Daily Speculations The Web Site of Victor Niederhoffer and Laurel Kenner


Sept. 1-15, 2006


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Briefly Speaking, by Victor Niederhoffer

The movement of prices relative to the high and low of the day has always struck me as highly non-random. Holbrook Working had a test for the range of prices using the individual tick moves and the number of transactions -- based on a simulation.

I believe the gist of the problem is more that the market moves a lot to generate trades, and the ranges are much higher than they should be considering where they end up. I also think that a test based on this ecological fact would be more to the point. I would be interested in ideas as to how to illumine this phenomenon for its relevance to natural philosophy and profits.

S P Z 6   - -   S & P   5 0 0   F U T U R E
  DATE   OPEN     HIGH     LOW      CLOSE

 T  9/14 1326.70  1329.80  1324.70  1329.40
 W  9/13 1323.40  1331.90  1322.60  1329.10
 T  9/12 1313.50  1326.00  1313.30  1325.10
 M  9/11 1306.10  1314.60  1302.70  1311.60
 F  9/ 8 1308.90  1312.30  1306.30  1310.50
 T  9/ 7 1308.70  1313.70  1304.00  1307.40
 W  9/ 6 1319.70  1320.10  1312.20  1314.00
 T  9/ 5 1324.30  1327.50  1321.70  1326.00
 M  9/ 4 
 F  9/ 1 1321.10  1325.00  1318.00  1324.00
 T  8/31 1317.80  1319.50  1316.00  1316.90
 W  8/30 1317.00  1319.80  1315.50  1316.40
 T  8/29 1315.30  1318.50  1309.50  1316.50
 M  8/28 1307.70  1318.50  1307.30  1315.10

Malfeesance, from C. Kin

Venture Capitalists' Pay Is Better Than Their Returns, WSJ Says
Sept. 14 (Bloomberg) -- Returns on venture capital may have been poor of late, but the salaries and bonuses enjoyed by executives of venture firms are still gratifying, the Wall Street Journal said in its "Tracking the Numbers" column.

Here's the fee menu:

I wonder what the menu of a fund-of-private-equity-funds would look like?

Stefan Jovanovich on Colonialism

In reference to recent posts, one cannot explain the world war of 1914 without reference to the literal rage for empire among the English, French, Belgians, Dutch, Italians and the peoples of both German-speaking empires. None of the governments or popular majorities questioned the right of Europeans to carve up ownership of the rest of planet in the name of the White Man's (NB: not Woman's) Burden. The greatest public gathering in England between the observance of the death of Queen Victoria and the coronation of Elizabeth I was the spontaneous celebration for the relief of Ladysmith - a town where the imperial forces were under siege for 118 days during the Anglo-Boer War which, as Churchill addicts know, was also the central event in his young life. The notion of free trade was considered a quaint relic of a prior age when "uneducated" (sic) people failed to understand the essential role of government in the conduct of economic affairs (Marshall wrote something like that, but I cannot find the exact cite for it right now.) Keynes may have questioned the weight of reparations from the Treaty of Versailles, but he had no doubt about the justice of the French, English, and Italians taking over the German colonies or the importance of Empire for its own sake.

Studying Nothing, from Jim Sogi

I am studying nothing. But that does not mean I am not studying anything! In fact I am reading Nothing That Is, A Natural History of Zero by Robert Kaplan about the development of the mathematical symbol zero, one of the most important advances in math.

There are more ideas or concepts than there are words to express them. The Hawaiian language for example has concepts that do not exist in English. There are concepts that have not yet been articulated clearly. The development of science and math is the development of new ideas and concepts that had not been thought of before, such as calculus, limits, asymptotes, statistics, the law of large numbers and laws of convergence and probability. Great discoveries in science by Copernicus, Galileo, Einstein, Laplace and Galton among others, allowed man to make computations and models that had practical applications. In politics also, ideas of freedom and democracy and equality have resulted in huge changes.

Fibonacci's book mainly concerned trade and divisions of profits among partners and the calculations of interest. These appeared in the same book as his popularized sequence. He was one of the first European adopters of Indian figures or Arabic numbers and explained in detail how to do the computations. It was required reading for business school back in the middle ages.

Why did the Greeks and Romans never have the number zero? Where did the symbol first arise? The Sumerian's cuneiform numbers first used the idea of a place holder, but it was the Indians who first properly conceptualized, used and symbolized the zero. The metaphysical tradition made the Hindus peculiarly well suited to invent the concept, and thus they had a symbol to signify both nothing and large numbers in different contexts.

How did this come to be that the same symbol has two very different uses? Consider that the oldest verbs such as to be, are classified as one verb, but the conjugation I am, he is, they are, are so different that they are actually different concepts lumped together by a modern English teacher rather than a philosopher. The existence of self, and the awareness of others is epistemologically a completely distinct function. So too is the use of the zero as a place keeper and as the symbol for nothing. Conceptually it is difficult to have a word for nothing.

In markets we are all looking for the next big thing that will help us decipher the markets. It might be a quantitative model or even an new breakthrough in mathematics that sheds a new understanding of the market functions. Numbers are changing now. Rather than use names like googolplex, or 10 million we use notation such as 1e-08 from computer notation. Recent developments in probability and computational math are constantly pushing the thresholds of our abilities to perceive and understand the data in the markets. Mathematical models allow accurate quantification of the relationships, the changes occurring second to second, faster than the mind can comprehend. These models give the mind added powers of huge memory, speeding complex calculations on huge incoming data streams, just the counters on sand boards doing Arabic computations with a zero, enabling faster and more complex computation had an advantage in commerce and business over those using their fingers or beads or the eye to count, those with the fastest, best, most powerful tools in the markets will have the advantage over the slow moving, over the old technology, over the backward looking, over the mechanical, the non adaptive, or the dogmatic. No man, no matter how smart, can absorb all that is presented or can compete with the power, speed and unflagging attention of the computers.

Taking for granted as fixed current financial, mathematical, political systems stultifies the mind. The ideas that language, math, the political system, the social system, the financial systems are status quo and locked in place or that they have always been like that or always will be, leads to dangerous complacency. Looking back at the amazing discoveries in science and math and the benefits flowing gives hope that things as we have them now can be changed and give way to newer and better discoveries that will push the boundaries of human thought and comprehension and bring profit and enjoyment to those who do it. It also helps to know the weaknesses and limitations of our current systems so as to better understand risk. Risk is in part based on the financial structure as it has pieced itself together. Past failures give clues. But the continued ever upward spiral is most apparent. There is no plan, and no one can control or regulate the development and growth of the financial system. Profits are to be made at the ragged edges, by pushing the envelope, and perhaps doing some counting on the back of the envelope on the way.

Licensed to Kill by Robert Young Pelton, reviewed by Robert Carlson

Private military contractors are war zone speculators and the new book from Robert Young Pelton gives an enjoyable glimpse into the history, formation and daily activities of these contractor companies.

Licensed to Kill does not go too deep and bore the reader but rather makes the most of Pelton's vast contacts and personal stories from operating in various war zones. His balanced writings give him access to the major players in the industry which allows him coverage that other writers cannot match.

The book opens up with an email which was circulated amongst contractors that summarizes their outlook and reasoning for such a job.

One investment theme that I continue to pursue is the government contracting out of infrastructure to private companies, and I felt the book was a great insight into the beneficiaries in global security infrastructure. Countless examples are given of the military being replaced for non offensive duties by fewer and more highly skilled contractors in a trend that gains momentum.

An important theme throughout the book is the difference between a mercenary operation and security contractors. The line is occasionally blurred but the greatest distinction is that mercenaries conduct offensive duties and security contractors only act defensively. Discussed in this regard are the Sandline affair and the failed coup attempt in Equatorial Guinea by former Executive Outcomes personnel

A few of the contractor companies mentioned in the book are Blackwater USA, Triple Canopy, and SCG International. Some offer interesting emails which update and assess the security situation around the globe as well. I am a big fan of anything Pelton puts out and if anyone has further interest in his works you can check his webpage.

Peacekeeping is a growth area for the contractors, and the President of Blackwater states in the book that, "We are going to field a brigade-sized peacekeeping force. You can quote me on that."

For instance in regards to Darfur, Blackwater's President elaborates that, "We are turning a CASA 212 into a gunship that would cruise around at thirty-eight degrees...and when we find the bad guys, we would lay into them." The Director of Business Development then followed up to say, "Yeah, Janjaweed be gone!"

One effect of market forces upon the contractors is the cost of an armored drive from Baghdad's Airport to the Green Zone along Route Irish. Pelton reported in July that the price of an airport run is as low as $1500, down from upwards of $20,000....but this is one expense not to skimp on! Perhaps the run is simply getting safer but I imagine that competition plays the largest part in the price drop.

In regard to everchanging cycles, it is also noted that suicide bombers would approach the convoy initially from the rear until the convoy gunners learned and would shoot anything that came close. To adjust, the bombers would slow down from the front and when that failed to consistently work, they began to drive from the opposite direction and over the median into the convoy. All that in addition to roadside IEDs makes for a lot of uncertainty.

Also, a useful technique that Pelton observed during training for new contractors at Blackwater was the role reversal where the trainees would act as terrorists assaulting a convoy and the instructors would act as the convoy. This enabled the trainees to get into the mind of their enemy and probe for weak spots which were fully exploited. In the markets, how many price takers fully understand how price makers operate? Very few in my opinion.

Yishen Kuik adds:

Oddly enough, all of the points in Mr. Carlson's post are directly applicable to aficionados of team based first person shooting PC games like Day of Defeat. Someone who has played the Axis team on a given map becomes much more effective when playing the Allied team. Hiding spots, ambush points become clearer.

On changing cycles -- an Axis sniper in a church tower can rack up kills, but will also eventually draw enemy fire. A skilled player knows when to move on to the next spot, for soon the tower will be strafed with machine gun fire and rockets. This also has parallels to fixed systems. The market will adapt and take you out.

When such an ambush point becomes 'hot', enemy forces will continue to deliver precautionary fire on it, regardless of whether anyone is there or not. It then becomes a very dangerous spot to be near - this is the trough of the cycle.

However, again very much like markets, if the church tower is left unoccupied for a long enough time, the enemy's wariness of it slowly diminishes, and the skilled sniper knows when the time is right to re-occupy it.

In fact, very good players make it a point to cycle between ambush points, leaving just before the previous point draws fire, moving onto a new point and then returning to the old point once it "cools" down.

First person team shooters are a wonderful laboratory of group dynamics. I've seen the above cycles again and again over hundreds of games.

A Question on Degrees of Competitiveness, from Byrne Hobart

One important conclusion is that the more differentiated a product is, and therefore less competition it has to contend with, the greater that company's profit margins.

I think Citigroup's position on the list of Dow companies ordered by profit margin belies this theory -- there is nothing more commodified than borrowing and lending, since money is the most fungible commodity around (pretty much by definition; if another good was a better means of exchange, we would use it as money instead). Perhaps returns on capital would be a better indicator of differentiated products, since returns on capital measure how high returns would be for a competitor, if this competitor could do everything the given company does?

I think the theory is basically right, but if it is not expanded to deal with cost-of-capital and return-on-capital, it is going to lead to errors when applied to industries with unusual ratios of sales to assets.

A Number of Friends, by Victor Niederhoffer

I have been trying to gain insight into the economics and sociology of the number of friends one has. Some concepts that are relevant are the substitution of family ties for friendship, the reduced time that we have for friends when we have children, the opportunity cost of having a friend when you have other high value uses for your time, the amount of investment that you place in a friend and what the rate of return on that investment is (and how to measure it). Mobility is often reduced by the amount of friends one has, but life-span is increased and apparently friendship is a more important determinant of happiness than money. Here is a simple mathematical study on friendship and its rewards, based on having 150 friends.

I believe that many of the same factors that determine the number of friends you have determine the number of markets or stocks that you own, and the loyalty that you place on them. Perhaps the methods of studying friendship and the concepts that help us determine our choices could be of use when determining what to buy or sell, and where.

We all could be better friends in one way or another, and I plan to reach out to a few people and become a better friend today. Perhaps this will make me happier and more profitable in my investments also?

Rod Fitzsimmons Frey adds:

There are those who are skilled at being a friend. The adolescent view of a good friend is that he is a good listener, concerned for you, sympathetic, etc. That also describes a Labrador Retriever. I think Optimism is the defining quality of somebody who is good at friendship.

He pays you a visit because he is optimistic you want to see him. He buys a small gift for you when he spots it because he is optimistic you will like it. He telephones after a year because he is optimistic the news will be good. Conversations are about the present and future and not past faded glories. Making new friends is the ultimate vote of confidence in the future.

Not quantitative, unfortunately, but relevant to market activities.

C. Kin comments:

Friendship is in some ways an early form of credit ... the accumulation of "favors" receivable. I seem to recall from Sidney Homer's History of Interest Rates that kings would make overtures of friendship with other neighboring kings. Gestures of goodwill, tributes, etc., would require reciprocity with a slightly higher value in the future. Failure to reciprocate (a default) would be met with derision, anger, distrust, a disruption of commerce, and all of the other unpleasant things that occur when royalty gets slighted.

Vince Fulco mentions:

While I am a strong believer in the more altruistic reasons for developing friendship vs. the commercial ones laid out here, Charles' historical mention scratches at some great work by Robert Cialdini, a psych professor, regarding reciprocity. It is a generally inherent trait, some call it a mental flaw, of all humans. A flaw because as Cialdini's studies point out; upon receiving something of only nominal value from a friend or acquaintance, we have a tendency to respond in kind with a return favor or gift many times the value.

This phenomena and many other excellent examples are found in his book Influence: The Psychology of Persuasion which I highly recommend for the reference library.

Jeff Rollert adds:

I differ with the implied symmetry of value. Last weekend I traded $20 and an old stereo for a very nice mountain bike for my son at a place where we normally donate stuff. They had a lot of bikes which were not selling. The receiving area needed a new stereo. I clearly won in my mind, they in theirs, yet on market value a third conclusion may have been reached.

Steve Leslie says:

One thing that I always admired about Winston Churchill was he would invite friends and associates for long dinners at his estate house. His suppers were legendary as some of the great politicians, diplomats and thinkers of his era were invited to discuss the events of the day. And these suppers would last long into the wee hours of the morning. I can only imagine the discussions and as I recall, Churchill continued these especially through World War II. Now if Churchill could find the time to have over a group for supper while the fate of the free world hung in the balance what does that say for us.

Speaking personally, there is no greater enjoyment for me than to be invited to someone's home for dinner. There is just something wonderful about being liked so much that another would want you in their most cherished and private part of their world. It is as if they are saying to me "We are welcoming you to be a part of our inner circle of trusted friends."

Kashi Vishwanath mentions:

Your book and website indicate that you (and your colleagues) are willing to look at alternate explanations than the conventional party line. Here is one on Winston Churchill for your consideration and debate.

Conventional thinking has put Churchill on a pedestal. Witness the recent comment in your thread on friends. Ditto the innumerable books and hagiographies on him. Etc.

All that for someone that sought to continue colonial exploitation, ridiculed and disparaged MK "Mahatma" Gandhi, abused the native population of the Middle East and Africa in his time there and sought to maintain that going into the future, supported slavery, and so on. To call him a "leader of the free world" raises weaknesses in one's own critical and independent thinking. Free for what and for whom? and at what cost?

Jan Petter-Janssen continues on the topic:

As a student on a foreign continent the first weeks are really exciting. Since most students know no one or very few when they arrive, making friends is really easy. Everyone is in a kind of friendship vacuum. After a while the number of friends declines a bit since one cannot find enough time for everyone. This is like in micro economy where a monopolist sets marginal revenue equal marginal cost.

Adapting economic thinking and finding how to increase the social revenue and reduce the time cost of a friend may be a good idea (with the risk of such an idea being regarded cynical - which would imply your friends reducing their revenue of having you as a friend).

Another aspect with friends is to balance socializing with working. You work in order to buy goods and services, so you could say that the marginal benefit of interaction and transaction should be equal? I can definitely see myself in such a dilemma because trading stocks gives me the benefit of competition, achieving goals, and studying the mystery of the marketplace, but little social benefit. However, the balance is found by cutting out TV and video games, so then I have enough time for socializing too.

Noodling, from Scott Brooks

I have never noodled. However, I possess some qualifications to speak on this subject:

  1. I am from Missouri
  2. Half my relatives still live in homes with wheels
  3. My relatives and friends go noodling
  4. I am bi-lingual. I can speak their language. I can speak English and "white trash"
  5. I grew up in a WT neighborhood. Basically, I am "escaped white trash"
  6. If I had not escaped, I would have been expelled from the WT neighborhood as my IQ is on the wrong side of the bell curve

Therefore, when it comes to noodling, I will say the following:

Snapping turtles.

If that does not get your attention try this:


It is like playing Russian Roulette with a much more painful ending. On top of that ...

Catfish have big nasty mean spikes on their bodies that hurt real real bad when they stick you. I am not talking about a little pain. I am talking about a pain that will alter how you walk for the next few days.

And while you are at it, lets add alcohol to the mix. It is a necessity. You need something to numb the pain of the having your arm torn up from the elbow down, and to get up the nerve to dive down underwater and swim up into a log or into a hole in the bank (still under water) and stick you arm into a catfishes mouth, grab his gills and then try to pull it out without getting tangled up on something, getting your hand irretrievably stuck in the fish, or having the fish win the battle. Think about it. If you grab a 30 pound catfish, remember, you are in his environment. He is P.O.'d and he is going to try to go deep, while you are trying to get up for air. Many a white trash funeral has as its impetus a dude in a wife beater shirt that lost a battle to a catfish.

