Letters to the Editors November 2005   Write to us at: (not clickable). Please include your full name, and omit attachments

Letters to the Editors Competition

This month's award winner: "Exploring Fama-French in R, from an Objectivist Researcher: Visualizing the difference between traditional CAPM and the Fama French Three-Factor Model in estimating cost of capital., using R" (Nov. 23)

While I agree with Mr. Niederhoffer that the Fama-French 3-factor model has its flaws and limitations, my explorations suggest that whatever its faults, it typically provides a better return explanation than the even more commonly utilized CAPM for estimating a company's cost of equity. This may assume, however, many things Mr. Niederhoffer rejects, such as the viability of the SMB and HML factors that French provides. And keep in mind that a model that explains past returns does not necessarily explain future returns. (I personally don't think that size (SMB) is particularly significant retrospectively, and may be irrelevant going forward.) Similarly, if enough people take up Fama-French's model, this may (and may already have) eliminate any chance of future exceptional returns out of the HML (value) factor, which in any case is not constant over time. And even if HML is not a good factor for identifying value and is not a future-return generator, it probably is a decent proxy for identifying intangible, knowledge-based asset exposures, versus tangible, book-value oriented asset exposures. And it is interesting to observe that utilizing the FF-model, one can determine that BRK-A most likely deserves a higher cost of equity (required rate of return) from investors than the CAPM suggests, because the CAPM under measures BRK's market Beta and ignores the company's exposure to the HML (value, distress, tangible-asset-heavy) factor.

I recently wrote a function for R that estimates cost of capital using both standard CAPM and the Fama-French 3-factor model, and allows one to see the impact of the different models (which are simply regressions) for a given stock. (For a non-technical discussion of the standard CAPM and Fama-French models, see:

Womack, Kent L. and Zhang, Ying NMI1, "Understanding Risk and Return, the CAPM, and the Fama-French Three-Factor Model".

I believe this exercise provides the following benefits:

1. The Fama-French model usually provides a statistically superior explanation of past return for companies. Using a more accurate model should allow for a better estimate of likely future returns, and provide a more accurate insight to the level and sources of investor risk perceptions for a given company ( e.g. provide a more accurate cost of capital estimate in a DCF model).
2. The function we wrote allows one to visualize to what degree the model fits reality (e.g. a vague, dispersed cloud suggests a weak fit, a tight band suggests a tight fit) and observe whether outliers significantly effect risk estimates.
3. The Fama-French model allows for the disaggregation of risk factors. Some believe, for example, that market beta is a true risk, while size and value betas are sources of return. If this is one's belief, one could actively seek companies with loadings on these factors, excluding SMB and HML betas from one's COE calculations (while still retaining the benefit of a more accurate market beta calculation provided by the Fama-French model).
4. Even if one believes there is no risk premium or discount related to SMB or HML, these factors appear to provide informational content and often appear to provide significant context in a regression. One may also explore the time-varying nature of the market, SMB, and HML factor coefficients. (In my limited explorations, SMB and HML factor betas sometimes appear to be more stable over time than market betas.)

Continued here ...

11/30/2005
Monetizing innumeracy in Italy, from Byron Gilliam

Dear Vic

In Italy, the state lottery offers a game called Late Numbers where you can bet on a particular number being drawn in the regular multi-number drawing. When a number hasn't been drawn in a while, betting surges. A real-life illustration of Gambler's Fallacy. In particular, in September 2004 wagers from core bets, (excluding late numbers), amounted to 518.3 million euro, (444.1 million euro in September 2003), whilst wagers from bets on Late Numbers amounted to 877.6 million Euro, vs. 78.9 million Euro in the same period of 2003.

I enjoyed your book and thought you all might find the above amusing.

Byron Gilliam

11/29/2005
A Letter from a Reader Down Under

Dear specs:

A brief note of appreciation for your web site and debates from Australia

My sympathies to the Chairman over the recent press. While it is easy and (I think) true to observe that the axles of the media are greased by a good thick layer of bullshit, I can only imagine what it must be like to be caught up in a maelstrom of hyperbole, exaggeration and the repetition of poorly checked 'facts'. Nevertheless, your results speak for themselves. In Australia, this targeting of successful people is called the "Tall Poppy Syndrome".

