that now have movies, hair emporiums, gymnasiums, food courts, and Internet access on site. This flows from the premise that once you get a customer you want to retain him and make his experience as pleasant as possible.

Ryan Carlson Offers:

A selection from Nock's Memoirs always struck me as the ideal way to run a business:

A salesman for the great house of Bagstock and Buggins, wine-merchants in the City ever since Charles I was beheaded, is a very different breed of cat from a high-pressure salesman of mass-produced gimcrackery. Bagstock and Buggins have always had about as much trade as they can carry comfortably, and their clients are their old hereditary friends, whose tastes and wishes they know as well as they know their own merchandise. So, when the salesman goes out he is aware that the House is distinctly less interested in his drumming up new clients than in his taking proper care of those he has.

Merchants of this type can be found on St. James Street in London and I have made a habit of frequenting there on every visit to London. My favorite store on St. James is James J. Fox, cigar merchants since 1787, and in the back of the store is a museum where one can light up and browse the history of the store which includes many items that Churchill ordered. Although the Davidoff store at the top of the street has a better humidor, it does not have anywhere to sit and smoke, or the ghosts of so many historic customers.

Also on St. James are wine merchants Burr Brothers and Rudd who have been on the street since 1698. My only purchase there was a moderately priced bottle of Scotch from their house label, and it felt as if they desired to make me a life-long customer, with wonderful service.

The world's oldest barbershop is now on St. James also, although it moved there in 1994. For guys, I think their shaving products are worth the premium and someday I will go for a hot lather shave.

A couple other shops of St. James are Gun & Rifle Makers William Evans and Lock's Hatters.

In regards to the market, does a company's unwillingness to split a stock and not cater to more pedestrian investors help or hurt it? Do companies which were established more than a century ago use their credibility to bring in and satisfy their new investors better than standard benchmarks?

My thought process would run a lot deeper if I were sitting in Winston Churchill's old chair at Fox's, enjoying his namesake cigar.

Gary Rogan offers:

Monopolies have similar economic characteristics to customer friendly companies. It is hard to tell one from the other from financial statements, but it is relatively easy to tell that it is either one or the other. All you need is return on invested capital. If it is (a) unusually high (b) unusually consistent over a number of years you have got a winner. If you look at real capital as financial capital plus intangible capital, then you can state that over time market forces will bring the return on real capital to the average rate of return available to investors. If the return on financial capital remains consistently high that means that there is a permanent intangible component symptomatic of either monopoly power, repeat customer loyalty, or both.

GM Nigel Davies on the Bulgarian Attack

I recently sent this letter to Chessbase after seeing the latest Bulgarian attack:

Dear Chessbase,
It was with interest that I read Mr Danailov's so-called 'statistical analysis' of the number of Kramnik's moves coinciding with the recommendations of Fritz 9. I am not an expert in statistics by any means, but in this case I might be able to offer some advice.
In order to show that the number of moves coinciding with Fritz 9's recommendations in this match is of a certain 'significance', Mr Danailov should test Kramnik's moves outside the match and then assess whether the 'match subset' differs by several standard deviations. In this way he might establish 'confidence' limits.
 There has been some interesting work in this area by Steve Levitt, author of 'Freakonomics', who the Bulgarian team might like to consult (no doubt at huge expense) if they are sincere in their claim. And to demonstrate their integrity and even handedness they might also commission a similar study of Topalov's moves, both during the match and after his ascendency to the number one spot.
I would expect that both studies would be entirely consistent with randomness, but who knows?
Sincerely, Nigel Davies (International Grandmaster of FIDE)

A Perspicacious Spec Surfs the Web, a Continuing Feature

Reading through the Mark Foley headlines, I found my thoughts turning to Barney Frank, and I took a look at his current website.

Clicking through to his Committee assignments, I noticed the Subcommittee assignments for Financial Services.

The Three Stooges -- Sanders, Waters, Maloney -- are all "ranking" and would chair their units if the Democrats take the House.

I am certain my 11 year old son knows more about monetary policy from sitting at my dinner table than Maloney knows.

This is really scary.

Transient and Persistent Markov Chains, from Jim Sogi

With the Dow's returning to its prior all time high, the issue of a Markov Chain in the form of a random walk's returning to its starting point is a good research topic. Probability and Random Processes by Geoffrey Grimmett has a discussion of transient and persistent Markov chains. One way to measure periods is the distribution of time it takes to return to a starting point for the first time. The question arises: will price ever return to the starting point? If so, when? A random walk, a form of Markov chain, is transient if the probability of returning to its starting point is less than 1 and persistent if p=1. This analysis might apply to a number of market situations other than whether the Dow will reach its all time high, such as:

The transition point is the boundary number which might yield some answers to the issue of whether we are in a range or the range is breaking out. It has been shown that the market drift in the long term results in long transient epochs and has an upward drift that makes the probability of a return to its start low. This has broad implications in day to day operations. Over shorter terms the market can be transient or persistent. Transient phase is a trending phase, and a persistent state travels through the same point over and over. Last week and this week price persistently went through 1347. The '60s - '82 epoch of persistence and the 80's bull market transient phase are commonly cited examples. We are in a persistent market phase now, with a 6 year lag of attempting to return to new highs.

Grimmett speaks of epochs of persistence. This is a cycle of range based price action. The states formulas are quantified on page 222. A symmetric random walk is persistent. A random walk with drift will tend towards transience. The mean recurrence time can be measured for drift. This allows classification of epochs by periods as the greatest common divisor of the epoch. Under the Central Limit Theorem, sampling of a random walk with the appropriate drift should give the distribution of times to return to price and the mean time. This might give the operator a measure of time expectation for trade durations and be a useful measure. A hypothesis is that on the short and intermediate term, the S&P tends to be persistent. These provide quantification for a definition of trend that has been problematic.