But wait ... there is more!

Hopefully you will not stumble onto a nest of water moccasins or copperheads. There is nothing that says fun like grabbing onto the gills of a big catfish only to discover that you just stuck your hands into the mouth of a 70 pound snapping turtle that will not let go, while at the same time disturbing a nest of water moccasins, while you struggle to not scream, while trying to get to surface to breath all while being swarmed by snakes ...

YEEEEEE HAAAWWWWW. Man that is fun!

And most of the guys who die each year (and there are always some), all die saying those famous last words of all white trash......"Hey everybody, watch this!"

Even Steve Irwin did not noodle!

Steve Irwin Redux, from Tom Ryan

One of the problems that I see repeatedly in my work is the confusion over probability regarding a single event, vs. the probability of a sequence or continuum of events. A good example would be Steve Irwin's show stopping stunts, or a question recently posed to us by one of our clients regarding mining safety, or trading, or the topic of this morning's coffee ... which was bicycle commuting. Although most people can easily think in terms of probability for a single event (e.g. there is a 50% chance of the roulette wheel hitting black or a .00000001% probability of being hit by a car on my commute) they have a difficult time integrating this probability over a long period of continuous exposure. To do that you have to do a Pulaski/Feynman "invert, always invert" and look at the probability of an event not happening given a certain long period of continuous exposure. Continuing with the bicycling analogy, as long as bikes and cars are sharing the road, and given some basic newtonian physics (F=ma), the mass differential between a car and a human on a bicycle, there is a finite, albeit low probability (lets say 1e-08?) of being hit by a car and getting killed as it goes past you. No matter the speed limit, size of bike lane, cell phone laws etc, there is a chance you will get mowed down from behind, as a good friend of mine found out last year (he survived, barely).

So lets say your exposure is 1e-08 to any one car, and 100 cars pass you on your commute. The probability of being hit by a car for the total exposure must be evaluated by looking at the probability of surviving which can be approximated by (1.0-[1e-08])^100. Which means that for that exposure you have a .999999 probability of survival or a 1e-06 probability of getting hit. This can be expanded for longer and longer periods of exposure. Lets stick with a single event probability of 1e-08 for now, and 100 cars per commute to keep it simple.

1 commute, 1-e06 (.0001%)
10 commutes 1e-05 (.001%)
100 commutes 1e-04 (0.01%)
1000 commutes 1e-03 (0.1%)
10000 commutes 1e-02 (1%)
100000 commutes 1e-01 (10%)

The point is that any one ride is not that risky, but if you look at the risk for longer and longer time periods or more and more continuous exposure the behavior can start to look a bit risky.

This gets back to Steve Irwin, why people should wear their seat belts, and why when you get the 30 year term life insurance there are three pages of fine print about what behaviors are not covered. What can seem responsible behavior for a single event can start to look a bit dangerous given a long enough exposure to the hazard. This is where the media tends to fall down when reporting on things like Steve Irwin's unfortunate incident.

Recently we were examining a mining safety situation and looking at PDI (prob. of individual death) and PDG,n (probability of death for a group of size n). There are no mining industry standards, but some general ranges that are well accepted. Generally PDIs for a one year exposure of less than 3e-05 are considered 'low' risk, 3e-05 to 1e-03 'moderate' risk and anything above 1e-03 'high' risk. People's risk acceptance however tends to vary between voluntary (surfing) and involuntary (my job) tasks. For example when we looked at traffic safety records for the highway between Safford Arizona and the mine at Morenci, we found PDI's (based on miles traveled annually commuting to/from home/work) between 2e-04 and 6e-04. A panel, of which I was a member, could not find any job related position at the mine which had a PDI exceeding 3e-05. Yet both regulatory personnel and the workers considered working "more dangerous" than commuting.

How this relates back to the market is that the markets are in many ways a "perfect trap" for the fund investing public to make poor risk taking decisions over long time horizons. You have relatively low barriers to entry which results in a high level of competition, ever changing cycles which makes it hard to predict long term effectiveness of strategies, and a lack of control which lends itself to an involuntary risk perception. This is a long winded way of saying "stay out of the switches" and focus on the longer term but that is why I think passive index funds are so valuable to the layperson investing for long term horizons ... because they allow anyone with a bit of math background to estimate risk in a quantitative fashion, which then allows one to set their own risk levels and create a portfolio that meets their long term goals.

A Letter from Donald J. Boudreaux to the New York Post

Dear Editor:

Falling gasoline prices are indeed welcome economic news ("It's a Gas! Pump Prices Fall to 6-Month Low," Sept. 13). But I worry about what these falling prices reveal about the ethics of American motorists. If rising gasoline prices are caused - as so many pundits and pols allege - by the greed of oil companies, must it not be true that falling prices are caused by the greed of consumers?

Donald J. Boudreaux
Chairman, Department of Economics
George Mason University

Follow the White Rabbit, from Jim Sogi

Neo is looking at a bank of computer screens. Figures scroll down the screen in columns. To the casual observer it is just gibberish. Neo is watching the matrix and a world full of life with action. I imagine being Neo watching my bank of computer screens. Figures scroll down time and sales. Its not gibberish or undecipherable numbers. The stories unfold, there is action. The 1 lot gang is always busy with random action. The 20 or the 50 lotters have certain habits. The 100-400 lot players have certain characteristics. Different groups play at different times. The 800 lot and 1000 lot guys like to chase momentum and have times they like to show up. Players have habits. I can just see the bank traders chasing the ask to fill their orders for the day. Its almost funny, but after a while staring at the screen you get to know the players. You can see them buying up surges or breakouts. You can see the shorts getting squeezed like today up at the 12-14 area or above the round on the index. When the market tanks, you can see the people panicking. You can see who is in trouble. You can see packs attacking the bid and breaking down the price until it crumbles. You can see the bottoms break and the dams breaking. You can see bridges being built. You see ephemeral ideas take hold like yesterday's 9/11 dip. It is imaginary stuff making people do silly things. Then you see the order flow move to the ask and the market changes direction. Its so fascinating, except when you become the hunted. Then its no fun...until the table turns again. What a world! The Matrix.

Some quotations from the movie that may be relevant to speculating ...

Trinity: The answer is out there, Neo, and it's looking for you, and it will find you if you want it to.
Spoon boy: Do not try and bend the spoon. That's impossible. Instead... only try to realize the truth.
Neo: What truth?
Spoon boy: There is no spoon.
Neo: There is no spoon?
Spoon boy: Then you'll see, that it is not the spoon that bends, it is only yourself.
Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.
Agent Smith: Never send a human to do a machine's job.
Morpheus: Throughout human history, we have been dependent on machines to survive. Fate, it seems, is not without a sense of irony.

A Head in the Clouds, from Rod Fitzsimmons Frey

I babysat my eight-year-old nephew Luke yesterday. We spent some time flying a kite and staring at the clouds.

Luke tended to spot the livestock in the sky: he would point out the horse, or the elephant, or the giraffe. He did spot two trucks and a train as well. I tended to see people: an old man with a hooked nose, a tennis player, a mom beside her minivan. I also found a map of Canada and a totem pole.

What was remarkable was how easy it was to point these shapes out to each other (Luke was skeptical about the map, though). Despite the obvious difficulty in following somebody's pointing finger to a single cloud, and in adopting the other person's imagination, it was usually only a couple of seconds before one would say "Yep! I see it too! Wow, an elephant!".

We did not see any head-and-shoulders, cup-and-saucers, or triple-tops. But on the walk home I thought we might as well have.

'How Low Can You Go!' featuring Hillary Volartillery, from Dr. Kim Zussman

Volatility of stock returns has declined markedly after the onset of Iraq II in March 2003. The price stability of the current period has been compared to the mid 1990's, as well as the event horizon at the edge of a black hole (terra no can see ya'). How stable is it?

DJIA daily returns were partitioned into non-overlapping 500 trading day (about 2 year) segments counting back from today to 1931. The standard deviation (vol.) of each segment was calculated, as was respective mean daily return.

Without giving away the entire plot, the answer is "A lot lower". The current 500 day standard deviation ranked 10th lowest out of 39 such periods. (You will get to see Hilly after the upcoming classroom scene).

Over most periods, high volatility accompanies concurrent low returns. This relationship was confirmed by regressing each 500 day period's mean daily return against the same period's standard deviation:

The regression equation is: mean return = 0.000769 - 0.0515 sd

Predictor       Coef       SE Coef      T      P
Constant       0.0007687   0.0001712   4.49   0.000
sd            -0.05150     0.01507    -3.42   0.002

S = 0.000496235   R-Sq = 24.0%   R-Sq(adj) = 21.9%

Looking further at whether the prior 500 days' standard deviation predicts the current 500 days' mean return, as usual, came up empty (slope coefficient N.S.). So it would seem that from a long-term historical perspective, current low volatility portends neither doom nor boom.

As promised, here are the dates and standard deviations of the 500 day periods, ranked low to high. One also notes the high vol. periods near the bottom, mainly around the depression, 1988 (containing 10/87), the start of WWII, and our old friend 2002:

  Date        StDev.            Date        StDev.
12/23/1964    0.0050          1/15/1971     0.0084
1/23/1953     0.0054          12/9/1980     0.0087
1/16/1945     0.0057          11/20/1984    0.0090
1/19/1955     0.0057          12/23/1976    0.0093
1/21/1969     0.0059          1/20/1937     0.0094
10/12/1994    0.0060          10/29/1990    0.0096
12/16/1966    0.0063          1/22/1947     0.0097
1/9/1973      0.0065          12/1/1982     0.0101
1/3/1961      0.0066          9/16/2004     0.0109
9/11/2006     0.0066          9/20/2000     0.0116
10/3/1996     0.0066          9/28/1998     0.0116
1/9/1959      0.0070          1/20/1941     0.0127
1/22/1951     0.0074          1/2/1975      0.0129
1/20/1949     0.0074          9/20/2002     0.0140
1/15/1957     0.0075          1/19/1939     0.0167
12/15/1978    0.0078          11/4/1988     0.0175
1/19/1943     0.0079          1/23/1935     0.0214
12/28/1962    0.0082          1/14/1931     0.0218
11/13/1986    0.0082          1/11/1933     0.0312
10/20/1992    0.0082

Carly Haiku, a Continuing Series, by George Zachar


Welch: HPQ's board
"dysfunctional." Like GE's
exec comp panel?

Specialization and the Division of Labor, by Victor Niederhoffer

Inspired by the sad passing of Crocodile Hunter Steve Irwin, and some wisdom from a 19th Century book on trading, I have been considering the benefits to society and the individual from the division of labor -- the separation of a job up into parts usually performed by different individuals. The division of labor is so common in our society, and so much good comes from it, that we often take its benefits for granted and forget about the harms from not following it. It seems good to gain perspective by starting with some scholarly work from the field, so that basic principles can be considered.

The division of labor is usually associated with the contributions of Adam Smith in the Wealth of Nations where he states that it is the main engine that is responsible for the wealth of societies. He gives the example of a pin factory. He shows there how the division of labor enables each laborer to produced 2400 times as much as each working separately without specialization and separation.

One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it,... and the important business of making a pin is in this manner divided up into eighteen distinct operations .. which in some manufactures are all performed by different hands.

Charles Babbage in the Economy of Machinery and Manufactures gives numerous other examples were ingenious methods of separation of the manufacturing process lead to ingenious and astounding improvements in output. At a more general level, the process of making something as simple as a pencil, has so many parts, and so many people involved, that not only would output be minimal without a division of labor, but few people would know how to do it all, since so many raw materials and transportations and communications are involved. This is all ably illustrated in the classic I, Pencil by Leonard Reed.

Smith believed that improvements to productivity by the division of labor were based upon:

These concepts have now been subsumed in economics as increasing returns to scale, and the great improvement in output or profits that come from continuing until variable costs are more than the marginal costs without regard to the high fixed costs in many processes. The concept has been generalized by growth economists into a beneficent circle. Increasing the division of labor leads to enhanced output from improvements in the productivity of labor. This increases incomes and demand, and leads to larger markets. With larger markets, more division of labor can occur starting the circle over again.

The major contribution to the benefits of the division of labor from the biology field was Charles Darwin. He pointed out that there was much variation in a species, that the variations that were good for survival and reproduction tended to be inherited, and that these inherited differences led to specialization among the progeny, thus creating niches where specialization would contribute to further survival and reproduction.

A major reason that specialization works in economics and biology is that everybody is different. Roger Williams in his book Free and Unequal shows that not only does everyone have different degrees of aptitudes, and appearance, morphology and physiology, but that everyone's internal organs are different. These differences lead us to be able to perform different tasks with different degrees of efficiency and productivity, and make the benefits of specialization great even when improvements in machinery are not available.

Another set of principles as to why the division of labor works comes from the work of Emile Durkheim in his book the Division of Labor in Society. He points out that people specialize in different occupations in a society, and this tends to bind them all together, as they depend on each other, but at the same time creates a sense of helplessness, or anomie, because no one person is responsible for the whole job. That is the reason that often the division of labor is not carried as far as it should be.

Let us apply some of these principles to trading. Fowler in his 1874 book, 10 Years on Wall Street concluded that most traders lose. And the reason is that people with abilities in one field feel that their success is transferable from their own field to trading. They come to Wall Street and do not realize it is a world of its own, with its own mechanisms for survival, and specializations for success, and thus:

The sudden collapse of fortunes, closing of elegant mansions, the selling off of plate, and horse at auction, the hurling of men down from first class positions to subordinate posts is an everyday occurrence in New York. In almost every case, these reverses result from outside trading and meddling with matters foreign to one's legitimate business

The attempt of a given person to move from one field of trading to another should be considered also as a major source of disaster. There are too many specialized rules involved, too many abilities needed to change willy nilly without a lengthy training period, careful study, and practice trading on a very small scale.

The feeling that one can transfer skills from one field to another is closely related to hubris, a lack of humility in realizing the importance of specialization and individual differences. It seems that this led directly to the death of Steve Irwin . Study of his career shows that he was raised from infancy in a croc zoo run by his parents. He knew everything about how to capture and escape from crocs. Indeed on on my visit to the Zoo in Western Australia the keepers pointed out that the crocs were particularly hateful when Steve was around because they knew it was him that had captured them all. They have good memories.

It is sadly predictable that Steve would die when dealing with something outside of his normal ken where he did not have the advantage of the division of labor and specialization to help him. Usually his side kicks are standing ready with equipment and knowledge to help him at all times, yet by failing to take account of the specialized knowledge required to deal with aquatic creatures like the stingray, Steve met his death as many traders on Wall Street do who succumb to an improper respect for the division of labor.

Vic adds:

An entire book could be written about the lengths to which specialization has been taken by the tennis doubles team of Bob Bryan and Mike Bryan. To watch them play, one could be looking at the ecology of the vent worms it is so specialized. In practice, each brother sticks to their side. Their shots are completely attuned to their side of the court and they hit with a minimum of backswing and angle directly at their opponents, saving all their energy. They practice with a game of doubles played cross court only and from their side only. This is called one on one doubles that is specialized training, and completely new in the last 5 years. It teaches the split step, volley off the serve, return of serve, and keeping it away from the net player. Their serves have no backswing and go directly in at 130mph or so, giving their opponents no chance for any errors. No wonder they have won the grand slam in doubles and are the most successful doubles team ever.

They have a coach who hits shots to them to practice, for the first, second and third shot that they are likely to hit from their side. They are identical twins, and predictably they seem to have a telepathic sense of what the other is doing. It is amazing they lost at the open but I noticed that they did much publicity, and perhaps lost their concentration. They could not make the Davis Cup for a long time, even though they were the best, because of the old time fairy tales about it being imperative to be a great singles player to be a good doubles player. Bob Bryan also just won the mixed doubles title with Navratilova.

It reminds me of the Renshaw brothers, the Doherty Brothers, the Guliksons and the Jensens, showing the importance of genetic factors in developing specialization and communication. There is much more to be said about the beautiful experience of watching these teams play and practice.

Jack rants:

Reluctantly I must dispute the Chair's conclusions regarding Mr. Irwin's death. Steve Irwin was more than the Croc Hunter; indeed, had he limited himself to that, his program would have never come into being. My granddaughter's favorite show is the one in which he hunts down the world's ten most lethal snakes and, of course, catches them barehanded.

I hated the program because we have plenty of snakes around here and they're nothing to fool with, especially the copperheads. A local friend calls it the "3-day snake." Its bite won't kill you but it most likely will put you in the hospital for three days...and I'd prefer not to have to visit her there (fact: 80% of people bitten by snakes are bitten while trying to capture them).

Now the allegation is that Irwin went beyond his specialty, or competency. In light of the many other programs he did with animals other than crocs, I think the point is debatable. But, for the time being, I will concede the point.

Now if we assume Irwin had stuck to his knitting, he would still be alive and amusing himself and the occasional visitor with his croc techniques. Similarly, we could imagine the chair forsaking the markets and contenting himself with becoming Brighton Beach's most notable accountant, It might have caused Artie less concern and, although his income would have been substantially less, he could have hustled the local young-gun racket ball studs for tuition money. Or, if the vision of Brighton Beach we receive via Law & Order is accurate, he might have achieved wealth through the Russian Mafia which would have treasured his business acumen.