I would ask a question if I may. Am I correct in presuming that you consider the use of the combination of the timeliness and technical rankings from value line in purchasing stocks a distinct case from the use of some 'trend following' trigger short and long on a financial instrument without any confirmatory information (statistical or fundamental)

Thank you Andrew Muir

Vic responds:

Dear Mr. Muir:

Your letter is very Australian, mate, and would certainly have helped the founders hasten their time out into the wilderness. I have not tested the combined information that the technical rankings provide above and beyond the timeliness in detail, in detail although I always find it a good working hypothesis in such situations to use a standard linear model without interaction in such cases of joint effects, i.e. that both effects are independent with much variability.

I believe the technical rankings may be successful because they take account of the path of recent prices and their effect on the future. Hopefully, the powers that be there change their regressions ever so often so that they dont run into ever changing cycles. The value of the timeliness rankings is probably that it tends to suggest risky, innovative, and growth oriented companies. vic

11/25/2005
A very simple trading idea from an Indian Spec

Dear Victor

I have been a reader of this website for over an year now. I find the discussions very interesting and informative. I am also a trader in the Indian stock market and I have developed a very simply model for trading.

It goes like this - over the past 2 years I have noticed, that I am always wrong about the direction of the market - when i begin to feel bullish the market promptly falls and when I begin to feel bearish the market rockets up.

Therefore I simply do the opposite of what I think is the correct thing to do

Actually i should say i try to do so, because most of the time, I am unable to find the willpower to act against my own feelings and I end up doing nothing. Still its only been 2 years as a trader, maybe another 2 years and I'll get the hang of things

11/22/2005
FX forecasting inertia from Riz Din

Hi Vic,

I have just started my own web-site/blog and have just published a piece about the FX Forecasting industry. I thought I'd send it along as it may be relevant to your site. Kind regards and thanks for an excellent web-site. I have only recently started trading full-time and your trusted wisdom is much appreciated.

Riz Din

11/21/2005
A Thanksgiving Wish

A thought of my own on Thanksgiving this Thursday. On my Mother's side we are directly descended from Captain Myles Standish of the Mayflower that landed in Plymouth. I often wonder that first Thanksgiving how the Indians and the Pilgrims got along together? From what I read we learn they shared their dinner that first year. Yesterday in Church we had a guest speaker by the name of Mr. Danny Buggs of football fame. Danny is African American and he noted that he was the only black in our church service Sunday. He contended while speaking that Sunday morning at church is the most segregated day of the week . I found that remark interesting by Mr. Buggs. Personally I feel all of us (regardless of ethnic background) would get along much better if our government would keep their 'nose' out of attempting to force equality on all of us.

My wish this Thanksgiving and over the holidays that in 2006 all of us can better understand each other , live together better and thus all of our lives will be enriched.

Sincerely,
Alan Millhone
President
American Checker Federation
Belpre,Ohio

11/21/2005
Asian Demographics

Regarding "Victor Niederhoffer Reviews  Fewer" you might be interested in the following article that I came across through the blog indianeconomy.org. Looks like India and China have their own "fewer" and grayer problems.

Young North, Old South

November 15th, 2005 by Amit Varma

In an  article in the Wall Street Journal on Asia's graying populations, Nicholas Eberstadt writes on India:

The overall population profile [of India] will remain relatively youthful, with a median age projected at just over 30 in 2025. But this is an arithmetic expression averaging diverse components of a vast nation. Closer examination reveals two demographically distinct Indias: a North that stays remarkably young over the next 20 years, and a South already graying rapidly due to low fertility.

It may surprise some readers to learn that sub-replacement fertility already prevails in most of India's huge urban centers-New Delhi, Mumbai (Bombay), Kolkata (Calcutta), Chennai (Madras) among them. Even more surprising, sub-replacement fertility prevails today throughout much of rural India, especially in the rural South. There, graying now proceeds apace. By 2025, South India's population structure will be aging unmistakably. In places like Kerala, Tamil Nadu and Karnataka, median age will be approaching a level comparable to Europe's in the late 1980s-and around 9% of population will be 65 or older (Japan's level in 1980).

Read the full piece here. John Jacobs

11/21/2005
Positive Emotions and Stock Prices

I read both of your books and enjoyed them immensely. I had a hypothesis about emotions and stock prices which is derived from your ticker symbol article mentioned in "The Education of a Speculator".

The stocks are TSCM and GOOG. With all the booyahs and high fives on TV and magazine cover stories, I think TSCM will go decisively above the next big level of $5, and even be transformed into a momentum stock. And GOOG will probably go close to if not above $500. These hypothesized outcomes does not take into account the company fundamentals and industry trends at all, they are purely based on pisitive emotions surrounding the companies. In general, if a stock with "halo" is trading close to a big level (5, 10, 100), it should go above it. Stocks are papers trading on emotions after all. In addition, the move may not be sustainable, as AMZN and QCOM both made their high around $1000 if I remember correctly.