Get Rid of Optometrists in a Blink, from Bo Keely

I am 20-40. I think glasses, on most people, are a scam by the vision industry. That eyesight can be improved by eye exercises such as the Tibetan Eye Chart and reading books upside down is not today's topic. There is a quicker way for many of us to rid ourselves of the supercilious optometrist.

Reading glasses are required by some of us in the later years of life. These require no prescription, ophthalmologist or optometrist. You can buy them with 1.00 magnification or greater for ten bucks at many chain stores. Mine at this moment are 1.25 magnification and called 'weak' reading glasses, but do the trick.

Skinflints will be delighted to hear that the same reading glasses are had for a buck at the Dollar Stores chains, and that is where this story takes a twist.

Your eye doctor has told you that non-prescription reading glasses will not work for you because the lenses have equal magnification. Your eyes, like mine, are asymmetrically sighted -- one is stronger than the other -- so there you are. Until I dropped mine yesterday.

One lens fell out and tinkled unseen beneath the computer desk. Serendipitously, it was the one for my normal vision eye. In fact, after replacing the glasses on my ears and nose I sat and read for ten minutes before realizing one lens was missing. I resolved to seem to see better with both eyes and one lens than previously with both lenses intact. I did further experimentation until lunch to bear this out.

Then I went out and bought another pair of reading glasses with just 1.00 magnification for a buck. I bent the frame slightly to remove one lens and inserted it into the open frame of the original pair. Now I began to read and write with a pair of $2 hybrid glasses: 1.00 and 1.25.

My vision is excellent as you can see by the punctuation, and I am a richer man! Your online optometrist, Bo.

Even If There Were No Drift ..., from Dr. Kim Zussman

Even if there were no drift and you could make an equal case for the long or short based on studies, since the thing is for the most part random it is good to think about what happens when you get it wrong. If you limit yourself to long only, there is one way to screw up instead of two:

Position: Long
MKT:      DN

Position: Long Short
MKT:      DN    UP

One could consider limiting trading directions as risk reduction (i.e., less ways to lose). But in that risk should be compensated, should not trading both long and short, on average, produce higher returns? Or is the long-only advantage completely attributable to drift?

SPY daily returns for the past 10 years were (expressed as decimal fraction):

avg    1.00038
stdev 0.01200

This standard deviation was plugged into a random number generator, which simulated 2500 daily returns having a normal distribution with a mean of 1.0 (or zero daily return -- a simulated market without drift). Then twenty different traders held these daily returns either only long, or half long and half short. Here is data for 20 longholders, with the product being the final compounded amount:

avg     stdev   prod
0.9996 0.0120 0.3410
0.9996 0.0122 0.3387
0.9996 0.0118 0.3445
0.9997 0.0124 0.4210
0.9998 0.0117 0.4857
0.9998 0.0122 0.5506
0.9999 0.0118 0.6535
0.9999 0.0123 0.6779
1.0000 0.0122 0.7678
1.0000 0.0121 0.9391
1.0001 0.0121 1.1213
1.0001 0.0119 1.2052
1.0002 0.0121 1.2838
1.0002 0.0121 1.3532
1.0002 0.0120 1.3768
1.0002 0.0122 1.4747
1.0003 0.0122 1.6099
1.0003 0.0121 1.8312
1.0003 0.0125 1.9530
1.0004 0.0122 2.0176

av daily  sd  cpd ret
1.0000 0.0121 1.0373

As expected, the overall average daily return for being long all the undrifting days was 1.0, and the average compounded return was 1.037 (+4%).

Here is the data for the strategy of long 1/2 the time and short 1/2 the time:

avg     stdev   prod
0.9995 0.0121 0.2469
0.9996 0.0124 0.2683
0.9997 0.0122 0.3479
0.9997 0.0118 0.3713
0.9997 0.0121 0.4079
0.9998 0.0123 0.5301
0.9998 0.0117 0.5398
0.9998 0.0122 0.5621
0.9999 0.0120 0.6176
0.9999 0.0122 0.6380
0.9999 0.0118 0.7248
0.9999 0.0121 0.7264
0.9999 0.0119 0.7374
1.0001 0.0122 1.1389
1.0001 0.0120 1.1730
1.0001 0.0121 1.1836
1.0002 0.0125 1.2056
1.0002 0.0122 1.4407
1.0002 0.0122 1.5368
1.0004 0.0120 2.2918

av daily  sd  cpd ret
0.9999 0.0121 0.8344

As expected, the mean daily return was essentially 1.0. However the average compounded return was 0.83; futher away than long-only (I suspect this is due to too few cases, and with more traders than 20 this would be closer to 1).

One measure of risk is the dispersion in compound returns. Long only ranged from 0.3410-2.0176. Long/short ranged 0.2469-2.2918, which is substantially larger.

So while long only and long/short simulated strategies give similar average returns in a no-drift market, the greater dispersion of long-short suggests greater risk.

Now if you put the drift in ...

Last In, Least Educated, from Craig Mee

Interesting that in Sydney's property market, the last area of housing to increase in price was from the socio-economically disadvantaged, and these guys were still buying when the richer suburbs had pulled up stumps. Now they are left with massive drawdowns and problems on a number of fronts, i.e. employment and servicing loans.

This seems to be a classic example of what to look for when analyzing where a market is in its cycle of price discovery -- the least educated and responsive are last in.

It also reminds me of working on broking desks for years and dealing with major banks over significant U.S. figure releases. I surmised that there was a four tier response in price action over these numbers:

  1. Locals with their own screens hitting bids and offers as these figures came out.
  2. Bank Dealers on telephones (as it was overnight in Australia) being told what the numbers were, and dealing accordingly.
  3. Bank Dealers asking to be rung after the numbers, and subsequently placing bets.
  4. Retail customers calling in , and believing they where on the pulse as they only called five minutes after the numbers were released.