But neither Irwin nor the Chair were satisfied with what was readily available. It can be argued that if Irwin had not stretched himself, he would have remained just another anonymous Aussie with a Crocodile Dundee complex. On the other hand, it is alleged this fateful decision brought about his death. The Chair seems to feel this was his destiny for violating precepts laid down by a Scotsman well over 125 years ago. The very fact that this was only the third death ever suffered in this manner, I would argue, is not destiny, it is just incredible bad luck. (Had he died of snakebite in the program previously mentioned, I'd have said nothing.)

The fact is both men chose professions that call for above-average (excessive?) risk taking. However, they made the choice freely and must live or die by it. But, and here is the nub of my dissent, the same cannot be said of traders in general. We have laws against practicing medicine without a degree, impersonating a law enforcement officer, and require the licensing of any individual who wishes to drive a motor vehicle. In each case the individual could endanger the life of himself and/or others.

When it comes to one's financial life, though, the warnings (such as they are) against trading (and investing) are so overwhelmed by stories to the contrary, that they might as well not exist. Ask these same individuals to wrestle a croc and they would tell you to take a hike. Tell them what the market did between '95 and '00, tell them about charts, tell them about trends, tell them about an irrepressible 10% upward drift, and you could not keep them out with a gun.

And once they are in, many of the same individuals who urged them aboard, will begin to lighten their wallets -- sometimes slowly, sometimes rapidly. And when they are broke, what do they say: "You really didn't belong in the market -- it's beyond your competency." But their financial death isn't a freak occurrence (like getting struck in the heart by the tail spike of a manta ray), it happens every day.

If possible, the situation is getting worse, The Capitol Hill Brain Trust has decided that not only may every worker play, but they must be offered an IRA account. With pensions quickly disappearing, individuals will have little choice. Some of the IRA funds I am familiar with (from several years ago) could be traded at least once a week without any penalty or commissions (I know, I traded thousands of shares of Tribune stock on just that basis). I understand that many funds which handle IRA accounts have instituted penalties for excessive trading.

Nevertheless, we have reached a point where almost every employed individual must take on market risk. You may believe it is necessary; I did too, until one evening I was talking with Anna, who had been cleaning our offices for decades. Asked how my day went, I commented, "Another day, another dollar." Anna said her family (which was Polish) had a different saying -- "Another day, another brick."

Anna's retirement predated mine by two years; she and her husband (who worked 38 years as a janitor in large apartment buildings, and in which they lived rent-free) sold the five apartment buildings they had acquired and moved back to Poland where they live very well.

So we must, first, save and then we must invest. But the market is not the only place, it is certainly the most convenient...and potentially the most treacherous. If we were reared in a croc zoo we would have an enhanced appreciation of risk. If, on the other hand, one were reared in a society that lauded you for spelling a word phonically (but incorrectly), if your athletic prowess were determined by T-Ball, if rowdiness were not dealt with through a severe reprimand but Ritalin-type drugs, and the ultimate form of punishment was a 30 minute "time-out," then you will have a populace of individuals unfamiliar with risk of any kind.

So how can we chastise these individuals for reaching beyond their competencies when they have none? The markets offer the only hope for many of ever achieving retirement. But like any dangerous endeavor, both warnings and training are essential. There are many books that attempt to provide one or both - but most, at least according to List reviews, also contain potentially lethal doses of misinformation.

As soon as I read the collaborators book I knew it would bomb. Advertising has been my game (I loathe the term "profession," as some insist), and to sell something, it must carry a promise of betterment. PracSpec didn't do this - it did just the opposite: it said there is no way to beat the market, all the systems are flawed. Its conclusion: you must work hard, study harder, and continually track a host of numbers and then maybe you might be successful.

I did not have to have Vic and Laurel tell me that. Sister Mary Margaret covered that in first grade. I did not like it then, I do not like it now. And the generations following mine, assuming they have any readers, will see it for the first time and despise it, assuming they even understand the written concepts, much less those that are mathematical. (Just look at some of the work being done by Williams, Bollinger, McDonnell, Sogi, and Zussman -- frequently, I have not the slightest idea what they are talking about - and I am not alone.)

(Just received this message Thursday from my daughter's teacher on my note to her as to why there is no math homework: "I am only supposed to give about 20 minutes worth of homework a night and it is (usually) always going to be reading and spelling, and math will be added." "Usually" is in quotes because it was first written and then scratched out; I have no idea when math will be added. A practice spelling test is given every Thursday, the "real" test is on Friday - student keeps the higher score. And no homework over weekends.)

I often wondered if Faulkner was either drunk or insane or perhaps both when he used his stream of consciousness while writing The Bear which makes me think maybe I ought to title this The Bull, but if I did that I would have had to have inserted a period back there which might have lent some coherence to this endeavor which is nothing less than a plea to appreciate Irwin for having the courage to stretch himself and the great misfortune to be almost as unlucky as Oedipus and that the over-riding consideration is to teach the younger generation that the market offers opportunities but they work slowly and not miraculously and that competency can be gained only through work and study and that paranoia isn't a bad thing since these market guys are out to get you 'cause they're not like your teacher or Little League coach who thought you were all swell and that the only turds in the world were on the other team but you still had to shake their hands and that like in Narcissus and Goldmund some of us have a great time going through life while others have it very difficult but that's OK because in the end we can all get together at the cemetery which is a depressing thought to end on but last week was depressing because Steve Irwin died and unlike almost everybody else in the world he could look at a huge, ugly snake and give his honest opinion: "Isn't she a beauty!"

Russell Sears comments:

Vic's description of the need for division of labor reminds me of Maslow's hierarchy of needs.

The reasons for the division of labor Vic gave seem to cover several of the five needs. Increase productivity, safety of sticking with what you know, finding a niche in which you belong are equal to 'accepted and enhanced reproductive prospects.'

Let me suggest another reason for division of labor is self-esteem. Competence, confidence and personal achievement all stem from doing a task superior to others.

However, such a superiority can easily lead to superiority complex or hubris. When instead of seeing the task mastered as the small contribution to the overall good. This mastered task is superior to all other task. Other inferior task can easily be assumed. Such an attitude is bound to be destructive in attempts at self-actualization.

However, perhaps the arch enemy of division of labor is obsolescence. It is not enough to be a master of one task. The plasterer, is replaced by the drywall finisher, whose skill is replaced with textured ceiling and walls, and improvements in tools and materials.

Let us not be too hard on Steve Irwin. It is not the drive to continually learn new different task, or even to assume that you can master these new task that is hubris. After all who would know the taste of obsolescence more than celebrity. While my kids loved watching him explore the animal kingdom, croc hunting was yesterday's news. It was his excitement of the whole animal kingdom that got my oldest daughter searching for diverse books each trip to the library after watching him.

Rather, than simply exploring new areas to conquer, as Vic suggest, assuming too much carry-over of expertise, probably was the cause of his death. However, it is not clear to me if this lack of learning was due to Steve's hubris assumptions or the true experts hired for his teachers, assuming that he did not need to be taught the basics.

What is clear to me too is that the tri-athlete, and the decathlete, train the longest hours, and need the best of coaching. When the very expertise is to multi-task, the teacher is critical and extra effort by the pupil is essential. The expert jack of all trades, at least once knew this. But perhaps this is why he is willing to put in the long hours. He bucks the division of labor, to be called "the greatest athlete."

Steve Elllison mentions:

A business with comparative advantage may find it beneficial to locate a production facility in another country to be closer to customers, avoid tariffs, reduce costs, or any of a host of other reasons. When a business locates production in another country, it must transfer knowledge from the home country to the country in which the new operation is located.

The multinational corporation is by far the most efficient vehicle for transferring knowledge across international borders (see, for example, the study by Gupta and Govindarajan). The simple reason is trust. As many western companies are discovering in China, joint venture partners have been known to expropriate intellectual property and go into competition with the business in which the knowledge originated. Conversely, employees within a multinational have a presumed trust based on their common alignment with company goals. Since much highly specialized knowledge is "tacit knowledge", i.e., cannot be codified into procedures but includes many nuances gained only by experience, it requires intense communication to transfer.

In markets, price is an efficient vehicle for transferring knowledge. Market participants with more knowledge than others can trade profitably using their knowledge. However, as such participants accumulate capital, the effects of their operations on prices become increasingly pronounced, and they drive prices to levels that incorporate their specialized knowledge. Trust in markets rests on mechanisms such as exchange rules and trade clearing procedures designed to ensure that sellers receive their money, and buyers receive their assets.

Jim Sogi offers:

Recent comments about the complexity of oil markets certainly highlight Chair's comments on the need for specialization in the markets and the problems in trying to extend a methodology from one market to another. Things that work in Equity futures do not work in Bonds for example. A surfer cannot excel in bike racing by virtue of his ocean knowledge. The benefits of firm size come in the ability to allow specialization. The ecology has many niches, each with their place. It is good to be able to find one and a meal ticket for life. However, it is worthwhile to have some broad knowledge to avoid the dangers of extinction in changing cycles or at least the ability to adapt. This is where broad knowledge of many things may not help today, but over time come into play in unexpected ways. My wife comments that she reads in obscure areas and by "coincidence" the subject will come up in conversation or in work over the next few days. My father always advised me to read broadly not just in your areas of specialty. Chair advises to his son to have another exit. Do not be a mouse with only one hole.

Pitt T. Maner III comments:

Although Steve Irwin was outside his area of experience he might have benefited from this training:

A SPSA (Safe Performance Self Assessment) requires you to ask yourself before performing a task "what is the worst thing that could happen?". What kind of protection can I wear to mitigate the risk. Should I increase my distance, etc., etc.

And LPOs (Loss Prevention Observations) make you take a look and learn from "near misses". Learn from potential mistakes and avoid them in the future.

This is excellent training for everybody. Even at home for the kids. And if something does happen -- do you have a first aid kit and fire extinguisher ready to use? Do you have all your emergency numbers and a hospital route readily available? Do you have Red Cross First Aid and CPR training (for infants and adults)? Do the kids know how to call 911? Do you know how to save a choking victim? Be prepared and prepare your loved ones.

The sad thing about extreme risk-takers is they do not always evaluate what the consequences can be to their family and friends.

Why all the attention to the Fifth Anniversary?, from Allen Gillespie

I asked myself this morning why all the attention, as opposed to the 4th, 6th, or some other random number. As best I can tell from my internet research, it is because the number five seems to be used as the number of humanity given that the body has five appendages (two arms, two legs, and a head) and five senses (hearing, sight, small, taste, touch). The fifth appendage provides the body symmetry. Thus remembering a fifth anniversary date must somehow reconnect us with our humanity. In music, the fifth is important because its addition makes a chord.

For the spec then, one might consider testing five market combinations like gold, bond, stocks, oil, the dollar for opportunities.

Michael Olds mentions:

Just one little note here. Five (actually probably any number) as standing for 'Man' is culture-specific. In Buddhist cultures it is six. There the mind is considered the sixth sense (and, unlike here, Man is considered to have one ... little joke).

As alien as it may seem to most of us, the mind as a sense is considered to operate like all the other senses.

We have mind and we have mental objects. Mental objects coming into the range of mind, together with consciousness [an element, just like earth, water, fire and wave-form, and subject to 'conservation' (recycling) just like those elements] produce consciousness of ideas. String together consciousnesses of ideas, given direction by the specialized consciousness idea called intent, and what we get is what we know as thought.

How is this relevant to speculation and trading? One way is in how the idea could be used to free the trader from error bound up with ego. Ego brings bias, and bias ruin. Seeing the process in the way described above is seeing without the notion of ego. There is mental object data, mind data, consciousness data. There is no 'my mental object data' [let alone the truly messy 'I think'] to cause possessiveness and the resultant hesitation to let go of a bad idea...it is all just data.

Five is important because it is the hand. Half of two hands. Half of 10, on which our number system is based.

Five is the number of "comprehensive and yet simple" unity or a set; it is applied in all cases of a natural and handy comprehension of several items into a group, after the 5 fingers of the hand, which latter lies at the bottom of all primitive expressions of No. 5.

My Mistress Cecilia, by Rod Fitzsimmons Frey

My young son, now 18 months old, has been "singing" for almost a year. Since both his parents sing a great deal both to him and to each other, it seemed natural that he would pick it up early. This month, though, he started for the first time to mimic pitch correctly -- very exciting.

What about musical tones make some sound lovely together and others clash terribly? Musicians call two notes consonant or dissonant depending on whether they blend or clash. Pythagoras discovered that when two strings were equally stretched, they would be consonant if their lengths were in the ratio of two small numbers such as 2:1, 3:2, etc. So important was this discovery of a law of nature being ruled by integers that it was extended to all the sciences, especially astronomy.

The simplest example of two notes that sound good together is when they are the same note, played one or more octaves apart. An octave separation between notes corresponds to a doubling of the frequency.

When a musical note is played on a stringed instrument, it has a primary frequency and numerous overtones, which are integer multiples of the frequency: for example the A below middle C has its primary frequency at 440Hz (by convention), while the E just above middle C is 660 Hz. The overtones of the A are 880, 1320, 1760, 2200, 2640 and so on. The overtones of E are at 1320, 1980, 2640, and so on. We see that the overtones line up with each other, and the result is a harmonious, or consonant sound.

A   440         880          1320         1760         2200         2640
E         660                1320                1980               2640

If on the other hand, we play the A with a G (freq ~ 785Hz, then the overtones clash with each other.

A   440         880          1320         1760         2200         2640
G             785                  1520                  2355

The result is a disharmonious or dissonant sound. Moving the frequencies of the note around to reflect integer ratios brings a sense of relief and correctness to the listener. This is true even if the notes are not real notes: for example, moving the G's fundamental up 100 Hz, the first harmonic down 200 Hz, and the third harmonic down 150 Hz is not a note found in nature, but can be produced by computer. It is consonant with the A because of its integer-bound relationship to it.

Musicians use these integer relations to great effect manipulating our emotions: they can elicit discomfort, relief, tension, and even laughter by moving further and more aggressively into non-integer ruled domains (dissonance) and resolving back into the more natural integer ratios that sound so lovely.

We know that the Mistress is a musician. Where in her symphony can we find the sources of consonance and dissonance that cause such anxiety and give such relief? An analogue to frequency in plucked strings might be found in volatility. As markets vibrate around whole numbers -- fundamental frequencies -- are other markets in consonance or dissonance with them? When SPX is ringing out the pure tone of 1300, are the vibrations of DAX part of a small-integer ratio? What has to happen to bring a dissonant market into consonance?

As a final note (yes, intended), one should probably be aware of the changing fashion of music. The notes that Bach wrote had mathematical progressions and rarely used dissonance: today's composers use dissonance to extract maximum effect and may never even resolve into consonance. You have to know your composer if you want to know when to applaud.

Does the Mistress have NPD, from Dr. Kim Zussman

Narcissistic personality disorder: (Summarized from DSM-IV-TR Fourth Edition)


A pervasive pattern of grandiosity (in fantasy or behavior), need for admiration, and lack of empathy, beginning by early adulthood and present in a variety of contexts, as indicated by five (or more) of the following:

She has a grandiose sense of self-importance (e.g., exaggerates achievements and talents, expects to be recognized as superior without commensurate achievements).

She is preoccupied with fantasies of unlimited success, power, brilliance, her own beauty, or ideal love.

Believes that she is "special" and unique and can only be understood by, or should associate with, other special or high-status people (or institutions).

Requires excessive admiration.

Has a sense of entitlement - unreasonable expectations of especially favorable treatment or automatic compliance with his or her expectations.

Is interpersonally exploitative - takes advantage of others to achieve her own ends.

Lacks empathy: is unwilling to recognize or identify with the feelings and needs of others.

Is often envious of others or believes that others are envious of her.

Shows arrogant, haughty behaviors or attitudes.

Propaganda as Accelerant, from George Zachar

After a decade of breathless hype peddling real estate to space starved New Yorkers, today's NY Times notes that, y'know, you oughta be careful in picking a pad!

... problems - like impaired views, lack of light and high maintenance or common charges - retain their repellent qualities in any slow market. Other immutable lemons include properties with extraordinary flip taxes, which may limit sellers' ability to negotiate, and buildings that don't own the ground beneath them....[read more]

I recall looking at flats in several buildings with ground leases, and upon learning about them, I just walked out.

I do not recall ever seeing a Times article warning about these risks during the upslope of the housing boom. How telling it is that this is now "newsworthy" during the press campaign to embolden buyers, not sellers, to bargain hard.

To "trend followers" I suggest adding the term "trend enablers".

Steve Leslie on Judo

The beauty of Judo is that it is a very subtle sport yet a very lethal one. In fact Judo means "gentle way" in Japanese. One soon finds out that there is not much gentle about it. It is still a martial art.

Judo is an isolated sport, often a lonely one. It is just you and your opponent and the battleground is the center of a mat in full view of the audience. There are no teammates, nobody blocking for you, and nobody hitting behind you. And no excuses. Plus, you are always in direct contact with your opponent. There is literally no let up and no time outs. It is combat at the highest level. Balance, strength and explosiveness are critical skills. And you have to be constantly aware of your opponent because one misstep one false move can instantly end a match.