Jin Qian

11/21/2005
A Fed Model Query

Might I request an update from your resident gurus regarding the Fed Model? Is the model failing us or is the mistress at work in her mysterious ways again? I note from reviewing the graphical data provided in the archive that:

Only twice since 1980 has the market declines when the Fed Model predicted an increase. In both cases, 1981 and 1990, this was followed by 3 years of solid market gains. Only once, in 1987, has the model predicted a high double digit gain yet the market achieved only a low single digit gain. This was followed by 2 years of very substantial gains.

I note the above these outcomes for 2005 now appear most likely, albeit we cannot yet hear the fat lady in full voice, yet the historical precedents for outcomes in subsequent years would have to be considered contrarian at best. Does this suggest that now is a good time to buy into any weakness?

Kind regards,
Philip Townsend
Bali, Indonesia

11/14/2005
A Letter from Mr. C. B.:

I was aimless in my life, in and out of prison in Singapore, when I stumbled upon the stock market and the pursue of riches. I became an avid reader of books on the markets and motivational articles. After reading Alchemy of Finance I became an instant fan of G#orge S#ros. Upon my release, I went to a bookstore and happened to catch a glimpse of Education of a Speculator. Having read Victor's name in S#ros's books, I bought and read it. Although it did have an impact on me, it didn't have a 'how to trade' section. It did help my understanding of the markets a great deal. I'm a chess fanatic, having made it to the quarterfinals of a national tournament at age 10. The explanation of how chess relates to the markets clicked with me instantly. I believe that playing the markets is like chess. Set up your defenses and use deceptive tactics.

I'm currently reading Practical Speculation. It has opened my eyes and cleared up the picture for me. I've always been a speculator at heart. I read Intelligent Investor by B#n Gr#ham, books about the Sage, and other books on long term value investing. Although people accepted these strategies, I was skeptical. I knew that markets keep changing. I imagine myself as an institutional investor, wondering how to unload millions of dollars of stock on the public. I'm currently trading in the Singapore stock market. Although my account is in red so far, I'm confident I can be a great speculator in the future.

11/11/2005

Hello Mr. Niederhoffer:

I don't know Mr. Melvin but I like what he writes! As a U.S. Army veteran I agree with him 100% that Veteran's Day should be an honored holiday and a time to reflect on the lives sacrificed that America can remain free. Seems like our government's focus gets shifted to appeasing too many special interest groups at times. The military is made of men and women of all walks of life, religion, ethnic background. Yes, Veteran's Day should be a revered holiday for all Americans. We have lost over 2,000 men and women in the Iraq war, and the war is still raging . Personally I honor all those who have made the ultimate sacrifice to keep our great land free. I am 57 and love America -- and if ever needed, would go again to help maintain our freedom.

Sincerely,
Alan Millhone
Belpre,Ohio

11/08/2005
Islamaphobia on Daily Spec

I had expected the Muslims in France to wait till they were a demographic majority, but perhaps it is better this has come sooner. It may stir Europe into action while there is yet time.

What an extraordinary thing to say. This forum has just hit a new all-time low! Simply changing "Muslims in France" to "Jews in Germany" should send shivers down the spine of any decent human being with any recollection of mankind's darkest era. Evidently, anti-Semitism is now being replaced by Islamophobia. That no one has stepped forward to condemn such rhetoric of hate speaks miles of the current climate. I am utterly disgusted.

11/08/2005
If It Can Be Tested, It Should Be Tested

Dear Mr. Niederhoffer:

Congratulations on your evidently fine returns the past two years, as per the recent article by Jon Markman.

Since I "volunteered" my services to Bulkowski in a recent email to some of my local trading buddies, and ALSO mentioned your name in the same context of TESTING....I thought the least I could do is forward you a copy of the email!

All best, and good trading to you also, sir.

Sincerely, Gregg Rainone Longwood, FL

Dear Mr. Bulkowski:

I am an enthusiastic follower of your work. As I was saying on the radio the other day, on the Tom O'Brien show from TFNN.com, regarding your article on GAPS in Technical Analysis of Stocks and Commodities magazine, "This guy Tom Bulkowski saves me quite a bit of work!"

Now, of course that's not entirely true, as I DO TRY to do my own work and due diligence.

However your work and backtesting is pretty outstanding in today's markets.