In reference to No.1, a bank dealer (who had recently seen some locals in action) said to me "I will never ever trade over a number again, after seeing the execution skills of those Locals, I am just too far off the pace!"

It Is Perfect, from Jeff Sasmor

Maybe it is perverse, but I bet a lot of parents get a kick out of trying to drive their kids nuts from time to time. Like me. I found a new way tonight, aided by some modern cable-tv technology: on-demand karaoke: a recently-added feature from our wonderful cable company - Patriot Media (their telephone number ends in -- wait for it -- 1776). It's amazing what fiber optic technology has wrought!

Let me add that I really don't sing well. Actually I can't even carry a tune. So my karaoke rendition of "Bennie and the Jets" had my two teenage daughters screaming at me and attempting to wrest the remote control out of my hand.

When that didn't work, threats of kicks to tender places begain to emit from the mouth of the Black Belt.

Hey, I know when to fold my position...

Briefly Speaking, from Victor Niederhoffer

Why is it that when oil rises from $60 to $75 per barrel, interest rates from 4.5% to 5.5%, and gold from $500 to $700, 99% of the commentary is how bearish and 'Steve Roach like', this is for the stock market and real estate? Also, how come the Fed has 'no choice but to tighten', even though when the reverse happens, (because of the effects pointed out in our review of the bestselling travel book, and most recently regarding the first stop being the best), there is supreme quiet about things being bullish.

Andrew Moe comments:

The authors of these bearish articles have absolutely no idea what the forward direction of the market will be. Instead, they are most interested in getting eyeballs to their pages and this is done via sensationalized stories of imminent demise.

As quants, we are already trying to drive our car by looking in the rear view mirror. Introducing news is like putting a blindfold on and trying to drive by listening to a backseat full of drivers who are each looking in a mirror of their own -- many of which do not even point to the road behind.

"Watch out for that grain silo"
"Don't hit the canyon"
"A herd of cows is in the way"
"Wow, I look good today"

GM Nigel Davies adds:

One has to ask: what is the motivation of the bears? In most cases they have no positions in the market, instead deriving their income from their views.

What will they choose to write about? Well, nothing attracts attention quite like disaster (car crash, plane crash, market crash), probably because it is an affirmation for those who never take risk. The market may go up a million percent without them, but they get to delight in a 5% drop, or at least salivate over the thought of it.

J. T. Holley offers:

Those who disregard paths of least resistance, Gresham's Law, the Law of Ever Changing Cycles, etc, and cling to "black and white" fixed trading systems seem to always have a sense of permanency to the direction of markets. The exception to this is when everything is running its natural course and they "think" they will try being a contrarian, just at the wrong time. DailySpeculations, more importantly than anything else, has a spirit of teaching and espousing "seeing things as they are" and utilizing tools to do so. Other authors do not do such, as it is easier for them to attach their feelings and decisions to those things that are in the direction of loss or some voodoo formula.

When oil goes from $20 to $40 to $60 to $80 it is easy to not do any math on supply and demand and project it to $400 a barrel, and then have fiction fill in the lines. With the markets it is so easy to be a bearish contrarian and cherry pick evidence from days of yore, and to do this at the wrong time when the odds just do not have it in the stack of cards, and the game has changed. I have always wanted to ask someone what he would do if he timed a 60-90% downside move and shorted everything "under the sun" (no explosion) and also bought every single available put option while it was happening? "So you won, everyone is broke, the banks cannot pay you because of their own runs at the doors, pestilence, vermin, and gloom is the theme and you are going to tell me you have a smile on your face?"

It is the sense of permanency that they attack, and their disregard for change.

Scott Brooks mentions:

Three things sell best to the masses; envy, greed and fear. Therefore, if you want to sell your writings to publishers, you must employ one of these methods.

As I sit around at holidays listening to my relatives (who have a very blue collar mentality) talking, I have to bite my tongue to keep silent (risk being murdered by my wife if I start another debate with the mentally unarmed) listening to the sky is falling mentality. These people love fear.

I also listen to them talking about greed. Their new get rich quick schemes or poorly thought out business opportunities. Or complaining about all the money that is being made by someone who does not deserve that much money ("no one is worth that much money" ... as I sit there and smile and hold my tongue).

So the masses will greedily chase returns from the investments that they wish they had purchased last year (as is probably true of the highly intelligent "accredited investor"). They will over-react to anyone telling them the sky is falling and run away from what they should be embracing, or embrace what the should be running away from. And they will elect politicians that will stick it to those that "have more than they deserve".

That's what the writers like Abelprechursaskyisfallingallthetime are selling too; fear, greed, envy. And it works (well, for them to earn a paycheck, at least!)

Thomas Miller contributes:

When the commentators get particularly bearish, it seems no one mentions the incredible growth and upward trend in corporate earnings, which are still growing nicely. To test this I suppose one would have to count and track the number of bearish articles in numerous publications and "experts" on CNBC and compare that to market actions over time. It would really be another sentiment indicator. Probably time consuming, but my guess is that it would be of value.

Jeff Sasmor adds:

I would submit that stocks are products sold to various types of customers. Like autos, so your stockbroker is actually a new/used car salesman. I am not being flippant.

My attitude is based on being someone having gone through the IPO and road-show process as a company officer and becoming quite friendly with one of the underwriters.

Sushil Kedia comments:

Behavioural Finance is a website with a long list of plausible explanations for the Permabears maintaining their stoic silence now, but mounting the rooftops the moment their original framework appears on the markets' horizons. Some of the ones that caught my attention immediately were:

  1. Cognitive Dissonance
  2. Communal Reinforcement
  3. Illusion of Knowledge
  4. Curse of Knowledge
  5. Selective Thinking
  6. Self Deception
  7. Framing

Ronald Weber adds:

Following Mr Sushil Kedia's comments on behavioral finance, may I mention the Investment Office website which contains (among others) information on behavioral finance on the left side of the navigation, under "market characteristics" (not yet optimized for Apple!).