Judo emphasizes fighting (randori) as its main form of training. Half the combat time is spent fighting on the ground, called ne-waza and the other half standing up, called tachi-waza. Actual fighting, albeit within safety rules, is considered to be much more effective than only practicing techniques, since fighting full-strength develops the muscles and cardio-vascular system on the physical side of things, and it develops strategy and reaction time on the mental side of things.

Judo's balance between both the standing and ground phases of combat gives judoka the ability to take down opponents who are standing up and then pin and submit them on the ground. A Judoka can also force an opponent to submit through a chokehold or a joint manipulation such as an arm bar. Thus multidimensional skills are essential to develop to becoming an accomplished judoka.

The skills in being a successful Judo champion and a successful speculator are very similar. Both require a great deal of discipline, awareness, and specific mastery of skills and techniques. Plus strategy and attention to detail are prime requisites for success. In addition accountability is paramount as there is none to blame for failure than oneself. In the end it is the combat, the battle, that determines the ultimate victor. There is no statistical bias no French judge who grades the combatant lower through political favoritism. The contest is decided on the mat. And the results are final. The vanquished accepts this and validates it through a final acknowledgment of bowing to an opponent who has bested him in the arena.

Bruno Ombreux offers some similarities between Judo and speculation:

Hard work. All the skills you mentioned can only be developed through hard work and practice. Provided weights and technical levels are not too far apart, the judoka who trains 4 times a week will beat hands-down the one who trains only twice.

Successful speculation is hard work.

Bruises. Pain in a full-contact martial art as judo, goes beyond muscle ache normally associated with sport practice. Shiai - the competitive form of randori - is very intense. First degree burns on the neck, resulting from judogi friction, are common. (judoki is the outfit worn by judoka). Passing out from strangulation happens too. Broken members also. My personal souvenirs from judo are a broken nose and a permanently paralyzed big toe.

Speculation is a source of bruises in the form of losses. One has to pay his dues.

Specialization. Every judoka has a "special". This is a throw that he excels at, often because his morphology is well suited to this particular move. For instance, morote-seoi-nage, a shoulder throw, is said to be favored by smaller players, because it is easier for them to get inside and under the opponent gravity center. The judoka trains his "special" more than any other move. He is going to use it a lot in competition. The idea is to excel at one thing rather than be average at many.

This analogy with speculation needs not be explained after Chair's post on Specialization and the Division of Labor.

Focus on the wrong the methods. For years, proponents of strikes-based martial arts like karate or kick boxing, proclaimed their superiority over wrestling styles, like judo, "a mere sport for schoolchildren". This changed with the introduction of "Mixed Martial Arts" fights. Evidence surfaced that in real-life, unlike in kung-fu movies, one-on-one fights with no limiting rules most often end on the ground after the exchange of a few blows, a grapple and a throw. The most efficient fighting style was Brazilian ju-jitsu, because of its emphasis on ground combat. But judoka and wrestlers also performed very satisfactorily.

In speculation, people focus on the wrong methods, as explained again, by the Chair in the first-half of Practical Speculation. Then reality kicks in.

Impossible mastery. It is impossible to master judo. It is an endless study. That is what the "do" in ju-do stands for. It is a "way". An endless voyage whose final destination is never reached.

This one is easy. Speculation too is a "do". An endless study in which perfection is unattainable, and the best one can hope for is improvement.

Principles and tradition. The other side of judo beside combat, kata, is a codified series of moves, almost like classical ballets. The first kata focus on basic throws, on mechanics. The last kata, which are learnt by very few people, focus on entirely different things.

Itsutsu no-kata, taught to 6th dan black belts, features only 5 throws which are supposed to contain the essence of judo. Those throws do not even have a name, yet they embody the principles of judo. They are simple, fluid, beautiful.

Koshiki no kata, taught to 7th dan, is an ancient kata from the Kito-ruy school of ju-jitsu, which was attended by Jigoro Kano. It is a throwback to medieval Japan's fields of battle, a series of throws designed for combat in samurai armor. Ideally, this kata should be performed in such armors.

Who knows what Jigoro Kano meant by the inclusion of these two final kata in his curriculum? It is perhaps that, in the end, one should focus on first principles and a study of tradition.

That is not too different from the site, focusing on principles is learning how to fish, reading old books is integrating ancient wisdom.

Education. I could go on and on drawing other parallels between the site and martial art education. Teaching by showing. Use of arcane yet limpid language, "when the yellow bird sings, the sun sets on the jade mountain, little Grasshopper". err.... Too many Hong-Kong movies. Haiku and people taking their shoes off before entering the dojo...

But that's not about judo anymore and I must trade the last half hour.

Dependent on the Wind, from Steve Ellison

In several of Patrick O'Brian's novels, Jack Aubrey's warship carries political officials to or from remote locations. Unlike the crew, these dignitaries are willing to directly state grievances to the captain or openly criticize the captain. In one case, Jack is told that an official has conveyed frustration with the slow passage. Aubrey asks incredulously, does this man not realize that these ships are utterly dependent on the wind?

Speculators are in a similar position. We try to profit by harnessing forces far larger than ourselves that we cannot control and that can be lethal at high intensities. Consider volatility, for example. This word has a negative connotation in the financial media. Volatility allegedly undermines the public's confidence in markets and dissuades some from participating. Consider, however, what would happen if there were no volatility. Like a sailing ship becalmed in the equatorial doldrums, using up its stores and surrounded by increasing filth generated by its crew, a speculator in a market with little or no price change can get nowhere. Such a market would become increasingly unhealthy if the lack of volatility persisted.

Open Water Swimming, from Andrew Moe

Conversation over a rollicking summer BBQ tends to magnify one's perceived abilities, especially when challenges of a physical nature are issued by the opposite gender. Somehow, the fact that I run a few miles every morning was transmogrified by my wife into my ability to swim a mile for charity, which does not sound too bad until they tell you it is out and back into the Pacific. As in swim 1/2 a mile out where all the big fish are, then high tail it back in. But no worries as it is a big event and there will be lots of swimmers in the water so the likelihood of sharks is very low. Safety seemingly assured, I plunged.

To prepare for the event, my runs were exchanged for a few days each week in the local pool, eventually building up to a mile. I learned the importance of rhythm and breathing and built a nice system tailored to my style. Stroke, stroke, stroke, breathe. Despite or perhaps because of no prior swimming experience, I made quick strides in getting up to the full distance. Paper trading like a champ, I began to envision a fast start and low time.

Heat 2 of the 77th annual Oceanside Pier Swim lined up on the cool sand at 8:45 AM. The surf was flat, but lifeguards watching Heat 1 advised of a strong drift south so the main pack started about 300 yards north of the pier with instructions to swim straight out and let the drift bring us back around. "But you're all experienced enough to know that," chuckled the lifeguard. I didn't get the joke until much later.

The horn sounded and around 150 open water vets sprinted into the water. Years of surfing provided an edge in getting out past the breakers ahead of the pack, but the early dash caught me out of breath as an unexpectedly large set rolled in just after our initial clearing. After fighting through the choppy monsters, I found myself sitting near the front but gassed from the effort.

Flipping over to do a little light backstroke and catch my breath, I was nearly mowed down by a churning mass of determined swimmers who had also just passed through the surf and were steaming out to sea like they just left port. Stroke, stroke, stroke, breathe went out the window as panicked reality was more like stroke, breathe, stroke, breathe, breathe, stroke, gasp, choke, swallow, stroke, breathe. Regularity turned Brownian in a hurry but what really scared the Hades out of me was the way the ocean looks through swim goggles.

In the pool, the crystal blue water provides a superb lens through which one can navigate lanes, lengths and laps. In the ocean, limited visibility magnifies the unknown. Terrifyingly long tentacles of kelp strain to wrap themselves around you and mysterious dark shadows cruise the murky bottom. It's like swimming across the top of a teeming rain forest. Gripped by fear, I chucked my goggles less than 200 yards into the race. CNBC had to go.

In the pool, I thought the water choppy when another swimmer was in at the same time. In the ocean, 3 foot swells quickly redefined my notion of a flat surface. At this most opportune time of embattled revelation, I became acquainted with the drift. Because I was moving slower than the field, the drift affected me more. That was good for a while, as it got me out of the grinding pack, but when I got too close to the pier, my perspective on drift changed.

Suddenly, it was like shorting a runaway bull and I had to fight my way back going 1/2 speed at triple effort to get around the outside buoy. I rounded the turn dead last, which is particularly bothersome considering everyone in my heat was wearing a neon green swim cap. We looked like bait. Discovery Channel aficionados know what happens to those who stray outside the safety of the herd.

But the turn for home was a rally point. It was like being down big all morning, only to have the market reverse and move back to breakeven. What a relief it was to be heading back. I found stroke, stroke, stroke, breathe rhythm across the swells. The drift became my friend as I plowed for shore.

Laying it all on the line as I approached the beach, I was suddenly lifted up by a breaking wave and slammed deep into the slop. Normally, I am good for about a minute under the surface. By the end of the race, I was down to about 5 seconds. Thoroughly mopped after a good thrashing on the way in, I staggered to the beach with about 1/2 oxygen, 1/2 seawater in my lungs.

Just when I thought I was out of the trade and done with the whole thing, I realized the finish line was another 100 yards up the beach through the soft sand. My kids were going nuts and the crowd was roaring so I pulled out all the stops and dashed for the line. It reminded me of chasing the ask as I try to unload a position into a dropping market. Every time I enter a limit order at the ask, the spread drops another tick and I have got to drop my limit, then it drops again. Like running in soft sand as it gives way before you.

But I finally crossed the finish line. Despite my poor performance relative to the competition, I did something I have never done before. I know I can do it again. All in all, I would say it was very much like my early days of trading futures. Reality is far different from theory. In the pool, you can always grab an edge. In the ocean, it is sink or swim.

A Market Analogy, from Scott Brooks

Since I have joined the spec list, I find myself looking for market correlations and market lessons in everyday life experiences. I had just such an experience tonight. I knew there was a correlation in this activity, but I was having trouble expressing it in my mind, let alone in a post.

My kids talked me into going out and jumping on the trampoline with them. First of all, as an aside: Jumping on a tramp is great exercise. As we were jumping all around, my mind kept thinking of connections to the market. We went up and down, we went sideways, and we fell on our behinds. We laughed a whole bunch. And there were even some injuries, and one incidence of tears.

Was the analogy in the up and down and sideways motion? Not really, that would be a stretch and too obvious. Was it in the physics of the trampoline. I could get some major height on my jumps if I built up a bit of momentum. But my jumps were, more often than not hindered by bad timing with the other kids jumping. If I was coming down to hit a big bounce, but one of the kids hit the tramp as I was coming up, it killed my momentum and made for a weak jump, and sometimes resulted in me falling. Maybe the correlation was that sometimes strong stocks within a sector can be hindered by the other weaker stocks within the sector, and of course that holds true for the market as a whole. I decided that correlation was a bit of a stretch too.

I knew there was a connection, but I was not finding it. So I just decided to have fun with my kids, going up and down, sideways, bouncing off each other, falling down, and even getting hurt, but then getting back up to continue having fun. I just released my mind of the task of finding a market correlation.

Then my knee really started to hurt. It hurt bad. But I was having too much fun to quit, so I kept going. I was just having fun. I love my kids and I love being with them and doing things with them. Then, as things often do, because I released my mind from the task at hand, the answer came to me.

It does not matter how much the market goes up and down, or sideways. It does not matter if I fall down in the market. It does not matter if it hurts, or abuses me or makes me feel like I am unhappy. I love the market the mistress. I love playing with the market mistress. I love being the in game. I don't care if she abuses me. I don't care if she hurts me. I keep coming back from more. I simply love the game. I love the market. I love the mistress.

Just as I find personal joy, happiness and personal satisfaction from my wonderful kids (even when they drive me crazy), I find professional joy, happiness, and professional satisfaction when I get to play with the mistress (even when she drives me crazy!)

I read this post before sending it to the list to my oldest son, David, who many of you met at the spec party. He liked the post. He also said to tell everyone, "hello".

Beneficent Circles, by Victor Niederhoffer

To what extent do vicious circles and beneficent circles work? Here is one that works for economic growth inspired by the division of labor:

Increasing the division of labor leads to enhanced output from improvements in the productivity of labor. This increases incomes and demand, and leads to larger markets. With larger markets, more division of labor can occur starting the circle over again. A break down in the relation between any of the links in the circle can stop the circle from working, and a negative chance in any of the sources can turn the circle into a vicious one.

A trading circle might work as follows. Good research leads to enhanced trading results, which leads to more capital, which enables more research to be made. The problem is that as you get too big, you tend to use up all the easy opportunities for profits in your field. And your research tends to bring you into new fields where you are not specialized to succeed.

How often do we see that when a system is applied to one market that it has never been tested for it fails. I understand a trader applied his methods for US stock markets once to markets in S.E Asia and went under by not properly taking account of the importance of the division of labor. On another front, I hear of a company that made most of its money by trading futures markets, applying its methods to individual stocks with the hubristic thought that the methods are transferable, and that brain power is directly related to success, and that foreign brain power is much superior to American. I wonder when the circle break down and become vicious in that instance?

Accident Prevention, from Pitt T. Maner III

I wonder if there are certain parallels between risk management in the financial world and the prevention of accidents at job sites.

When I first started my career as an environmental geologist about 20 years ago the emphasis at that time was on data validation of laboratory analytical results. In other words, if you collected a soil or groundwater sample and had it analyzed for petroleum or solvent constituents (volatile aromatic hydrocarbons, chlorinated solvents, lead, etc.) you wanted to make sure the laboratory provided you with results that were accurate and reproducible. There were many small labs and some not that good, so you had to check the Quality Control/Quality Assurance (QA/QC) of the lab reports closely -- bad data could lead to bad and costly decisions. Sort of like analyst reports?

As lab methods became more standardized and the environmental lab business consolidated and good labs rose to the top, QA/QC (while still important) was not as much of a focus for environmental consulting firms.

Today much emphasis in the environmental field is placed on health and safety of workers. Major corporations want subcontractors who will come to their sites and perform work (such as environmental assessment and remediation and construction activities) safely and without incidents. Accidents are costly events on a lot of different levels -- financially to the company and the person involved and emotionally to the accident victim and his co-workers and family.

In order to perform work now at many company sites you need to provide a health and safety plan (HASP) that will address the hazards you expect to encounter and what you will do if you run into those hazards. What telephone numbers do you call, where is the hospital, what actions are you going to take if X occurs, etc.? Identify the risks and plan ahead at all times. Avoid exposures to toxic compounds. Be trained in First Aid and CPR.

Now what is often seen in the field are risky work behaviors that can lead to serious injury or long-term disabilities. Why? Well, often the worker has been doing a task a certain way for a long time and he thinks the way he does it is acceptable and there is no reason to change. He does not appreciate or recognize the true risks in the way he does a task.

One old timer told me in the old days in Chicago it was considered perfectly acceptable for heavy equipment operators to go to lunch and drink ("pound") several beers and come back to work with a slight buzz and continue working.

In the field you try to make sure that people bring the proper tools for the job and the proper personal protection (i.e. hard hat, safety glasses, steel-toed boots, work gloves, etc.). You try to involve people who have the skills, the training, and the knowledge to do the work. And you always try to think of the worst thing that could happen in advance.

Now all this sounds rather dull and common sense but it is surprising to see how often one encounters risky behavior and how often a safety officer needs to remind people to protect themselves. People will do the darndest things to 1) Save time and be lazy; 2) Do it as usual when it is not a usual situation; 3) Be oblivious to the true risks -- i.e. not educated in the task at hand; 4) See no benefit in doing something safely; and 5) Be part of a system which encourages risky behavior--i.e. "macho men don't need no stinking protection".

No matter how good your loss prevention system (and some have been shown to be extremely effective) is, however, the major thrust is that the individual is the one who has to take charge of protecting himself. Like the fight referee says, "gentlemen, protect yourselves at all times".

Well like investing there are times when you can overprotect yourself too. If you go to a site with minimal concentrations of constituents of concern wearing a chemical resistant suit in 98 degree weather you may die very quickly from heat stroke!

Always you need to adjust your level of protection to match existing conditions.

Everybody wants a BONAR, from Jaime Klein

Woody Allen said that "hope is that thing with feathers". I read it in his memorable book Without Feathers. Why I am writing this instead of working? Because Argentina emitted a new series of seven year bonds and the demand was three times the supply. Figuratively, people pushed and trampled over each other to give their money to Argentina and get one BONAR. Only four or five years ago Argentina was broke and paid out its bonds at 20 or 30% of face value. Savers were harmed. People have no memory?

Thai BBQ, noticed by Steve Wisdom

Life for woman who BBQs husband and feeds him to tigers

The Thai woman who arranged for her English ex-husband to be barbecued and had his remains scattered around a tiger sanctuary was jailed for life today. Mr Charnaud had divorced Pannada because of her gambling debts and had been awarded custody of their son Daniel, now seven. (.. ) They tried to shoot him with an antiquated long barrelled musket but it backfired. They then beat Mr Charnaud to death with iron bars and a lump of wood. The killers placed his body on an already prepared charcoal barbecue then cut up his cooked remains and spread them around the tiger reserve. (.. )

Option Valuation Using Historical Stock Data, from Dr. Alex Castaldo

Thanks to a helpful hint from my colleague Vince Fulco I have recently become acquainted with an academic paper that I do not think I had seen previously, and would like to remark on:

Michael Stutzer: A Simple Nonparametric Approach to Derivative Security Valuation, Journal of Finance, Vol 51 #5, December 1996, pp1633-1652

As my friend Kris Falstaff often points out, the Black-Scholes framework for option valuation is based on an erroneous assumption, that stock price changes are lognormal. Of course alternative models can be and have been developed, such as those that incorporate jumps in prices and fluctuations in volatility, to get around this limitation. But then Kris could reply "that is not the real stock price process either."