Accordingly, I sent the following to some of my local trading friends, regarding your article in this month's issue of SFO magazine. Below that is a missive I fired off today at Traders-talk.com, on account of all the UNTESTED, INVALID, and UNPROFITABLE information in the markets -- otherwise known as about 99.99999% of what information there is.

I hope you might at least find the interest in your work to be of interest.

I wish you all best continued health, happiness, and success, then, and good trading to you, sir!

Sincerely, Gregg Rainone, Longwood, Florida

Dear Orlando Hard Core Streaking Emperor Gurus:

I can't get you the article, but in this month's issue of SFO magazine, there is a great piece by Thomas N. Bulkowski Barnes & Noble.com - Book Search: thomas n. bulkowski , regarding his backtesting of stock performance related to "event" announcements, such as earnings reports, etc.

SFO Magazine Official Journal for Personal Investing in Stocks, Futures and Options

The article I refer to, along with Bulkowski's books, is a good example of what I consider to be requisite professional researching and trading system design in this business of technical market speculation. The software reference on his charts is...."Bulkowski Proprietary Software", btw... No surprise to me.

If you are not a GIFTED, INTUITIVE trader in Wall St., like Micheal Steinhardt or John Henry, then you are probably going to have to do some pretty extensive research and testing to find a method that really works, the way Larry Hite, Richard Dennis, and Linda Raschke have done, to mention 3 OTHER "Market Wizards".

If you put a gun to my head, and said I have to volunteer my services to some well known trader/market guy right now, I would probably pick Bulkowski, Niederhoffer, or Ned Davis at this point. It seems to me that they have put out some of the most interesting, and possibly the most valid, publicly available quantitative testing on the stock market. Davis' is proprietary, whereas Bulkowski and Vic at least publish a few things. Davis' mutual fund doesn't do much, btw Ned Davis Research Asset Allocation AAA Report (NDRAX) | Snapshot . Maybe after I spent some time with them I would throw in the towel on the whole things as rubbish, but I'd like the experience under my belt first.

Here's Bulkowski's bio, true, false, or whatever, since I don't KNOW the guy, which is PROTOTYPICAL of the best traders I know in TODAY'S markets: all are programmers, all are engineers --

THOMAS N. BULKOWSKI is a successful full-time investor and contributing writer to Technical Analysis of Stocks & Commodities. Before earning enough from his investments to "retire" from his day job at age 36, Bulkowski was a hardware design engineer with Raytheon and a senior software engineer for Tandy Corporation.

To the board at Traders-talk.com:

The Prechter thread caused this to detonate.

I met Bob for the first time this spring; nice guy.

He's been basically pretty close to 100% wrong about the stock market for some time now, including the most recent CRASH call on 10/19/05, which was an IBD follow thru day, technically, on the current rally phase in stocks. About par for the course for Bob since he was named "Guru of the Decade" 16 years ago in 1989, it seems.

How a bright guy can be so wrong...I do not understand for the life of me.

But here's a slant on it:

I heard at an LBR seminar that Tudor Jones spent $10 million backtesting Elliott Wave and found it to be RANDOM and NON-PREDICTIVE.

That's an unconfirmed rumor, as is about 99% of all info in Wall St . anyway.

POINT IS, in my experience, about 1 in 100,000 speculators, MAYBE, has a methodology that is VALIDLY backtested, and indicative of profit potential on the backtest.

And most of them are to be found in Schwager's books.

In my opinion, if you do not have a methodology that can be tested out as systematically profitable, how do you expect to make money? Answer -- you could be an intuitively gifted gambler, who can mysteriously defy odds, but there aren't many of those around either....

..Oherwise, absent a methodolgy that is demonstrably profitable in market investing, you will lose money. There is little other possibilty. Even if lucky enough to start at the bottom of a bull market, given enough time you will still lose, STATISICALLY.

So, everyone here throws around this chart, and that chart, and this method, and that method, and this indicator and that indicator -- and I SELDOM IF EVER SEE... a backtest.

A trading indication without a backtest is little better than a drunk boasting at the end of the bar at the pub on Friday night.

I think Elliott Wave may be useless, and maybe that's why Prechter has been wrong for 16 years. But I don't know that. And I do know that Fibonacci ratios DO exist in nature. So, I keep messing with the thing, along with Wyckoff, and Tim Ord's/Tom O'Brien's stuff, and a bunch of other stuff.