Dim Lights, from Steve Leslie

Among American authors, my favorite is Steinbeck. And I have always had great affectation for Jack London. But George Eliot is my favorite author after Charles Dickens, so I wanted to share this passage from her novel Middlemarch:

With dim lights and tangled circumstance they tried to shape their thought and deed in noble agreement; but after all, to common eyes their struggles seemed mere inconsistency and formlessness; for these later-born Theresas were helped by no coherent social faith and order which could perform the function of knowledge for the ardently willing soul.

Magic Oil, from Ronald Weber

When oil began to rise in 1999 I liked to think of it as a form of efficient "emerging markets tax" for stability and growth directed at regions that need it the most. Think of Putin of Russia running with oil at $10, or the Royal Family of Saudi Arabia under such a dire scenario.

Sixty dollar oil is a moderate price to pay for the benefits of having these regions busy building a better infrastructure, improving their political system, and buying Western goods -- materials, corporate advice, entertainment, iPods. Moreover, it's a tax that doesn't need any political approval process or that risks getting dissipated in the distribution process.

Recently, however, just as the US economy seems to be slowing, oil has decided that emerging markets have had enough of a boost, and it's now time to give something back to the Western consumers. Let's keep the Champagne on ice, but everything seems to come in handy just when needed through some form of higher-order mechanism!

Jeff Baatenberg adds:

I can see peak worldwide oil production in the rearview mirror. December 2005 will be peak month, May 2005 being the only other month to reach 85 mbd. Q1 2006 will be peak quarter. Year to date 2006 is slightly ahead of 2005, but 2006 has a steep treadmill to run to maintain the lead. December 2006 will certainly lag December 2005, possibly dropping the ball in the clutch and handing the peak oil title to 2005. Natural decline rates mean you can forget about 2007 or any other year taking the crown away. So 35 years after U.S. oil production peaked and entered permanent decline the world is following suit. Meanwhile the air slowly being let out of the credit bubble. The Pollyannas and the Abelprecs ridicule each other. Yet when credit expands, the optimists are right; but when credit contracts the doom and gloomers are right. With a big public homebuilder slashing prices 30% plus appliances, fiat currency protection looks very good at this point. Seems owning a piece of North America's largest hydrocarbon deposit might be worth looking into. By chance it is located in the world's most friendly business jurisdiction. This young man looks north, way north.

Book Review from Victor Niederhoffer: 'An Illustrated Guide to Theoretical Ecology'

Every now and then one comes across a book that completely clarifies what every educated person should know about a subject that is essential to understand as we go about our the humdrum business of life and trading. Such a book is An Illustrated Guide to Theoretical Ecology by Ted J. Case. I cannot recommend this book too highly, as it provides a foundation for thinking about competition, mutualism, growth, resource depletion, diffusion, population density, predation, life cycles and space. The book introduces the basic principles behind each of these subjects with simple algebraic equations and illustrative charts that describe various plausible relations. It then follows through with analytic solutions to develop a deep understanding.

The book is divided into 16 chapters, starting with unrestricted exponential growth models, moving to spatial variations in birth rates, population growth classified by age, methods of analyzing age structures, growth when density-dependent resources are limited and density-regulating and limiting factors, life history, strategies, predations, predator-prey systems, stability, interspecies competition, multispecies communities and spatial variations.

A nice appendix introduces the main ideas from calculus and matrix algebra that are helpful in forming a backdrop for the kinds of techniques used in developing understanding using difference equations, differential equations, matrix solutions, Taylor expansions, correlograms, optimization solution, boundary analysis, phase space,  Jacobian and reaction dispersal equations.

Many of the solutions have a closed form and are difficult to unravel, but the author is very good in giving graphs that illustrate the main relations involved and describing the likely outcomes for practical problems. The book was written in 1999 and it makes use of simulation in many areas, but probably not as many as would be desired in present-day technology, and there is a web site that provides simulation models for most of the areas covered. Some numerical work with the basic principles and simple examples would lead the average user to have a better understanding of the often complicated and unintuitive dynamics of the ecological factors considered.

The guiding principle that holds the book together is that everything that goes in life is the result of evolutionary forces. A key feature of this book that distinguishes it from others is that it shows how natural selection and changes in gene frequencies at different loci in the context of Darwinian thought bring about the ultimate populations and interactions observed. By the time you finish the book, and it can be read on all levels, you'll have a good understanding and analytic apparatus to understand all the things you're always reading about how s-x and genes control all our behavior, including a deep understanding of basic concepts found in the popular literature such as fitness, exploitation, disk equations, clutch sizes, reproductive value, Lottka Verra equations, niche theory, patch models, k versus r growth, Leslie matrices, cannibalism, pulses, chaos, stability, cycles, extinction and death.

The key variables considered in ecology that form the basis for everything in this book and other ecology books are the age, resource and competitor varying impacts on the structure of population, birth rate, survival rate, fecundity rate, death rate, inheritability. Based on simple models of how these affect each other, many beautiful regularities that will illuminate all aspects of your life and everything you've ever thought about ecology can be drawn from this book.

The study of ecology is key to markets. There is a finite amount of money and resources that different species in the market are competing for at all times. The growth of one species is constrained by the amount of money and people in the system, ability to communicate, and competition from all the other species. The species develop experience and knowledge as they grow, but their value to maintaining the market system is reduced as they gain it. The battle is between the strong and weak, the young and the old, the flexible and fast-moving versus the fixed and slow moving. Find a niche where the competition won't be too fierce, or perish.

I found the principles used to study growth in Case's book particularly helpful for considering the value of investments in new issues versus seasoned issues. The new issues have more opportunity for growth, but also much more of a chance for death. Thus, there is more risk, and depending on the space and resources available, and the stages of the life cycle that one is in, and the distribution of companies is in, different strategies are optimum.