A more radical approach is to make no assumptions about the distribution of stock price changes but just use the actual changes that have been observed in the past. This would amount to using a histogram of price changes instead of an analytical form for the distribution (for example the lognormal form). If the observation period is sufficiently long this should give an accurate representation of real life stock price changes. This can be called a 'nonparametric' approach or a 'historical' or 'empirical' approach to option valuation. ('nonparametric' in this context simply means "without assuming a distribution"). The Stutzer paper gives a simple procedure to implement this approach.

In brief there are three steps:

  1. Using a large amount of historical price data, compute the empirical distribution of stock price changes over the time horizon T of interest (T= the maturity of the options we are trying to value). This gives a vector RH of all the possible price changes that have occurred over intervals of length T, and a vector PIHAT that assigns a probability to each. Since we have no reason to assume any one outcome is more likely than any other to occur in the future, all the entries in PIHAT should be the same, i.e. an equiprobable distribution. For example if we have 1000 different entries in RH, we should set PIHAT(i)= 1/1000 for i=1 to 1000.
  2. We transform the empirical distribution found in (1) into a risk neutral distribution. Stutzer argues this should be done using the Kullback-Leibler Information Criterion. The vector of possible outcomes RH remains the same, but the probabilities PIHAT associated with these outcomes are replaced by a different set of probabilities PISTAR. The beauty of the Kullback-Leibler Criterion is that it gives an explicit, relatively simple way to compute PISTAR:

    PISTAR(i) = \frac{exp[\gamma RH(i) / r^T}{\sum_j exp[\gamma RH(j) / r^T}

    where \gamma is a constant given by another relatively simple expression, and r is the interest rate.
  3. We can now compute the value of any option (or other European-style derivative) by taking the expectation of the payoff under the risk neutral distribution. For example to value a call option we would compute the expectation of Max[S-E,0] over all scenarios contained in the RH/PISTAR vectors.

It is a very interesting algorithm. The part that I am not completely convinced about is the idea that the Kullback-Leibler criterion is the correct one to use to find the risk neutral distribution; Stutzer has an explanation that makes it sound plausible, but somehow it was not completely persuasive (or rigorous) to me.

This is the best published paper on empirical option pricing in my opinion (although there are not many published), and it forms the basis for Emanuel Derman's Strike-Adjusted-Spread concept, that we can talk about next time.

Laurence Glazier comments:

This is very interesting and it would be good to see a worked example. It does rest upon an assumption that previous stock price movement is to some extent predictive of the future. Can we test if this is so? Also if Black-Scholes or similar is universally believed in by options traders does that not make it effectively true in a cultural context? I would be most interested in pricing theory to see an account made of the latent energy of an option, i.e. as the stock drifts slowly up, the option is gearing up, tensing to jump to the next level, and we want to identify this point so we can buy just beforehand. I am thinking here of a spiral motion up from a kind of Argand plane -- when a full revolution is made the real option price moves up.

I think the weakness of Black-Scholes is the use of Vega, which is like the god of the gaps. It is a truly useful piece of social engineering, however, which enables the industry to run.

Fed Model: The Last Four Months of the Year, by Tom Downing

In the table below, I have classified August to December returns for the past 27 years into 3 groups. A positive differential (Forward Earnings yield - 10 yr yield) has boded well for stocks. The current differential is about 2 percent, so the expected return is greater than 5 percent. Note that the unconditional mean is 3.89 percent for the last 4 months of the year, so the results are not as statistically impressive on that basis.

Also note that since 1979: when the differential has been greater than 0, the S&P has never dropped more than 4 percent (ignoring draw-downs) from August 31st to December 31st.

     GROUP        AVG        STD      N       T     %POS     MAX     MIN
--------------    -----     ------   ---     ----   ----     ---     ---
     DIFF < 0     0.07%     12.26%    9      0.02    67%     14%     -25%
 0 > DIFF > .01   5.38%     9.96%     9      1.62    78%     28%     -4%
     DIFF > .01   6.22%     7.08%     9      2.64    78%     18%     -4% 
     ALL          3.89%     10.00%    27     2.02    74%     28%     -25%

Upstaging Tom Cruise, from Dr. Mark Goulston

A super star does not a super apology make, but you don't have to be a superstar to make one.

Tom Cruise recently went over to Brooke Shields' home and apologized face to face for putting her down about taking meds for her post-partum depression. She not only accepted his apology, she had him join she and her family for breakfast. You don't have to be a "superstar" to give an apology and you can do something that even they don't do. You can give a "super apology."

Here are the five steps to making one, all done while looking the other person in the eye (to demonstrate sincere remorse which is the cornerstone of the process):

  1. Say what you did wrong
  2. Acknowledge how it hurt, disappointed, frightened or upset the other person
  3. Admit you were wrong to do it and then apologize
  4. Say what you are going to do to correct it and make sure it doesn't happen again
  5. Ask those people you upset how you can make it up to them and then do it.

Michael Olds comments:

Dr. Goulston's response is well said from his point of view.

In the system of ethics taught by Gotama Saccyamuni [aka The Buddha] the manner of handling the situation where one has perceived that one has made an error in ethics is different than this. Gotama's manner of handling error might be found to be instructive here in your forum where there is clearly an effort being made to see things as they really are. In Gotama's system the process would better be called 'making conscious', and goes as follows:

  1. Approach the individual transgressed against stating words similar to these: "Friend, I have committed a blameworthy, unsuitable act that ought to be admitted. I admit it."
  2. Say what you did that you perceive needs to be admitted by describing your understanding of how what you did is wrong according to your system of ethics. Here, in Gotama's system, in highly simplified form: A) What was said was said knowing it was an untruth, B) What was done was done with intent to injure either mentally or physically, C) What was done was done with intent to take the un-given possession of another.
  3. Ask that your admission be acknowledged as heard by the injured party with the intent that by having admitted it, brought it to consciousness face-to-face with the injured party where it cannot be easily forgotten, and where it will be easily remembered, future restraint will have been facilitated.

It will be seen that in this system there is no assumption that one understands what was experienced by the other person as a consequence of one's actions or to correct the situation.

This is because in this system there is the understanding that however much one may practice empathy there is known to be variation in beings which is largely beyond the scope of understanding of the ordinary person and which results in individuals being altered by events in various ways. We do not assume to know all.

With regard to correcting the situation it is understood that what is done is done and cannot be corrected. On the other hand there is no problem with expressing empathy ["I can imagine how I would feel..."] and doing a good turn for someone one has injured [compensating a person for losses incurred as a consequence of trusting in one's word, returning something stolen...perhaps manyfold, paying for medical care, and so forth].

In the case where one is unable to find and face the injured person this making conscious can be done face-to-face with some highly respected individual.

There is no expectation of 'forgiveness'; that is a thing that the injured party does for their own good. Should the injured person refuse to acknowledge having heard one's admission, that is considered their problem.

A Labor Day Lobster Hunt, from Jim Sogi

A couple of years ago my surfing buddy and I went up north to the uninhabited valleys and had quite an adventure [read about it here]. We had always wanted to bring the family to show them this magical place full of ancient history and feeling, that was now deserted and overgrown with ancient ruins of temples and habitation from a millennium ago. We felt like we were approaching Jurassic Park.

The Labor Day Opening of Lobster Season hunt is becoming an annual event, so this year we took Sunseeker, a 61 foot Hatteras, and went in comfort and style, with hot showers, air conditioning, microwave ovens, stereo, TV, video, top flight dive and fishing gear: the works.

As we approached the valleys, my wife, a hula practitioner, recited the appropriate ancient Hawaiian chants and we left appropriate offerings to the local gods and powers that be in the valley. The locals call the feeling "chicken skin" , but you may know it as "goose bumps". Strawberry guava and lilikoi were in season. The stream with waterfalls gurgled in the bright tropical sun and we hunted crawdads and shrimp as we made our way up the valley. We saw where wild boar rooted. The big waterfalls off the towering cliffs threw sparkling diamonds of light and rainbows on the green sea foam while surfing the waves along the base of the cliff. Flying fish jumped out of the water and flew for dozens of yards ahead of the boat's wake. Birds hunted back and forth on the ocean searching for fish, and we followed the birds. The shore was covered with driftwood and we collected great canes and walking sticks. I wish I could have brought one back I found one that looked like Gandalf's staff for Vic and Laurel. I found out how useful they are when traveling through uncharted rough overland terrain to keep ones balance.

Despite the comforts oddly the big yacht was not as seaworthy as our primitive small Hawaiian outrigger canoe designed 1000 years ago with two intrepid adventurers with paddles. Despite relatively mild conditions, the big yacht could not stay overnight up North and could not handle the local conditions. Expensive chairs were tipping over and breaking. The crew scurried around fixing breaking things: a million things to break. When we went last time, the waves were 10 times bigger and the wind much worse, and we stayed without a problem overnight. The captain was cautious compared to how aggressive we were on our last trip with very basic, primitive tools. However, with the wives and kids along safety and comfort were the overriding concerns.

As always, I could not help but make market connections.

Carly Haiku, a Continuing Series, by George Zachar

Sept. 6 (Bloomberg) -- Hewlett-Packard Co. is being investigated by California's attorney general to determine whether the company broke the law in discovering the identities of board members who leaked confidential information to the media. (.. ) Fiorina, who was fired after more than five years, said her ouster came after she had a "fundamental disagreement" with board members about management changes they sought. In October 2005, she criticized unnamed directors for providing details of discussions that took place in January of that year to the media. "When confidential board conversations become public and what should stay inside the boardroom goes outside the boardroom, then a very important bond of trust is broken," Fiorina said in response to a question after a speech at the Massachusetts Institute of Technology on Oct. 7.

The boardroom antics
at HP never end. It's
like she never left.

She threatened Deutsche Bank,
and table-hopped at Davos.
Carly's "bond of trust"?

HPQ's leakers
forgot the obvious choice.
Dude! Use a pay phone!

Steve Wisdom adds:

A coup in progress?
She's hearing whispers from her
hair and makeup guy.

The Salesman, from James Bitumen

Several months ago, Victor wrote a beautiful post on The Salesman. "When you call a man a salesman, you flatter him," I think a quote from the piece read. It stuck in my mind, as did, "Nothing in the world happens without a sale being made." It was a piece that would flatter anyone associated with the art of sales. I took great comfort in it at the time, as I had recently returned to a sellside platform on Wall Street, mainly because I felt that the opportunities on the sellside, and the less rigid structure, offered a much greater reward in comparison to the rewards offered to a manager of market risk who is forced to operate under buyside confines best defined as ignorant, inept, and hypocritical.

But sales, as an art, is dying, at least in the industry we refer to as Wall Street. Yes, there are "research sales" people who still get all excited when a firm analyst comes out with a new recommendation. They make the call into the portfolio manager's office or analyst. "John, how are you? So nice to take my call. Listen, I have some really important things to discuss, but we will get to the dress your date was wearing the other night at the gala in a second... No, John, this isn't Mike from Buckingham. No, this isn't Mike from Weisel either. This is Mike, the guy with the Salsa moves from Pru... Now you got it, listen, about Ann Taylor, we love it today." Everyone is saying the same thing with the same routine. Institutional sales people still get goose bumps when calling a customer to schedule a meeting with the CEO of that new growth stock, but at the end of the day, they are just appointment makers. And the hundreds of firms making hundreds of appointments is disastrous.

What is even more scary is what happened earlier in my day. I had a conversation with my friend Tom, who recently made the switch from the still-in-existence telemarketing department of his firm to the institutional sales side. He only knows telemarketing of the retail kind, and he is not going to change his approach whatsoever. He has no research, just his own ideas. I am not so inclined to believe that such an approach is going to bring Tom a windfall in commissions from all of these hot hedge funds, but all sales efforts need enthusiasm and encouragement if they are ever going to get anywhere.

Here's a transcript of our Instant Message dialogue. I love Tom like a brother and I had to play along with him so that he would be excited and not lose enthusiasm to go out and write some tickets.

Tom: I am telling you, it isn't so often I get an idea like this one. You ready for it?
Me:  Go
Tom: NOC. You love it already, don't you?
Me:  I don't really know anything about it to be honest. What do you have?
Tom: Think of the geopolitical mess going on around the world. It is a nightmare
     to say the least. First, 9/11 -- the US and world starts to militarize. Then 
     Iraq, Korea, you with me?
Me:  Yeah, I guess so.
Tom: Militarization is only going to continue -- everyone is going to continue to 
     build arsenal and these NOC guys can't go wrong.
Me:  I suppose that could be the case, but I am on the other side. A Democratic 
     landslide in the elections is a risk. And, that combined with a world that 
     will politically and culturally start gravitating back to the left is going 
     to be major inflection point in the business cycles of anything defense.
     Buy the cheap long-dated puts -- your risk is clearly defined.
Tom: Great thought, but you have to admit, defense is not a partisan issue, and 
     you can't tell me America, as a nation, wants to be less safe. 
Me:  So missile buying continues or escalates. Good luck with that. Anything else?
Tom: It is, no pun intended, defensive in a lousy market. Ha Ha Ha. Isn't that great?
     Gotta love the chart, decent forecast. This is a fast trade with a tight stop. 
     Why don't you give me an order to buy 50k and let me trade it for you?
Me:  No thanks, but good luck with it. Appreciate it. But keep me up. I am too 
     wrapped up taking all of the time off from my screens for these meetings.
Tom: Time off is time lost from making money. In fact, you are going to lose money 
     by not having it on. Do want to lose money?

I am not going draw any brilliant conclusions here, but these examples are evidence that the salesmanship of today cannot beanything like of what is used to be, and this might be presenting all sorts of problems for Wall Street. This in no way is a prognostication of an unfortunate market direction, but it is representative of the times.

Dr. Kim Zussman reviews The Devil's Eye

Don Juan the famous lover was dead and condemned to hell. Each day he awakes and chances to meet another lass who he proceeds to woo, until at last she begins to fall into his spell. Only just at the moment petals are quivering to fall from the rose, he would snap instantly back to the breeches of hell. This act he repeats every day, for an eternity of infinite frustration for Mr. Juan.

After much pleading by Don Juan to end his cycle of torture, the devil finds himself suffering with a sty. It turns out a vicar's daughter is still a virgin, and in seek of a cure the devil gives Don Juan a task to earn peace and be released from his condemnation. He was given one day on the surface to seduce the vicar's daughter, and if successful, he would be allowed to finally rest ...

The irresistible Don was ecstatic -- this would be easy! Up he went, and proceeded to work his unfailing magic on the lovely girl. She was a nubile blond maiden (there are lots of them in Sweden), 30 years his junior, graceful and sweet like a dream. Don proceeded to charm her, and though she resisted mightily she began to weaken. Yet before he could make the move that would save him from eternal condemnation, paradoxically something happened to him for the very first time. Don Juan fell in love.

He was tormented now. Could he violate his one and only love in the name of the devil, just to save himself? Even worse, his eternal charm began to flicker as he fell deeper in love with the girl, and his love made him look weak and pathetic to her.

Needless to say, Juan's infinite quests continue to this day.

Read Martin Lindkvist's Letter of the Month Winning Post, Keep Out of Those Switches!

Steve Leslie comments:

I re-read Martin Lindkvist's award winning post for June and I think we would all do well to keep it in our files for regular reference. I add these bullet points:

The list goes on and on, the point being that nobody does anything perfectly and to suggest so would be a canard. You cannot avoid the unavoidable. Remember "a big shot is very often a little shot who just keeps shooting." -- Zig Ziglar

When Doomsdayists are the Photographers, from Russell Sears

I consider myself lucky that my studies of the markets began with Investments by Bodie, Kane, and Marcus. Then before I could be corrupted, I started reading Vic and Laurel's books. The study of "Investments" begins by reading the difference between "real assets" and "financial assets". Then it explains their relationship to each other. How financial assets are used to transfer real wealth. This foundational underpinning often will clarify the fallacy in the arguments of the prophets of doom.

When the doomdayist is the photographer, one of the most common deceptions is to magnify the problem, then focus on only one side of the picture completely blurring the other side. He artistically crafts this clear snapshot of one side of the current state. Then he imagines a future world with both sides, but doomed to failure because of its imbalance.

Being interested in demographics, I often will read articles about the impending boomers retirement. This also is one of the doomsdayist most fertile grounds. The USA's boomers, the most productive generation in history will go from being a net producer of wealth to a net consumer. Transfers of this wealth will occur, either through boomers life or at their death. Because many in this generation have amassed a fortune, framing such pictures to imply your prophetic ability is a rich field. Also boomers want to know how this transfer will occur, to determine how to position their wealth. Do you hold "real assets" or "financial IOU's"?

Because of this great wealth, it is the rare author that will take a balanced look at how this transfer of wealth will occur. Often I find articles that will use the actuarial approach to the boomer's problem, that is taking the present value of future benefits then look at the current US debt and add it on to this social security present value and perhaps throw in a the present value of other future government debts.