All my indicators called this bottom off 10/13 (VIX vs. 200 day, 10 dma NH/NH+NL, 3/39 week Equity put/call ratios, IBD put call ratio, IBD follow thru day, % stocks below 40/200 day, McClell Summation weekly, McClell osc, Fosback hi-lo logic, Sentiment surveys, Swenlin's T/TM model, etc. etc.), so SOME elements of TA do have some functionality, and can be tested as such IF you have the staff AND RESOURCES to do it, which almost everone DOES NOT. Including ME, btw. Recall that it took Dr. Thorp some 18 months working alone just to test a one-deck game of blackjack 45 years ago.

But, as world #1 hedge fund manager curently, Vic Niederhoffer, says, "IF IT CAN BE TESTED, IT MUST BE TESTED."

If you have a profitable equity curve over time, that will suffice as a surrogate backtest. Even if you don't know how you make money, as long as you do make money, well that's good in promoting survival.

But, the fact is, most people in this business, and most people on this board, don't know what they heck they are doing in this business in the first place. I mean that LITERALLY. They DO NOT know if what they are doing ACTUALLY WORKS. It is a guess and a gamble, at best, for most people.

To refute, SEND IN YOUR BACKTEST, personal EQUITY CURVE, IRS 1040 for 10 years, or a net worth statement that can be audited by several accountants.

11/7/2005
Paris Pasśe

Paris is burning, rioters are shooting at the police, the first man has been killed, the elegant XVII Arrondisement is scared, twenty countries warned their nationals to avoid France, the Chirac government is paralyzed, and the CAC 40 index is 6 points up.

There is no need for the gift of prophesy to see that the French tourism industry is going to have a bad season or two. Why are shares not reflecting reality?

-- J. Klein

11/7/2005
Thai Trap II

From today's Bangkok Post: Derivatives market to lure retail investors

I want the Chair to know that in the spirit of Team Manchester I have given up eating at Thai restaurants as well!

--Mr. Fee

11/5/2005
7 Sisters

Hello Mr. Niederhoffer:

Patricia Breen has just defended and kept her woman's world title vs. Jan Mortimer of NZ. 6-1-9 draws. She has 6 sisters and the entire family plays Checkers! I know you have 6 daughters and found it amazing that 7 girls in a family all enjoy the game:-) Ireland runs at a little slower pace than we do here in the USA. Thus they must manage to have the time to enjoy one of the best board games ever conceived.

Regards,

Alan Millhone

11/02/2005
What People Really Think About Vic and Refco, by a Future Visitor to Sweden

First of all, I don't agree that you need much rehabilitation, though I can certainly understand why you might think you do. I can only imagine how difficult it must have been for you and your family to go through the aftermath of your 1997 crisis, but you should keep in mind the following things: (1) The public perception was that you made a big bet that went the wrong way; (2) It is well known that many other traders suffered severe losses that year; (3) There was never any hint of any inappropriate behavior on your part; (4) You are one of the most accomplished traders in the business, irrespective of 1997, and this is widely acknowledged by the entire industry; and (5) You've rebuilt your business.

Now compare these facts with, say, the folks at LTCM who suffered considerably more at the hands of the public media than you did (no one ever wrote a book about you titled WHEN GENIUS FAILED), and observe that all of them are now completely rehabilitated as well. In fact, the combination of Meriwether's JWM Partners and Chi-fu Huang's and Myron Scholes's Oak Hill Platinum Partners has combined assets under management that exceed LTCM's assets just prior to their demise. Whodathunkit?

The point of this chain of logic is that your personal perception of how you are viewed is quite different from the actual public perception, thanks largely to your midbrain over-riding your neocortex. No doubt you had detractors and critics prior to 1997, but you weren't as sensitized to them as you are now. And even if there are more of them now than before, well so what? As Richard Feynman once said, "What Do You Care What Other People Think?".

Finally, with respect to Refco, the public perception is that what went wrong was not that some of their clients lost a lot of money, but that they hid those losses at the time of the IPO. While I can understand why it pains you to see your name mentioned in that context---and it's important to clear the air, as the article and your statement does---the attribution is interesting only because you're a well-known public figure (like Soros, Buffett, and other investors), and not because there's any aspect of blame assigned to you. Refco's troubles have to do with securities fraud, not trading losses (I suspect that several respectable firms lost even more money during 1998). By the way, there's one important difference between Beethoven and Refco: Beethoven was beloved.

Sorry to have gone on and on, but I wanted to make sure you had a more complete perspective of this situation.

Best regards,

Letters to the Editor: Archive