The parents of new issues may be likened to the underwriters , and the care that they spend on their progeny must be considered in the context of the number of issues that they spawn, the survival rates for the companies, and the reputation and age of the underwriter.

Companies developing new products or hiring new managers must face some of the same issues that birds face in determining clutch size. How many eggs or new products should they lay? How much resources or money should they spend upon raising them? And how should they change their strategies based on competition? Some conclusions of Case in his chapter on Life History Trade-offs might illustrate some of the illuminating principles that ecology offers here:

  1. The observed clutch size of a population is often what which yields the greatest productivity of young. This optimum clutch size is well below the physiological maximum size.
  2. Bird families have enormous variation in typical clutch size. Lower latitude species generally have small clutches.
  3. Hole-nesting birds like woodpeckers and starlings have larger clutches than open nesting birds.
  4. Island species have lower clutches than closely related species on the mainland.

One of my favorite sections in the book comes in the chapter on density dependence where Case uses the child's game of rock, paper, scissors to illustrate one aspect of the competition among species. "Scissors cut paper, paper covers rock, but rock breaks scissors. These interactions form an intransitive lock. In such cases, the fitness of each of these three strategies depends entirely on the strategy your opponents are playing. Under conditions like these, all hell can break loose and cyclic solutions can emerge. In pairwise species bouts, usually one of the pair is dominant, yet several species can apparently coexist because of intransitive relations."

No better model for the existence of hedge funds, dealers, and the public and their changing populations at various stages of the market cycles has ever been developed.

As someone who, along with my former colleague, Harvard professor Richard Zeckhauser, was a pioneer in considering the ecology of markets, having written thousands of pages on it over the course of 30 years, including two chapters in my 1997 book, "Education of a Speculator,"e; I can say that this is the one book that I would recommend to all who wish to understand the nitty-gritty of the competition, cooperation, growth and decay of the everyday life that market people live in. This book bridges the gap between the anecdotal examples and topics covered in most books on ecology, and the completely abstruse mathematical material that regrettably has seeped into so much of the mainstream ecology studies and journals today. It will leave you with a foundation for understanding such crucial overriding principles as your strengths and weaknesses, the effect on your activities of those with resources and knowledge different from yours, opportunities for longevity and extinction, the relative merits of growth versus value, the time to move at high velocities and slow, and will enrich your thoughts and pocketbook over a lifetime.

Steve Ellison adds:

A similar problem to optimum clutch size in ecology is an existing business attempting to develop a new line of business. I read two papers this weekend on developing new businesses, one by Strebel and Ohlsson in the Winter 2006 Sloan Management Review, and the other by Andrew Campbell in Strategy & Leadership in 2005.

Campbell believes that most companies try far too many diversification initiatives. Individually, the new business efforts receive too little management support to succeed; collectively, they cost too much and divert management attention from the core business. Many a company has regarded its own industry as having unattractive potential, tried to venture into a faster-growing segment, failed, and realized in hindsight there were opportunities it could have seized in its own industry had it not been distracted by its diversification efforts.

Most dangerous of all are the hot growth industries everyone is excited about. Such markets attract the most competition and can incite management to suspend its usual risk aversion. Campbell suggests choosing a line of business based on where the firm's capabilities provide advantage rather than on the potential growth rate. To guard against hubris and limit the number of new ventures, he suggests a hurdle rate of 130% of the likely leading competitor's profit margin. Strebel and Ohlsson find a higher success rate on ventures that are distinctive relative to the competition. Extensions of the company's existing knowledge generally are better than "leaps into the unknown".

Very similar to the rock-paper-scissors analogy is Strebel and Ohlsson's finding that management of a new venture must balance the needs for innovation, efficiency, and customer intimacy. The most effective way to do so is to periodically reprioritize the relative importance of each and manage differently to support the new priorities. In another Strategy & Leadership article, Leavy describes the practice at Intel of alternating between "letting chaos reign" and "reining in the chaos". The cycles change because a particular management style, while it meets the immediate priorities, produces unbalanced results if pursued too long.

Ecological Shift, from J.T. Holley

The food chain seems to be adjusting and the effects are starting to run rampant. I have to learn how to predict the tectonic shifts of laws passed? Frist sneaked in a piece to a Bill on Friday to ban US banks and credit cards from dealing with online gaming. Equally, important the private equity/hedge fund world comes out and announces its intentions of buying HET out for around 15 billion just three days later today? Assuming that all those that "love to lose" and need their fixes cannot sit on their tales at home anymore within the U.S. borders means that Vegas and Atlantic City will be hot tickets again, as if they ever were dented? Horse Tracks and Lotteries should see a possible increase as well? Are Vegas, Horse betting and lotteries better moralistically than poker or online gambling? So so convenient too that Tennessee Frist may be behind in the polls and needed to appease Mr. Falwell and Mr. Robertson here in Virginny. The President cannot expect a 6-8 billion dollar industry to roll over can he? Politicians ruin everything it seems.

Guaranteed to Happen, from Victor Niederhoffer

The market news is buzzing at the moment with such things as the fact that the average October low over the last nine years has been seven percent below the close, (let us never exclude October 27th, 1997), and that the number of stocks in the Dow that are up is only ten of thirty over certain periods. Also the number of new highs is less than usual for this type of market at the moment, and we have gone an unprecedented number of days without a ten percent decline from peak to trough. Has anyone thought to test whether any of these things are guaranteed to happen with randomness?

It is also guaranteed that if the breadth is low, the Abelprecs will be bearish, because it shows that investors are choosy, which apparently is bad. But if the breadth is high, i.e. ninety percent of stocks are up, then Dr. Brett will not be listened to when he fires off a memo that he is truly impressed with the bull move, but instead Mr. Nelson or a old or savvy friend, or Bob Farrel will be trotted out to say that such blow off rises, such total abandon in positive sentiment, cannot be sustainable, and it is time to take the punch bull away before too many drunken investors do bad things.