All of this is put in fiscal terms, with mind numbingly large numbers even the most numerically literate has trouble understanding. The real wealth currently held by the US and the boomers is an ignorable blur. The conclusion is that the only solution is to devalue this debt by inflating your way out of it. Therefore you hold "real assets" such as gold, a doomsdayist favorite. This is of course what every generation X, Y, and Z'er will want; gold, hard assets.

This perhaps shows the brilliance of Mr. Gross's recent article No Cuts, No Butts, No Coconuts. He, like a good doomsdayist photographer, magnifies the problem. But unlike the fiscal doomsdayist, he focuses on the real imbalance. That is that the boomers have the real wealth, and the demand for that wealth will decrease. He uses housing as the basis for every real assets. He insist there will be a slowing of demand for housing therefore implies a slowing of demand for everything real. He implies that you especially do not want to hold a real company producing real wealth. He implies you certainly do not want to bet on the US, the current largest holder of the world's real wealth.

The intended message of this deflation is of course you want to hold bonds, or fiscal assets. Remember he is the biggest bond salesman around.

I would suggest that the truth lies somewhere in between. Boomers will have to transfer that wealth to someone. Generation X, Y and Z'ers clearly will not have to work as hard to obtain that wealth as the boomers did.

However, much of this ease in effort to meet needs will be due to increases in productivity, not totally inflation. There will be a slowing of demand for some assets, and a growth in demand for others. The more we look to the emerging markets to make up the shortfall in human capital, the more basis goods will be in demand. The more we look inward the more scientific discovery, quality and artistic expression, the human element, will be valued.

The younger generation will not lose an interest in obtaining wealth once their survival needs are meet. The US will not suddenly lose its real wealth advantage to motivate others. Neither will it loses its foundational ability to through creative destruction and nurturing of the individual spirit to produce wealth.

There will always be problems to solve and people reaching for the stars. In fact I would argue that, in a world where the fundamental shortage is human capital, in this world the wealthiest nations will be those that give the individual spirit the most freedom, not just the nations with the most humans.

Scott Brooks adds:

I have said this before, and I will say it again (even thought I am resoundingly ridiculed for saying it); losses hurt you more than gains help you.

If the premise of the long term positive drift of the market is true (which I believe it is), then getting good returns is simply a function of "showing up at the party". All one has to do is be there to get good returns. Unfortunately, getting good returns is not good enough.

Human beings are ruled by a two sided coin: greed and fear. When things are going well, we and forget the adage that "things are not as good as they seem", or worse yet, we think we are smarter than we really are. So we get greedy. "Hey, look at my returns, I'm pretty smart...so If I'm smart enough to get these returns, then why not go on margin, leverage the money and double, triple, quadruple my returns!"

And of course, you remain a genius, and/or your intelligence increases in direct proportionality to the acceleration or momentum of the "positive drift of the market" until the momentum or positive drift stops. Then you find out, in a very painful manner, what a margin call is.

Maybe you are not leveraged, maybe you just bought into the "safe stocks", argument, or the "new economy" stocks argument, or the "positive earnings" argument. And your newly acquired personal genius told you to hold onto to Cisco at 50 because it was recently up at 80 and it should be worth at least that much. Or Coca Cola, because it had positive earnings growth all thru '00, '01, '02. Or because the long term positive drift of the S&P 500 said keep being "long" even though the 1550 high ('00) is where it should be and not at 755 ('02) it got down to or even the approximately 1300 it is at now.

You see, it is during these times that the other side of the human nature coin rears it ugly head. Fear! Fear leads to rationalization. It leads some to be afraid to sell for fear of missing out on a big run ... and thus they ride Cisco down to 12, or Enron to pennies, or Global Crossing to zero! Or maybe you sell after losing half your stake, and you become fearful and indecisive as to when to buy ever again, and the first time the market hiccups, you panic and have sleepless nights, and ulcers.

It does not matter how well you do when times are good. It does not matter how much you make during the market that has such a "positive drift" that tow truck drivers can buy an island, or dot com companies can advertise a monkey playing around in a suburban home garage for 30 seconds during the Super bowl and not even mention their name or what they do (or when tulip bulbs go from $1 to $600 and someone named Newton who missed out on the rise from 1 - 600 finally decided to jump on the tulip bandwagon). It does not matter during those times. What matters is how good you are during the bad times!

It does not matter what you make, it matters what you keep. It doesn't matter if you get 10,000% return, if you lose it all during a market hurricane.

The beaches of Florida may have long term positive effects on human beings (sunny days, warm weather, refreshing water), but you better get your butt off that beach when a hurricane is coming. Why? Because its hard to enjoy the beach if you are dead.

It is hard to enjoy the long term positive drift of the market if you have lost your nest egg, seed money, portfolio, clients, etc. Therefore, I submit to the site that the most important activity for any of us, is to become absolute experts at determining what is the likelihood that the markets are likely to decline. Therefore we should discuss what are appropriate courses of actions to take during those times. How do we recognize them? How do we know that the risk levels in the market are elevated?

What I am saying has nothing to do with being a bear, or discussing fear. It has to do with reality. How do we achieve good solid returns during the good times, and then preserve those gains during the bad times so that when the bad times are over, we have our portfolio intact and we can ride the new long term positive drift (the next wave) of the market again.

Why do I suggest this? Because losses hurt you more than gains help you!

Steve Leslie comments:

Nietzsche said that which does not destroy you makes you stronger. I say that depends on a person's evaluation of the experience. It hurts more when it is personalized.

Behavioral psychologists tell me that people avoid pain more than they seek pleasure. Or more importantly perceived pain. I am not a behavioral psychologist so I will allow some others to chime in.

After a plane crash people are reluctant to fly in a plane even though they stand a far greater chance of being killed driving to the airport. From personal experience I know that losses stay longer in your memory than wins. I can tell you every bad hand that has knocked me out of a major tournament. Or the putt I missed that cost me the club championship.

Everyone says they want the ball at crunch time but only a few of them really mean it. The rest hope that they are not called upon to face Mariano Rivera with the game on the line. Or having to make a knee knocker to go into a playoff with tiger Woods. (See Chris Dimarco at the Masters).

How about this one. Get a 50 percent return for 2005 receive your industries highest award CTA of the year, and then have a few months of drawdowns. Now you are a heel. It goes with the territory. Schadenfreude is ubiquitous.

It is a lot easier to be average or above average than it is to be exceptional or superior. It takes different wiring. Most analysts and all Re-elected politicians understand this, at least those who have long careers.

Dr. Kim Zussman contributes:

One hypothesis is that bull and bear markets have some correlation with the investment lifetimes of generations living through various markets.

For example my parents, who lived through the depression, did not own stocks when they were young because (besides not having much money) they had directly witnessed ruin. It was not until a close family friend did well in the bull of the early 1960's that they bought in the late 60's, and held down through the mid-70's. Thus from then on they eschewed stocks, pronouncing the mantra "Lost $20,000 in the stock market".

Undoubtedly there were many families burned like ours who got and stayed out by the end of the 1970's. By then, boomers only vicariously touched by the bad market of the 70's were becoming flush enough to buy stocks and help fuel the great bull that ensued.

So if painful memory of investment losses has lifetime effects in many people, this could explain some of the decade-length duration of bull and bear markets. And what effect, if any, the 2000-03 decline will have on the current cohort would seem to be a vital question.

Scott Brooks replies:

All good insights, but I am not talking about just having some losses, I am talking about having a methodology to measure risk and the likelihood of downturns. How does one survive 1968 - 1982, or 1939 - 1946.

It seems to me that long term secular bear markets can be devastating to the long term drift theory. Just as a hurricane can damper the Florida beach experience. Markets seem to go thru long term secular trends. The last great bull basically lasted from 1982 - 1999, the one before that from 1950 - 1967.

If one looks at a chart of the long term market one will see that the long term bull cycles are punctuated by basically smooth sailing with the wind blowing pleasantly in the direction that we want to go. All one has to do in those markets is basically index and let the markets blow you to prosperity.

But if one looks at the long term bear cycles (for the sake of this discussion, a long term bear cycle is one where the market goes down and then takes many years to get back to its past high levels...i.e. it hit a high in 1968, proceeded to go down, and then did not get back to that high until 1982), one will notice that they last a long time (usually longer than a long term secular bull cycle) and one will notice that, unlike the smooth sailing of the long term bull markets, they are punctuated with extreme volatility.

Now I know that there are/were big downturns in the last bull market (1987, 1990, 1994, 1998 just to name a few) but they were quick. They went down, and within a short period of time (less than 18 months in the case of 1987) they were back to new highs. All I am saying is that there has to be a way to preserve capital during these downturns. There has to be a way of measuring the likelihood of their occurrence.

Make no mistake about it. I am a bull. But it is my job to be realistic about the markets, asses them and figure out a way to make my clients money. I do not care if the market is going up or down. It is my job to:

  1. Preserve my clients capital
  2. Grow my clients capital
  3. Perform actions 1 & 2 with the least amount of risk necessary

So, my questions to the are simply:

How do we reliably measure risk? How do we manage the portfolio's during higher risk times? How do we make a profit when conventional methodologies (i.e. long term drift) is out of favor, or when our personal pet systems, markets, sectors, regions, investment types, are out of favor, because they are experiencing a long term secular bear market?

Abe Dunkelheit contributes:

Marcel Duchamp, the famous French artist, was sharply criticized for his attitude towards the French Resistance in WWII. Instead of fighting against the Nazis he emigrated to the United States. In an interview he explained his attitude. He said to him it appeared that in any conflict there is a third alternative besides fighting for or against a perceived evil, which is withdrawal! Of course 'withdrawal' is a highly individual response to conflict; it cannot be the strategy of a whole nation. No wonder that such an attitude must seem to be anti-patriotic from the group's point of view.

The idea of long term investment is an illusion because investors as a group cannot survive the bear market periods. (The individual can but not the investors as a group.) The paradoxical situation is that the illusion of long term investment is necessary to keep the economy going. If we look at the wealth of the nation as an aggregate we see it growing; but if we look at individual lives we see much misery. Why is that? Because the wealth of the nation comes at a price! The price is the sacrifice of personal happiness. The welfare of the group depends on behavior that is not good for the individual! For the whole nation the investment meme is good but for the individual it is not!

What can one do? One can develop extremely individual solutions. I think one must become extremely individual in order to survive bad things which tend to hit whole nations. One must totally stay away from the crowd and eradicate anything which is crowd-like in one's own bosom. A lot of unconventional thought must go into the question of 'investment' but nothing definite can be said in an email.

There are many unpleasant truths and one must look at them. "When killers stop killing they get killed." (A wise gangster in a movie.) I do not know if I can make myself understood. What I am basically saying is that 'investment' cannot work for the many, not in the way it is advocated; it works only for the few, but in order to work for the few it needs the many. The whole thing, from a humanistic point of view, is perverse. Trading is not 'human', neither is 'life'. Yet, paradoxically, the long term effect of this 'inhumanity' is economical growth and prosperity, which is good for the group, at least in theory, but comes at a price, which is the sacrifice of the individual, because the individual member of the group ('the many') must be tempted to act in ways which are, from the individual point of view, not good.

As an example for unconventional ways of thinking/acting I studied how to lose money. It is said, people hold on to losers and cut winners. Some time ago I opened an FX account and traded such a strategy: buy low, sell high, based on hunches, otherwise hold (no stops). I did 100s of trades - and broke even! I had a dozen big losers which offset the 95% small winners. Now that was a basis to work from; I gained some highly precious insights from this experience. I learned, for example, that it is not wrong by default to hold on to losers and cut winners; what is wrong is doing this without regard to the liquidity process.

Among many other things, I noticed the unhealthy tendency to increase exposure after a particular market had gone up! In my opinion that is the real reason why people lose money. They tend to do the right thing after experiencing it was the right thing - only that it is now the wrong thing.

I also noticed that trading in and out of stocks is not increasing profits; but dramatically reduces drawdowns. I further noticed that profits tend to come 'like thieves in the night' - rather unexpected. I learned I cannot predict and do not predict. 90% of what I am doing is exposure (or inventory) management. No single decision holds meaning to me; I look and think in terms of the 'whole'. My trading tended to be highly fragmented and I had to stay focused all the time which was draining. Now I am still trading very actively but with a detached attitude, rather disinterested in any particular move. I hardly ever react. Almost all of my trades (entry/exit) are placed before the markets open. I also noticed that when the markets turn busy that this does not necessarily mean I will trade more; it means I will think more!

Finally, I was surprised how small but good decisions can add up to quite substantial profits. There is more to it, like a positive attitude; also useful is following news in conjunction with particular moves. I noticed that moves in individual stocks are often explained by news that are already known to the market for a week or more (like DELL); also that stocks can go up with hardly any comments (like EBAY). I also realized that it seems to be a good time to buy a stock now and not later when people recommend to buy it not now but later (like AMD).

Tom Ryan mentions:

In reply to Scott, it seems to this rather sunbaked speculator that there is an inherent conflict in logic here in the sense that having a long term goal, in this case growing capital, but an operational plan that is geared to minimizing a negative event in the very short term (preserve capital), well this will always produce a sub-optimal solution. if a client comes to me and says five years from now I want to look back and have made a 15% CAGR (doubled my money) but I don't want to suffer more than a 25% loss in any one year, then the reply has to be that really, they do not have a five year plan, they have a one year plan for each of the next five years. In other words the short term operating constraint always overrides the long term plan. Always.

As for risk, there is absolutely no reason for anyone to hire a money manager in order to pursue below average market risk as anyone can do that by calling 1-800 VANGUARD and apportioning the appropriate %s to stock and short term bond index funds to get whatever risk level they want. The only reason to hire a money manager is, to use Tim's phrase, to "pursue alpha". Now all strategies to pursue alpha boil down to one of two things, either selective/focus of positions (hopefully into things that will do better than the market average), or increased turnover of positions (trading). Theoretically, therefore, it is not possible to pursue alpha without above average risk. And yes, before I get 15 replies to this email (including from Melvin) it is possible to show in retrospection how someone or some strategy achieved higher returns with below average volatility or risk in the past, but theoretically, from day(0), all alpha pursuing non-indexed strategies have higher than average risk.

So at the end of the day the issue of how to grow and preserve capital at the same time, or grow capital whilst minimizing risk, can not be solved without proper definitions of risk, such as target CAGR, the significant time horizon, maximum leverage allowed, and what constitutes impairment of capital. Even with these factors mathematically defined, the solution will always have to be probabilistic rather than deterministic because we can only use the past behavior to construct general distributions which can guide us as to future expected behavior. Hence we have come full circle to my first assertion that there is a logical conflict between growth and preservation of capital i.e. your items one and two.

As a postscript: I suppose the one other reason for a layperson to hire a money manager even if they are not pursuing alpha would be to avoid fraud risk as brokers are subject to fraud from time to time. but fraud risk is hard to detect beforehand even for professionals as the past 10 years has repeatedly demonstrated. You can probably achieve the same effect much easier simply by some diversification.

Russell Sears adds:

I would disagree, short term draw downs do not always out weigh the long term goals, just usually. To paraphrase a recent conversation I had with Gordon H. "Principle protection is currently the biggest scam on Wall Street." Anybody that understands indexed options could design a plan that maximizes your exposure to a market, but limits your yearly loss.

The problem is two fold. One, doing so causes you to give up tremendous potential earnings, opportunity cost is high, as you suggest. Second, most advisers on Wall Street upon hearing this their mouths will salivate, they spotted the chump at the table.

How, do you get the client to understand you cannot make money without taking risk? And how do you explain that such a "no losses allowed" strategy, is a chump strategy that those without any integrity will gladly execute at your expense?

I wish I knew the answers, to that last one especially. My current strategy is to assume that most people with money are comfortable acknowledging "business risk", and you have to take business risk to make money. So I try to present "investment" risk as diversification of their current risk... it just has solid $ figures attached to it.

Buy and Sell Orders, from Dr. Phillip J. McDonnell

There are two types of buy / sell orders. Market orders are orders to be executed immediately at any available price. Limit orders are orders to be executed only if the specified price or better is reached. For all practical purposes the market maker bid-ask quote can be viewed as a limit order. The combination of market buy/sell and limit buy/sell gives us a total of 4 possible orders. To that we can add the cancellation of limit orders for a total of 6 possible type of trading orders. The case of cancellation of market orders is effectively eliminated because presumably the execution occurs so fast that there is no time for a cancellation.

So the interaction of these six orders is what determines a market. For a long time little was known about the distribution and interaction of these order types. The market micro-structure was a black box to most. However some early researchers, notably Vic and M.F.M. Osborne, studied the structure of markets. Vic went so far as to examine time and quote data when it was not widely available and to get permission to analyze specialists' books on the exchange in the 1960's. The findings are outlined in Education of A Speculator. A couple of key ones are:

Today markets are a bit more transparent in that the order book is often available to participants willing to pay for it. However this opens up a new dimension of deception not previously available. Many orders are large bluff orders which are immediately canceled. Other gamers will repeatedly place and cancel an order at one second intervals. First this will create an aura of flashing quotes on a real time updated quote screen. Anyone who has ever seen the mesmerizing effect of a slot machine with its myriad blinking lights will quickly get the idea. The blinking lights have replaced the old time hypnotizing effect of the mindless ticker tape forever droning on.

Another trick is when there is a fairly small order on the bid or ask side and the gamester wants to attract attention to that side of the market hoping for someone to take the limit order out. They will use the same 1 second alternating big order then cancel routine to attract the eye just to the bid or the ask side of the quote. It reminds one of the mythical seductive sirens of ancient mariners seeking to lure the traveler over to the bid or ask side simply by attracting the eye.

The net result of the greater transparency has been to increase the deceptive aspects and the gaming dimension of order analysis. In addition effective analysis of order flow is now a job for a computer. Humans simply cannot keep up with the rapid fire order placement and cancellation. Even though the analysis is more difficult now compared to when Vic did his seminal studies of order flow at least we have the data.

Ohio's Oldest County Fair, from Pamela Van Giesen

Every year I venture back to my roots to visit the Geauga County Fair where it often seems that time has almost stood still. Hoover's fudge has been selling the best fudge in the world to locals since the beginning of time; the corn dogs are hand dipped; the fries greasy and skinny and drenched with vinegar. The 4-H animal husbandry competition is always robust, the draft horses huge and wonderfully tricked out (the agricultural version of Harleys), the Amish kids are almost always found by the grandstand sneaking cigarettes. This year there seemed to be a few more veteran tents, the Dems still had a lousy location, the GOPers had prime real estate but both tents seemed a little empty (maybe everyone was getting corn dogs and fries and too sugary lemonade).

This year did bring some changes, though.

First, a couple of new Walmarts opened in Geauga County, one smack dab in the middle of Amish country and another at the other end of the county. I expected long faces but the locals appeared happy about it. The feeling seemed to be that existing clothing shops such as Peebles would sell more discount "upscale" goods (Woolrich, Tommy Hilfiger, et al.) and let Walmart have the very low end; Giant Eagle might feel it but since their produce is not so hot and their prices are not all that cheap maybe they deserve to go out of business, and Heinen's, the upscale grocery store, would be fine. Meanwhile, everyone was tickled about the low prices. Johan and I ventured into one of the Walmarts, my first visit to the establishment, and I have to say I loved it! I loved the greeter, loved the merchandise, and really loved the prices. It was bright and while not hip in the manner of Target, the goods were nicely displayed. The stores seemed to be doing decent business though it was a bit slow on Labor Day but that was because nearly the entire county was at the fair or stuck in traffic trying to get to the fair (we hit the fair early and took the secret back way, figuring that the wet weather earlier in the weekend would lead to high attendance).

The second change took place at the fair. This year we were fortunate to see the new coon hound races whereby three coon hounds chase a fake raccoon across a large pond and up a tree. It was a crowd pleaser and also offered some interesting lessons. In the first race the hound that seemed to have the greatest lead gave it up because his front legs were too high in the water and he was not properly using his back legs. He was fast, but not using all his equipment led to loss. In the final heat where the three previous winners faced off, two of the hounds were neck and neck the length of the pond. As they neared shore they started snipping at each other. Meanwhile, the dog that everyone had given up for loser and that appeared to be swimming in the wrong direction materialized out of nowhere to beat the other two to the tree. While the "neck and neck" hounds were busy snipping at each other, the apparently really smart hound swam the shorter distance to shore and then ran the rest of the way. Lesson: taking the shortest distance to the prize will not necessarily get you the win; it's important to play to your strengths (dogs run faster than they swim); and, finally, while you are busy looking at your closest competition someone else is bearing down out of left field. The crowd loved it and roared.

Ohio now has two of the poorest 10 big cities in the country (Cleveland and Cincy) but life in Geauga looked to be on an upward trajectory. A fair bit of building, some of it still in the planning stages, more businesses in most towns (though not all). Real estate prices not out of control. You can get a nice farm house, updated, with 6-12 acres in Middlefield for under $400k, and a sizeable ranch or colonial in a very desirable village in Cuyahoga County for $300k or less. One local realtor informed us that it is a buyer's market at the moment, softer than it has been since 9/11, but she is still selling homes. Over on the northwestern side of the state the fields were flush with nearly ready to harvest crops.

Folks looked to be happy and enjoying life. Maybe it was the $2.29/gallon gasoline in Chesterland or the agricultural subsidies. Maybe they are just too fat and happy to know otherwise. Or maybe more rural folks are naturally optimistic or see that life outside an urbanized view of things is not so bad. Anyway, it was nice to go home again and see that the standard of living continues to rise for most.

John Kuhn mentions:

Talk about memory lane: I caught my first calf in a calf scramble at the Idaho State Fair when i was around 11. 1953. Named him "Sir Cumference." Sold at .33/lb. An outstanding price as he weighed over 1000 lbs by the end of the summer a year later. Pretty good ROI, (small rope burn) for an 11 yr old. He had a nasty disposition however, even before the hideous heel flies began to emerge (the 2" long grubs migrate from eggs laid on heel up and out thru the back which ugly emergence irritated even the most docile beast. We would paint the stock in creosote but did not always get 'em soon enough). I got to show him and talk to the folks on the Sheriff Spud TV program too that year. I figured I was pretty much a celebrity what with the TV appearance and being the President of the "Pick and Shovel" club. 4H.

Geeze, makes me want to go out and buy me some cotton candy and fried dough. But now all you can get downtown where I live is mocha lattes. That standard of living thing.

A Bond Maven Reads the Newswire, from George Zachar


This is the new news, to me. Everything else Poole said today is "I am above the fray" claptrap. The quote above is the first indication I have seen that the Fed is walking away from a metric they have consistently touted, to wit, that "inflation expectations" can be measured and used as a critical variable. We know that the TIPS spreads are FUBAR for a host of reasons. Now, if they "distrust" the surveys, how the heck are they supposed to straightface us with "well anchored" expectations? It's no coincidence that those surveys have been creeping up.

A New Statistical Framework for the Market, by Victor Niederhoffer

We are often confronted with a series of observations that form the basis for a decision. The classic example is the series of defective and acceptable products that come out of some manufacturing process. Another classic would be the lifetimes that occur when groups of patients are confronted with two treatments. In our own field, a series of prices from markets occurs, and it is helpful to inquire where it's going, what the process underlying it is, and what treatments might have described or predicted it.

A class of statistics called sequential statistics has been developed to deal with decisions, estimates and procedures for a series of observations where the decision is made before the end of the process. Sequential Statistics (University of Kentucky, 2004) is a provocative and challenging book by Zakkula Govindarajulu and covers the subject well. The book starts with a helpful introduction in which examples are given, the problems are put in perspective and a framework is provided. The author describes two-stage procedures where you stop at a certain point, get your bearings and estimates, and then continue sampling until a specified stopping rule is reached.

The second chapter is on the classic ways of treating such problems. The Sequential Probability Ratio Test is a procedure where the probability of observations coming from two different hypotheses is continuously calculated. When the ratios get beyond certain control bands, a decision is made that a difference in parameters exists. For example, after 10 observations of a heads-and-tails process, with 10 heads, it's 40 times more likely that the process came from a 0.90 heads process than a 0.50 process. So if one observed 10 out of 10 heads, one would be 97.5% confident that the process came from the 0.90 process.

The third chapter covers decision-making where there are not two simple alternatives but composite hypotheses concerning a range of values for the parameters. This chapter gives Bayesian procedures for non-parametric decision-making including ranks and sign tests, as well as methods for deciding between more than two hypotheses.

The fourth chapter covers methods of estimating parameters and confidence regions as you're going along in a sequence, including methods for determining regression estimates on a going-forward basis. Generalizations to cover decision-making with different loss functions and multiple significance tests are covered.

The fifth chapter covers applications to biostatistics, including problems dealing with optimal dosages, and lifetimes that arise from different treatments. Particular reference is made to a procedure called the up and down rule where you keep changing the dose level up or down by a unit based on whether it improved or hindered the outcome between the last measurements. The final chapter gives code and descriptions of Matlab programs that can be used to implement the major tests and procedures covered in the book.

Most of the methods used in the book can best be derived by simulation. That is, you would take a random series of numbers, and look to see what kind of statistics would be forthcoming based on the underlying process that determined the sequence at a given point. Signs, differences between means, variables and ranks of competing hypotheses would be calculated, and based on repetition, one would generate probabilities of occurrence for the statistics, and confidence regions for decision-making.

There are few if any references to uses of sequential statistics in the literature. Aside from their use in biostatics and quality control, most of them appear to be in the field of linguistics, where it is interesting to consider how people understand words based on the constituent phonemes involved. I believe there is a wide range of uses for sequential statistics in market decision-making. One important example would be in systems analysis where you are trying to decide whether a system is helpful or whether a phenomenon occurred. How far back do you go before you make a decision? Certainly not to the beginning of a period, because by then your data would be out of date. But you don't want to stop too early either, because then your data will be subject too much to chance. Given you've stopped at a certain point, how far do you wish to go forward before you conclude that the process has changed?

On another front, what confidence do you have that certain levels will be reached given the sequence that occurred in the past? Procedures similar to estimating the maximum of a 100 numbers when you're confronted with just the first n are similar to those that a student of sequential statistics would derive, but the procedures here are much more robust and precise.

Our whole field cries out for sequential statistics, and simple methods for applying them in practice would be useful to all.

“Sequential Statistics” often draws upon theoretical work in advanced calculus, probability theory, measure theory and statistics. It's not light reading or accessible to those who aren't already versed in the field. However, it will get you thinking about a class of problems, and provide useful guidelines, tables, and types of procedures and decision rules that should be immensely useful in quantitative finance and counting.

A Tutorial on Measuring Risk in Stock and Options Portfolios, from Dr. Phillip J. McDonnell

Measuring the risk of a portfolio which includes stocks and options can seem to be an insurmountable problem. Options move with respect to their underlying stock as a function of the option delta, and at the money option with a delta of .50 will move 50% as much as the underlying stock on a point basis. The CAPM theory says that stocks will move with respect to the market as a function of their beta. Empirical evidence says that the alphas are non-persistent, so only the beta need be considered. Thus a stock with a beta of 1.50 will move 150% as much as the underlying market index moves.

So if we wish to construct a portfolio scale metric which will measure the combined market response of a portfolio of stocks and long and short options we would simply multiply the delta and beta by the quantities suitably adjusted.

Suppose we had an IWM Russell 2K ETF call option with a delta of .50 and IWM is at $72 per share. We wish to convert the position to a common metric of an equivalent dollar amount of SP index.

Convert the option to a dollar equivalent IWM by taking 50% of $72 times 100 shares. This gives us $3600 dollars. Let's say the beta of IWM with respect to SP is 1.50. Multiplying $3600 by 150% gives us $5400 worth of pseudo SP index.

For a stock take the stock value of $7200 times the beta of 150% to get a dollar equivalent of $10,800.

Remember that a short position puts a minus sign in front of the above numbers. Also note that a put has a minus sign built in as well. For a short put it is -1 * -1 = +1. After the equivalent risk of each position is calculated then add them up with their signs to find the total of the portfolio.

A final note of caution - this type of analysis is an excellent way to measure linear risk for small movements in the underlying index. However for non-linear assets, such as options one may wish to consider other measures which include gamma and even the third and higher calculus derivatives of the option model.

Turning Points, from Dr. Michael Olagnon

In a recent post you used the words "turning points" that rung a familiar bell to my ears. In a follow-up to that article Dean Teffer complains about the jitter in the signal and the difficulty of defining correctly "turning points", and that also sounds familiar to me.

"Turning points" are typical of studies in materials fatigue. Engineers and statisticians who work in that field have developed "counting methods" (you should like the idea) in order to deal with the phenomenon. Fatigue is a mechanism by which a very small crack in the beginning extracts energy from a load history in order to make its way through a piece of metal. It has similarities with the problems exposed on your site in that the crack is "not interested" in jitter of small amplitude that does not let it open and grow, and in that due to the limitations of the fatigue testing machinery in the labs, the algorithms have to deal with discrete levels.

The most interesting and commonly accepted method for counting in fatigue is Rainflow. Here is a small presentation adapted from a fatigue study. Many results on level-crossing intensities, on time to the next maximum or to the next level-crossing, etc. have been developed by the statistician Igor Rychlik, his mentors Ross Leadbetter and Georg Lindgren, and his group at the University of Lund in Sweden. Even more interesting, all those theoretical results have been practically and reliably implemented into a Matlab toolbox, WAFO.

I have thought for more than a decade that those results might be of interest for trading and finance, but I did not have access to the huge databases necessary to test them in that field, nor the time to go and look for them. Perhaps you can find some bright young student to investigate it. Up to now, we have taken the point of view of the designer fighting fatigue, it would be pleasant to try to play it in the crack's seat!

Craig Nelson on Technical Analysis and Practical Speculation

I have read both of your books, and I loved the first one but am a bit disturbed by the second one, which goes into some length at proving the uselessness of technical analysis. After all, is not the study of price, any price, in all its shapes, forms, and expressions (whether it be patterns involving the prices themselves, trend lines, or other functions derived from, or based on, price) all part of the definition of "technical analysis"?

If that is the case, and I think you might agree, then could you not also dismiss "price patterns" found in earnings figures, regressions, correlations, and all that stuff covered in your second book as just different expressions of "technical analysis"?

If that is the case then pretty much all of what you covered in Practical Speculation can be disregarded if you consider my broader definition above and agreeing with you that all forms of technical analysis are essentially unreliable. In which case, (and assuming you also feel that fundamental analysis is useless and/or already reflected in the price), on what basis should one trade?

Debunk this Please! from John Alabaster

The following quote was sent to me by a caring sharing type. Originally written by one Robert McHugh. It sounds like he has done a study; can you debunk it? I do not have as much data as you ...

The probability of a decline -- often significant -- is high whenever the percent of Dow Industrials stocks above their 30 day moving average rises above 80.00 percent. We show every instance this happened over the past two years. There were 8 occasions when this occurred and 11 prior occasions if you include three that got close to 80.00 readings. All but one generated declines of several hundred points shortly thereafter. The one that did not resulted in a smaller decline, yet still a decline, and 60 days later we got a sharp decline. We sit Friday, September 1st, 2006 at 83.33, a twelfth occasion. So, if history is any lesson, we have a 91 percent chance of a sharp decline occurring over the next several weeks...It takes being a cock-eyed optimist, or having full faith in government intervention, to see a long-term Bull market rally continuing from where we stand today.

I am an optimist because it works -- however cockeyed I may be sometimes!

Vic replies:

This is totally ad hoc. The period chosen is selective and probabilities are given rather than expectations. Many other factors besides moving averages of that length can be given. It is biased and helping a position along.

Waiting for Blotto, from Dr. Kim Zussman

Along the lines of generational length of market regimes, I used DJIA daily closes to look at wait times between new 10 year highs (actually 2500 trading days). From the present back to 1928, each day looks back over the prior 10 years to see if it is a new high, and if so how many days has it been? Here is a graph of these results.

The bands of points cluster along two intervals (bull markets) when new 10 year highs were being set frequently: 1950-65, and 1982-2000. Notice there are gaps between the intervals, which represent the intervening bear markets of 1929-50 and 1965-82. During these bear periods, new 10 year highs were set infrequently (duh the market wasn't going up), so you see points during these periods representing many days. The longest was over 4000 days, and occurred in 1945, followed by 2500 in 1982, and 1677 in 1972.

Interestingly the current period (through 9/1/06) has not seen a new 10 year high for 1667 days (I put a point there to illustrate this, even though we have not yet seen the new 10Y high). So in 10 days, assuming the DOW does not jump over 300 points (i.e. youtube video of sniping Osama with a 50 cal. in slo-mo), we will be in the third longest wait since the 1930's!

Who cares? Perhaps these many-year length intervals are related to generational risk-aversion and memory of losses and ruin, which go on vacation when a new generation's pockets fill up. If the size of the gaps between bull markets has such consistency, the gap we are now in may have a number of years to go.

Shaping the Industrial Century by Alfred D. Chandler. A (very) brief review by George Zachar

This is a bone dry 300 page genealogy of the European and American chemical and pharma industries, primarily of interest to historians. The lessons of focus, adaptability and barriers to entry are endlessly repeated.

The only non-obvious things I learned here was that the US chemical industry profited mightily from confiscated German patents during WWI, and that US pharma successfully exploited trade disruptions during WWII.

Stocks as Molecules and How Phases Change, from Jan-Petter Janssen

I wonder if the resemblance between how molecules are structured and how stocks are traded can be used to explain some "irrational" price moves that occur sometimes. By irrational I mean large jumps or declines in the price despite no new information.

When heat (energy) is added to a substance two things can happen: A higher temperature is observed, caused by higher kinetic energy. Or, if the substance changes phase, the heat will change the bonding of the molecules, increasing the potential energy. The idea is that stocks have phases (or equilibria) that change in much the same way.

Note the two fundamentally different reasons for trading: #1 Buy one, sell another to take advantage of differences in relative prices, #2 Buy or sell based on whether consumption or investing makes one better off.

These equivalents are being used: Temperature (kinetic energy) <=> The expectancy and return at the price where #2 buying and selling balances. Bonding (potential energy) <=> The value the #1-participants add to the market. Heat (kinetic + potential energy) <=> The price from the impact of both #1 and #2

Normally stocks can be thought of as being in the liquid state. Trades trying to benefit from the differences in valuation (#1) are the forces which keep the stocks connected. This will normally imply very little impact on the price from selling or buying (#2) in a particular stock when no new information is released.

When the net price impact from those who go in and out of the market (#2) is higher than the #1-traders can deal with, stocks will change phase.