One of the things that we always tend to forget during such times as these, when we have gone six years without a new high, is that bullish sentiment can be euphoric and hard to fight, as the bulls get more funds to buy more stocks at margin, and talk more of their friends into coming on board. I was often in the wrong situation vis a vis this at the palindromes weekend parties where everyone in the world was bullish on the Yen or some such, while I was short, and collectively there was a trillion dollars of wealth in the room, all of whom just made five percent on the previous Friday.

But of course one is reminded of Rumpole. "Why is it always s-x that's behind the murder". Yes, why is the real reason that stocks are going up and that you can get about a five and a half percent greater real return on them than bonds, i.e. a six percent estimated earnings price ratio with four percent growth versus four and a half percent on ten year bonds? Is it the pension funds, the asset allocaters, the endowments, or just Joe and Jane public that eventually decide during the end of the year that it is better to get ten percent on stocks, with earnings having increase double digits for sixteen quarters in a row than accept four and a half percent in bonds? Perhaps the Bishop who does not believe in God, or the stock commentator who does not believe in stocks will have the answer.

Briefly Speaking, from Victor Niederhoffer

One of the virtues of a market near its all time highs is that one can read Heard on the Street again to see why the always negative columnist is bearish again this time. It seems that investors are being choosy (breadth is not above ninety percent, and many stocks are below their high), the housing market is down (and it is not at the bottom yet), the Democrats might make gains, earnings comparisons could be down, and there is a general feeling of unease. He could only find two gimlet and acerbic observers, to quote from who share his bearish views.

While all of his reasons for bearishness, if tested, would probably be quite bullish, (there is a negative predictive correlation between real estate stock prices and general market prices three months later), and there is no correlation between earnings changes and coterminous stock price moves, but a high one between interest rate changes and stock price moves, I am admittedly quite uncertain also.

The market is near new highs, having beat the highs, intra-day but failed to close above twice. I believe that double tops and triple tops are bullish in the small and the large but have found this difficult to test. The funny thing is that the market is more bullish when canes are appropriate than when it is most fun to ridicule Alan Abelson and wonder when the last short selling fund is going under. And buying after new highs is not a overly winning proposition. But somehow the market does go up its inexorable ten percent a year, and it has to do this with new highs. Last October was down, and that is bullish, and the fourth quarter is bullish, especially with this degree of divergence between interest rates and earnings. A totally trepidatious time, when the probabilities are near 0.5 but the expectations are old faithfulesque.

I have been reading both Price Theory by Steven Landsburg, a technical book with analytical principles and ways of thinking that illuminate the structure of competition and industry, and The Illustrated Guide to Ecology by Stephen Case. Both books are a constant source of new ideas and better foundations for me in thinking about the markets. I will elaborate further on both soon

In my Quixotic quest to find empirical regularities that relate to The Little Book of Scientific Principles, Theories and Things, I have been considering the Pythagorean theorem and its market insightful regularities. I have been thinking of the relations between numbers, like 3,4,5, and 5,12,13, and also thinking about the simple proofs that divide up the horizontal lines into two overlapping triangles and its applicability. Finally, to the squares of variances as they relate to the variances of other markets. I am open to testable suggestions.

Risk, from Scott Brooks

Risk is different depending on your perspective. Lets look at it in a non-academic manner. The risk is as follows:

Lets take a fictional person named Joe in 1975. Joe starts to get his life in order and finances stabilized in his early thirties. He starts saving some money and follows the edict of investing in the stock market.

He experiences extreme volatility for the first few years, but since he's only got a small, nearly inconsequential nest egg, he is able to ignore the extreme swings in the market that occurred from 1975 - 1982. After 7+ years of investing, his nest egg has built to a tidy little amount and by the accident of timing, he now has his decent nest egg positioned to take off with the greatest bull market in history.

And we are off to the races.

1987 hurts him, but he's got such huge gains, that he is able to overcome it, and "hold the course". less than 18 months later, he's back to even and off to the races again. The glitches along the way are still there, but they are quick, fairly painless, and its off to the races again.

By the end of 1999, between his pension account and 401k, he's built up $1,000,000 in his nest egg. Since the market has taught him that he can easily get consistent double digit returns on his money, usually in the upper teens or lower 20's, he decides to roll over his pension and combine it with his 401k in a rollover IRA.

He has expanded his lifestyle through the greatest bull market in history, and thus needs about $100,000/year from his portfolio to live. But that's no problem, with the market "drift" yielding him 15% - 20%/year (heck, in the late '90's, he was getting a 30%+ return), pulling 10%/year off his principle to live each year is no problem.

Then comes 2000.

He finds out he was right about being able to get double digit returns. Unfortunately, he finds out that they also come in the negative variety, too.

He pulls out his $100,000 to live on in year 1, and earns a negative 10% return. Now he's got around $750,000 in his nest egg. But that's only a glitch (and he's experienced these short term set backs before). In a few years he'll easily be over $1,000,000 again.

Then comes 2001.

He pulls out his $100,000 and the market goes down again. Now he has got around $500,000. He begins to sweat. Then comes 9-11. And it scares him badly, but he remembers 1987 and the big run up that occurred afterwards and decides the hold the course (heck, what choice does he have if he wants to maintain his current lifestyle).

Then comes 2002.

He pulls out his $100,000 and the bottom falls out of the market. The S&P 500 is at 755 (off from its 1550 high around the time he retired). Since he was an indexer to begin with, his nest egg is cut in half not counting withdrawals. Counting withdrawals, he is down to under $200,000.

He has to go find a job.

He has to stop taking withdrawals (which he was doing under reg. 72t since he retired early), and in some cases, the "Joe's" of the world mortgaged their houses to take advantage of the boom, and lost all or most of their equity.

Remember, when we talk about drift, and we talk about risk, we are doing so in a largely academic sense. We are discussing it in a manner that the average person cannot relate too.

If you're running a huge hedge fund and have tens of millions of dollars under management invested with you from people that can afford to lose millions and not have it ruin them, or if you are running your own money and can get another "job" if necessary, or have another means of support besides your portfolio, that you have a vastly different perspective on drift and risk than the "average Joe's" of the world who have no other means of support nor do they have the intellectual capital to figure out what to do and how to fix a problem as severe as seeing their entire life's work melt down 80%.

A few years of losses hurt Joe more than a lifetime of gains helped him.

Dr. Kim Zussman responds:

Someone asked earlier "What risk I am compensated for when the drift is a certainty?" I have a few clarifications:

Phil McDonnell adds:

The idea of the long term upward drift in the market is a stochastic reality. It would be inappropriate to apply words such as 'certain', 'always' or 'never' to a stochastic process.

As Dr. Zussman indicated the drift is not guaranteed to be a certain amount or even positive in any one year. It is increasingly likely that your diversified returns will approach the long term drift rate if held long enough. However even the phrase 'long enough' implies risk. For there is no guarantee that one will live 'long enough' to realize the drift rate due to other risk factors.

Our Daily Bread, from Bo Keely

It is hard to believe that it is almost October and 110 degrees in Sand Valley. Yesterday I went for a walk and had a nice tan going by noon when I felt dehydrated, dizzy and passed out under a cactus on an anthill. I awoke in ten minutes to the facts of black, big ants and was covered with bites. Perhaps it was their war for salty flesh after a long, hot summer. I leapt and danced feeling better for the fresh perspective.

I returned today to the anthill with a slice of whole-grain bread and put it on the ground, pouring on water. It covered with a fury of black. I lay beside watching it turn to toast in ten minutes. When there were no more ants to see I raised the slice to find a hundred clinging to the moist underside. I walked away without a bite and reflected on the moral of the story.

Turn the other cheek one time and have more friends with fewer enemies.

The Hero Within Each of You, from Dr. Janice Dorn

A hero is an ordinary individual who finds the strength and courage to persevere and endure in spite of overwhelming obstacles -- Christopher Reeve

Seasons come and go, markets change and evolve, but human behavior which is hardwired into the brain has not really changed much over many generations. Each of us looks and acts differently, but these are outward manifestations which are subject to societal pressures and ever-changing cycles of fashion and trends. Inwardly, we are all classic, fragile and captivating human beings. We have wants, needs, hopes, dreams, fears, joys and tears. Even now, when we have come so far in time and space of evolution, we are still enchantingly and ever-fascinatingly human. It is simply wonderful!

Every one of you who is reading this wants to learn how to make money from the markets. Over the years, I have provided a number of guidelines, and principles to put you on the path to trading mastery. While simple, they are certainly not easy. Take personal responsibility for your trades, cut your losses quickly, stay healthy in mind and body, always practice good risk management , plan your trade and trade your plan, master your emotions, strengthen your neuropsychological capital, learn patience, stay with what is working, and take profits on a regular and radical basis. That sounds all well and good, but the majority struggle daily to figure out how to do it. Most continue to search for this or that method or this or that indicator or newsletter which will give them the answer they seek.

I cannot emphasize too strongly that there is one immutable fact which underlies all successful trading: The answer is within you. It is not out there somewhere. It is about your brain (your true trading system) and how, not what you think. Traders, with few exceptions, are made not born. Anyone, given the passion, determination and willingness to work hard, lose, fall down and keep getting up, can learn to trade successfully. I assure you, if I can do it, you can do it. Now I will tell you secret that only a few know. I have two Ph.D. degrees: one in Brain Anatomy and one in Futures Market Losses. I had to get the latter in order to get a true grip on who I was as a person, and turn myself around completely onto a path of success and consistent profitability. Long story, but it took five years and was the most gut-wrenching and painful period I can recall. Would I change one single minute of the excruciating process? Absolutely not! Not one second of it, because all of those seconds brought me to where I am today. The point is this...If I can do it, you can do it.

How? You must totally believe that you are called to trading, that it is the one thing about which you are completely passionate and that you are willing to forego many things in order to succeed. If you can take these steps, you will make it. Not easy. If it were, everyone would be doing it. But, it can be done and it is within the reach of every one of you who is reading this. You can do it, but you must be willing to sacrifice everything you are for everything you can and will become. You must be willing to change key elements about yourself, particularly the way you think and act in real time when bombarded with conflicting information in an environment where you have total freedom of choice and where the only thing you can control is yourself. Moreover, you must learn to make decisions involving varying degrees of risk in an atmosphere of real time and total unpredictability. You must learn to change the way you think and what you have been taught about right and wrong and good and bad. You must entrain the qualities of being counterintuitive and peripatetic. You must become a chameleon, and a great actor, an acrobat on the largest and most intimidating stage in the world. Most of all, you must be absolutely determined and passionate about it.

Courage is more exhilarating than fear, and in the long run it is easier. We do not have to become heroes overnight ... just one step at a time, meeting each new thing that comes up, seeing it not as dreadful as it appears and discovering we have the strength to stare it down -- Eleanor Roosevelt

And then what? What do you have left in your life once you have made it. What happens when you finally do "get" it , trading becomes relatively effortless and you are consistently making more than you are losing. What is up with the trader who is wildly successful, has all the stuff he or she needs and yet keeps trading? Why is that? Is it greed, and the need to keep making more and more money in the face of abundance? Yes, in part it is.

But there is much more and on an intensely deeper level.

Why do we trade? Why do successful and wealthy traders keep trading, some of them into their 80's or until death? Passion. Challenge. Continual striving to be better and better with each passing day. Mastery. Freedom. And what do most of these great traders have in common besides the ability to amass (and keep) large amounts of money?