If the change is a negative one, price will fall until we again find that Price = Money in / Shares out (#2), This new frozen price will be where the expectancy and risk is the same as for liquid stocks; i.e. a stock could fall from P=10 to P=5 despite no new information and be neither more nor less attractive than before. The reason is that the individual participants no longer have the benefits the #1 traders give them. Few will have incentives to trade because relatively small volumes will move the price in an unfavorable direction. A low price also harms the fundamentals, and private placements are less favorable for the existing shareowners; which can be considered costs of buying a frozen stock.

Similarly, when a stock boils it has more buyers than there are available sellers. A bubble will occur, and the participants who are fond of the stock have the power over its price. During the Internet bubble no one could stop it, and those who tried going short were most likely squeezed out anyway.

Whereas the individual stock must be in any of the three states, the entire market exists of a fraction of the stocks in each state. This is comparable to a pool of water which has an ice cube floating in it at zero degrees Celsius.

The Prophet, from Debra Kettle

The Prophet by Kahlil Gibran has always been one of my favorite reads and is recognized as one of the classics of our time. In his work, Kahlil describes the art of parenting in a way that reminds us of the beauty and responsibility of raising children that allows for our offspring to experience their own journey without being tarnished by the personal agenda of parents. Application of the gifted insights of Gibran to investing might be considered both humorous and profound.

The Prophet (original version)
And a woman who held a babe against her bosom said, Speak to us of Children.
And he said:
Your children are not your children.
They are the sons daughters of Life's longing for itself.
They come through you but not from you,
And though they are with you yet they belong not to you.
You may give them your love but not your thoughts,
For they have their own thoughts.
You may house their bodies but not their souls,
For their souls dwell in the house of tomorrow, which you cannot visit, not even in your dreams.
You may strive to be like them, but seek not to make them like you.
For life goes not backward nor tarries with yesterday.
You are the bows from which your children as living arrows are sent forth.
The archer sees the mark upon the path of the infinite, and he bends you with His might that His arrows may go swift and far.
Let your bending in the archers hand be for gladness:
For even as He loves the arrow that flies, so he loves also the bow that is stable.
The End.

I am not surprised, given the dominant male presence in the world of finance, that the stock market has often been called a mistress. I would like to offer a new, perhaps more female minded perspective, and suggest that the market is less like a mistress and more like a child. What would happen if the mistress were ultimately married and bore a child? What tenets might need to ensue to shape the outcome of this intellectual and emotional shift? I think Gibran's piece, and viewing investments as children, offers a great new metaphor.

Most would agree that a full commitment is required of parenting. Planned or unplanned, a child makes certain demands of parents that must be met in order for the child to develop and thrive. Moral implications aside, a mistress is certainly a thrilling concept. The mistress metaphor seems to play on the internal ache and frenzy that the market causes many investors. Her risk is great, she can never be fully possessed, and often she drives investors to levels of despair and ecstasy emotionally and otherwise. The mistress is often blamed whereas we miss the real culprit, the lack of emotional management. I have always held the position that parenting, like investing, when done well is a predominantly intellectual enterprise and I would like to propose the head over heart approach of parenting as a new, perhaps just as playful and heart wrenching metaphor, for investing.

We all know that a full commitment to a mistress would render her no longer a mistress. The short version is that she would be given legitimate status. Soon to follow might be the ho-hum, the status quo, the banal, the boring, the responsible, the dutiful, even quiet desperation of legitimate union. A full and honorable marriage to the market would likely bear offspring . The children, the investments, and inevitable associated responsibilities cannot hope to compete with the excitement of an illicit love affair but might ultimately prove to better serve the future. Concepts such as balance, discipline, nurturing, boundaries, and limit setting would replace reckless abandon, passion, and longing. The former concepts, however, with regard to investing, might also make for a greater long term relationship. While indulgence might make a mistress happy. An indulged child rarely thrives. Neglect, probably more so as it reflects the mistress not the child, is not a good idea either if you know what I mean. Granted, the thrill, the lack of commitment, the not being required to spend holidays, the come and go as you please nature of a mistress, may make her more desirable as a metaphor, but I am optimistic that the benefits of a metaphor with a firmer foundation might be plausible and worthy of consideration. I realize that I risk my "image" as a fun loving, risk taking, emotions drenched, liberal in writing this piece. Truth be told, I am the type to run with scissors only to put them back where they belong.

So, back to Gibran. What exactly would be required of investors if they married the mistress and bore a child? What tenets might need to ensue to shape the outcome of this emotional and intellectual shift? So Here goes: With all due to respect to the genius of Gibran, I unleash, The New Prophet. [read the rest of this post]

Still Stable after all these Fears, from Dr. Kim Zussman

Even with the recent pause in stocks that made Ben pause, volatility is still low and there has not been a steep decline in a while. How long exactly?

There are lots of ways to count this, but here is one: SPY daily closes 1993-present were checked to see if they were more than 10% lower than the high close of the prior 40 trading days (2 months). This method of screening does not specify the duration of the decline (bounded by 1, 40 days), only the magnitude, so the drops could span 2-40 days.*

Looking for declines this way does not eliminate all those nasty periods with many consecutive days meeting the loss 10%+ criteria, which clutters up attempts to gauge wait times between drops. To help with this, look-back days were counted only if the prior 3-days did not meet the 10%+ decline criteria.

Here are the ranked wait times, in trading days, between closes more than 10% less than the high close of the prior 40:

1160+, 388, 201, 161, 126, 98, 98, 50, 39, 39, 27, 24, 17, 11, 10, 10, 9, 9, 7, 7, 6, 6.

The top entry, 1160+, is from the start of the series in 1993, which you will recall from your almanac was another volatile period for stocks. The date of the next longest 388 day wait was April 2000, which more or less heralded the end of the 1990s bull run. (One wonders how many boys born 4/00 were named Herald).

History buffs will note that as of 9/1/06, the current streak without a big decline is 883 days-approaching the record length set in 1993.

Using macro analysis, compare and contrast the markets of the mid 1990's and today. Use this analysis to explain why volatility declined in both periods, and make a prediction of how many days are left before another down of 10%+. (This last bit turns the thing into an exam question for all the prof's on the list. If you use it please either send royalty of $0.25 to your ex-wife in my name, or mine in my name).

*this is a slight modification of something posted previously, only this way pins the day you look back from to survey your losses.

A Few Points on Housing Markets and Banks, from George Zachar

  1. The markets, though imperfect, are right far more often than they are wrong.
  2. Interest rates are low by any historic or absolute metric, and falling.
  3. The stock market had the "Greenspan put", wherein investors believed Sir Alan would ride to their rescue, cutting interest rates if prices faltered. We are seeing the emergence of a "Bernanke put" on housing.
  4. Extension of the old joke: If you owe a bank $1,000, you have a problem. If you owe a bank $10,000,000, the bank has a problem. If mortgage holders are upside-down $10,000,000,000, then the Fed has a problem.
  5. There is a tremendous political interest for the chattering classes to induce fear in this area, making it hard to stay objective amid the screaming.
  6. There is also great ambiguity about the mix of economic ordinary home purchasing, and speculative "investor" positioning. Real pain is likely to be concentrated primarily in the very last cohort of non- economic house buyers. How big is that group? And how are the vulnerabilities distributed? Those are the core questions that remain unanswered amid the daily scare stories.

Crocodile Hunter Dies Whilst Filming, from GM Nigel Davies

This seems like a warning to us all, despite the relatively low-risk nature of our hunting.

It is Pleasing to Me, by Victor Niederhoffer

It is pleasing to me to see that there are few if any posts on this site regarding doomsday scenarios. Such are the kind that make owners of stocks and markets sell at the exact low. That has always been the way of syndicates, spread the news of impending pass of the dividend, and impending bankruptcy right before buying a tremendous line from the last sellers. Daniel Drew was famous for this with Erie stock, and in 1885 Worthington Fowler finally figured this out (helped by the advice of Colonel Smith) and bought a 1000 at 3, before writing 10 years on Wall Street in 1887. At the same time the chronic bear and ghost Jacob Little rushed from Trinity Church to New Street to short himself to his oblivion with the same stock ... [read the full chapter entitled 'Drew Plays His One Stringed Lyre - Erie']

The same thing of course happens today with the markets. Right when we are hearing the most about how interest rates could never fall because Bernanke has to prove himself, or how SARS is going to destroy us all, how housing prices are going to rise 10% or oil go above 100, war in the Middle East is going to escalate, bombers are arrested in England, the President's popularity is at a new low, the Democrats are going to sweep the electorate, individual stocks are going up only on hype and there is chronic unemployment in factories in Bethlehem.

But such times are the time to buy, especially if the market has not gone up in a few years, and stock rate returns are 3% or 4% above bond yields.

I try not to allow such a coloring of the news from ghosts and fellow travelers of the modern-day syndicates to populate this site. You see, I would be doing you a big disservice, because you might think that there is more of a chance of doomsday now than any other time during the last 100 years when stocks went up 10,000-fold. If it were more likely, you would have to figure out whether that was bullish or bearish or whether it had been discounted, or whether there was anything on the other side that was more relevant.

I have tried, ladies and gentlemen, to provide an agenda for you free of propaganda, devoted to self improvement and an optimistic view of life that takes account of the resilience of the economy and the infinite nexus of connections that keeps the flow of capital and goods going; an agenda that takes account of the regularities between the shares of wealth, the Gini coefficients if you will, between those who take on risk and those who are indirect second-handers for the big traders trying to get you on the wrong foot so that they can quietly cover their positions at the bottom.

I hope it has not all gone in one ear and out the other.

Such marvelous insights have come from over 40 years of working in an environment as brutal and unforgiving an environment that exists on this planet -- the management of OPM (Other People's Money).

Steve Leslie offers:

I add just a few thoughts pre-Labor Day weekend:

  1. Crisis creates opportunity.
  2. Confusion offers exploitation.
  3. Those who are the least qualified are the most willing to offer advice.
  4. Things are never as bad as they may seem, nor as good. They are somewhere in between.
  5. It is better to win a small pot than lose a big one.
  6. The general public usually has it wrong.
  7. Listen to what people say, but watch what they do.
  8. If someone is not committed to your success they most likely are committed to your failure.
  9. Life is a journey, and not a destination.
  10. We do not need to be told things as much as we need to be reminded.
  11. Wherever you go, there you are.
  12. And my all-time favorite: When you wrestle with a pig you both get filthy -- but the pig likes it.

David Higgs comments:

In the book Fisherman's Luck, by Henry Van Dyke, 1899, there is a nice chapter titled, Lovers and Landscape. It begins with this quote:

He insisted that the love that was of real value in the world wasn't interesting, and that the love that was interesting wasn't always admirable. Love that happened to a person like the measles or fits, and really of no particular credit to itself or its victims, was the sort that got into the books and was made much of; whereas the kind that was attained by the endeavour of true souls, and had wear in it, and that made things go right instead of tangling them up, was too much like duty to make satisfactory reading for the people of sentiment.

239 pages full of preludes on old and foolish maxims, in 10 chapters. Very much a book that falls along the lines of Mr. Leslie's teachings.

The Market Comedy, from Laurel Kenner

Victor and I have written extensively about stock market cons, but I realized recently that we missed one crucial aspect: entertainment value. In fact, drama has been important in the marketplace for as long as the marketplace has existed, as merchants need to attract a crowd if they are not to go hungry. What brought it to mind is my study of the Commedia dell'Arte, the 16th-century Italian folk comedy whose archetypal stock characters have permeated Western culture from low to high over the past few hundred years – the rich old miser, the boastful but cowardly military man, the wily servant, the hapless lovers.

The link between charlatans and comedy is explored with great sagacity in John Rudin's handbook for Commedia actors. Rudin views the charlatan as a kind of shaman who enchants the audience; the spell can only be broken by the transfer of hard cash.  He passes along this list of the various types of charlatan from his own teacher, the great scholarly practitioner Antonio Fava:

I would add:

Rudin urges actors to observe street merchants making their pitch. What these hawkers do, he notes, is to broadly hint that the goods just might be stolen. Students of big and small cons will observe at once that this technique is fundamental to all cons. If you can appeal to the mark's dishonesty, you've roped him! (At one point in long history of the Commedia, the actors wore out their welcome in Italy and dispersed all over Europe, sometimes falling so low as to serve as come-on men for quacks, as pictured in the print of Notre Dame above.)

 Here's an English tourist's description, published in 1776, of St. Marks Square in Venice, which served as a center of the charlatan world thanks to the toleration of the local authorities. (The word “mountebank” comes from the practice of these sellers to mount benches fastened together as a makeshift stage.)

These Mountebanks at one end of their stage place their trunke, which is replenished with a world of new-fangled trumperies… the principal Mountebanke opens his trunk and sets abroad his wares, [then] makes an oration to the audience of almost an hour. Wherein he doth most hyberbolically extol the virtue of his drugs and confections…though many of them are very counterfeit and false. They would give their tales with such admirable volubility and plausible grace that they did often strike great admiration into strangers that never heard them before.

One could not say more of our own modern-day market mountebanks. In fact, today's charlatans could learn a great deal from the Commedia dell'Arte.

Bacon on Regime Changes, from Steve Ellison

Today is the last trading day before Labor Day and hence marks the end of the summer market period. In Secrets of Professional Turf Betting, Robert L. Bacon noted the shifts from winter racing to summer racing and vice versa as times when many betting systems stopped working or could not be used for a time until sufficient results from the new venues were available. He recommended a couple of all-purpose systems that could be used at any time (e.g., the horse that had won the largest percentage of races over the past year, provided it was not a favorite). For the transition from winter to summer tracks, he advised careful attention to workout times. Mr. Bacon favored horses that had raced on winter tracks over those that had spent the winter resting. If a winter-rested horse managed to win a race in early spring, the effort almost always resulted in poor results (with the public, remembering the win, betting heavily on the horse) the next several times out. Perhaps there is an analog that if a sick company such as General Motors manages to report good results, the effort required will so strain company resources that a period of below-average performance will ensue.

Prediction Markets for Promoting the Progress of Science, from Tom Ryan

I thought this article was interesting ... the gist being that profit oriented prediction markets can provide a useful counterpoint to unsubstantiated claims in science that are so regularly published in the media. In other words, a prediction market could act as sort of an "open source" technical review on claims being made regarding key, unresolved scientific issues.

NFP Comment - Can I go Home Now from C. Kin

A largely in-line data set this morning may serve to further a flattering bias to the bond market. Among a few comments from primary dealers that I work with are indications that:

  • The 5yr area of the curve is exceedingly rich, largely for technical reasons (the on-the-run 5yr issue was tight in repo. this week, also Asian central bank buying).
  • February Fed Funds futures are indicating 5.20%, so there are slight odds of a rate cut 6 months out.
  • the hourly earnings figure (the only area of the report that was weaker than the Bloomberg estimate) provides a slight bias to flattening.
  • While I generally do not recommend trades, I would like to point out the the 1yr/2yr inversion is ~20bp following the NFP report. I am finding it hard to envision a reasonable set of circumstances that would not cause this relationship to flatten or normalize (on a constant maturity basis) over the next few months.

    Photography and the Markets, from Hanny Saad

    Speculation is a very consuming endeavor that involves all the senses and extends to the imagination. You often hear these statements uttered by traders:

    As you can see these statements all involve the senses, the reflex and the imagination. One should normally find it beneficial for speculators to sharpen their senses and reflexes to pursue this potentially profitable but ever consuming game of speculation.

    For example, you can listen to a flawed piece of music and try to spot which note is out of tune. You can also just play an instrument (more time consuming) to develop your hearing and imagination. You can develop your reflexes by playing a quick sport like Hockey or squash.

    One endeavor I would like to talk about and that I trust no one has touched upon before is Photography. During the last three months, I spent most of my waking hours trying to sharpen my photography skills. Why photography? Photography is the process of making pictures by means of the action of light. Light patterns reflected or emitted from objects are recorded onto a sensitive medium or storage chip through a timed exposure. The process is done through mechanical, chemical or digital devices known as cameras. To catch that perfect photo, you need a good tool (camera), skills, good reflex and most importantly the imagination/vision and the sight to spot that perfect frame in the first place. Photography also involves treachery and deception. For instance, You want the viewer to focus on a certain subject in your photo. In that case, you put the subject in focus and blur the background (known as shallow depth of field). While the camera took a photo of a certain frame, the photographer used his skills to ensure that the viewer is focusing on one subject and ignoring all else.

    Notice how in this picture the butterfly and the flower are in focus but the background is all blurred? You do that by using a wider aperture (lens opening) Other techniques involving moving subjects where you want to give the viewer the impression that a car is moving for instance is called panning. In this case you move your camera in the same direction as the moving subject for the effects.

    While in photography the deceptions (a.k.a. art) are very well defined, It is not as cut and dry in markets. Let us start a discussion on deception in markets and how the markets want you to "focus" on a certain subject while ignoring the blurred background. What are the tools (aperture) the market uses to make you focus in the wrong direction.

    Vic and Laurel started with the news, propaganda and the other doomsday scenarios including wars, bankruptcies, SARS, etc. that make you pay attention to a subject in focus (the news) and forget all about the blurred background (the markets' general upward drift) to your detriment. I will offer another (more micro) deceptive tool -- it is the bid and ask size. Amateur traders pay attention to the size of the offer and bid which are insignificant most of the time but the big carnivores of the markets use them to "wrong foot" the naive into selling when the should be buying and vice versa.