The answer may surprise you as much as it delights me. They have in common: an attitude of gratitude, humility, manifestation of kindness to themselves and others and an intense understanding of their personal neuropsychology and the mass neuropsychology of the markets. They have learned from the greatest and most brutally honest psychotherapist in the world ... the financial markets. They have suffered, been beaten down, brutally battered, lost money ,but kept the therapy going because they knew that somewhere inside of them was the person they wanted to be. After intense personal pain and internal searching, they found out who they really are and embraced it without fear. They went to the darkest recesses of their soul and emerged as their own hero. Now, they bring flowers to themselves instead of waiting for someone to send them flowers.

Their wants have been met, so they work on their needs. For them. trading becomes an activity which nourishes and uplifts their spirit. They approach the markets with humility and passion yet can be total ambushing wolverines while in the trading moment. They can be sharks, waiting to feed on the poor little fishes. Yet, they are chameleons. For the master, trading is a game to be played to the ultimate scope of his or her ability. They never forget the ones the got away, the Ph.D. in losses, the missed opportunities, the times when they were the little fish. They remember these bitter, gut-wrenching times and have them etched in their hippocampal memories so as to never forget.

They have rich and full lives outside of trading, especially those who took the time to keep family and friends in some degree of intactness. They cherish relationships and put people before money. People first, money second and "stuff" third. They value and reward those who have supported and loved them. They cherish and love themselves. They are kind to themselves and others and recognize that kindness the greatest gift we give to each other. Even the most successful traders and investors with the highest degree of longevity approach the markets with humility. They are non confrontational and go flexibly with the flow. They are in sheer joy with the moment. It is the perfect moment, and they are always in it. They are in gratitude for the privilege to partake of the gifts which they receive from the market. For them, trading is a spiritual activity!

My greatest hope for each of you is that you never forget this. In the end, it is always about gratitude, humility, kindness and love. Love what you do and those who nurture and sustain you. Focus on yourself, who you are and what you want and need and then practice and keep practicing. Do what you truly love, and the money will always follow. In the process, you will begin to see that you are evolving and growing your capital: financial capital, mental capital, emotional capital, and -- as the topic of this essay -- spiritual capital.

Thank you for the opportunity to share with you my experience, strength and hope. I wish each of you everything and more that you wish for yourself.

When you feel like all is gone, look inside you and be strong. And you'll finally see the truth, that a hero lies in you -- Hero, Mariah Carey

Portfolio Comparisons, from Steve Ellison

I submit that high mutual fund management and load fees would have a much more direct and deleterious effect on investors' ability to catch the drift than stock options or executive compensation.

Consider two hypothetical investors, A and B, who each invest X dollars per year and earn a drift of 9% per year. A invests in index funds with annual expenses of 0.2%, while B invests in actively managed funds with annual expenses of 1.2%. At the end of 20 years, A's portfolio is worth 55X, while B's portfolio is worth 49X.

Now consider investor C, who every year switches into the previous year's best performing mutual fund and pays a 4% load to do so, in addition to the funds' 1.2% in annual expenses. At the end of 20 years, investor C's portfolio is worth only 31X.

A Fall Chill is in the Err, from Dr. Kim Zussman

... and as leaves drop from the stem
at least in the northern hem (ahem)
People worry about October and other months:

A study of big intra-month declines. Using SP500 daily closes since 1980, at the end of each month we look back and check the minimum of the last 10 days, and the max of the first 10. For each month the ratio min/max is a measure of severity of historic decline. This series was sorted to check on the worst such declines, over 5%, then count months:

Stem-and-Leaf Display: bigaldrops

Stem-and-leaf of bigaldrops N = 64

Leaf Unit = 0.10

7   1     0000000
12  2     00000
17  3     00000
22  4     00000
28  5     000000
30  6     00
(7) 7     0000000
27  8     000000
21  9     0000000
14  10    0000000
7   11    00000
2   12    00

The distribution looks quite even, with the possible exceptions of lower risk Junes and Decembers. And worst months in terms of big declines are tied: January, July, September, and October.

In fairness now look at equivalent big increases: Max of last half of each month/Min of first half, and note months with gains >5%:

Stem-and-Leaf Display: hichairpops

Stem-and-leaf of hichairpops N = 75

Leaf Unit = 0.10

11  1    00000000000
15  2    0000
22  3    0000000
29  4    0000000
(9) 5    000000000
27  6    000000
31  7    00
29  8    00000
24  9    000
21  10   000000
15  11   000000000
6   12   000000

Large intra-month increases are less uniformly distributed, and occur most in January, may and November, with October still well represented.

It Was a Crash Out of the Blue Sky, from David Bacille

It was a crash out of the blue sky - an unexpected, death dealing bolt which in a twinkling turned into shambles the busiest corner of America's financial center and sent scurrying to places of shelter hundreds of wounded, dumb-stricken, white-faced men and women, fleeing from an unknown danger. -- The New York Times, September 16, 1920.

No, this is not an account of the World Trade Center...but sure sounds like it. This is an account of the JP Morgan Bank bombing in 1920. The crime remains a mystery although most believe that it was the work of anarchists, many of whom organized against the involvement in WWI and the profiteering that resulted by businesses such as JP Morgan.

The book is Eyewitness to Wall Street by David Colbert. It is a beautiful collection of articles and letters describing the major events of 400 years on Wall Street. It is a wonderful book, allows you to pick at it for 10 minutes at time and is filled with first hand accounts of Wall Street's movers and shakers. Very enjoyable and - like most history - helps to keep life in perspective.

Bull Runs, from GM Nigel Davies

When considering the impact of the computerization on the the world and its markets, with all the spin-offs and synergies that has entailed, it might be interesting to consider the extent of bull runs after other revolutionary developments.

Actually it seems that we don't have data to cover the 50 years following the discovery of fire or the invention of the wheel. But I would argue that going short in the periods following such developments was even less smart than usual.

  • R#fco Notes: Victor's Statements on R#fco; Media Coverage.