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The Chairman
Victor Niederhoffer


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An Open Letter to Doomsdayists, by Victor Niederhoffer

Is it possible, worthy sirs, that you credit the existence of palfreys, damsels-errants, serpents, dragons, giants: all the wonderful battles, furious encounters, enamored princes, witty dwarfs,--- in short all the absurdities which books of chivalry contain? Miguel Cervantes, Don Quixote

Dear Composite Doomsdayist.

It has now been more than eight years that you and followers have been proclaiming, hoping and averring that the end of the Dow and the American economy is near. You have adduced and set forth innumerable reasons, hopes, and fancies for this downfall as far from truth as the rise of the S & P to 1240 is from Dow 5000 itself.

Is it possible that human reason can credit the existence of black swans, can make comparisons to the Bronze Age when interest rates were twice their current levels, can countenance fears about the growth and quality of jobs , savings, current balances, outsourcings, competition from our Asian brothers, P/Es above 10, declining premiums for risk, evidences of speculative enthusiasm in IPOs, returns to the golden age of feudalism because of the energy crisis, imminent earthquakes, jihads, viruses, el Ninos, and other natural disasters set off by the age of tsunamis, terrorism, conspicuous displays of excessive earnings and pay of high executives, defaults by our leading remaining industrial manufacturers, evidences of impropriety in the accounting and ethics of the leaders of our companies, ugly and grotesques shapes of yield curves, Fed tightenings, negative views from ascetic noble investors -- in short, all the absurdities and fears about imminent collapse that books by academic economists such as Bodie, Graham, Krugman, Shiller, Sornette and Soros contain?

For my own part, I confess that I have read all of the books, and listened to all your fears, and find that they do not contain any reason to think that the conditions of our own day are considerably worse than they ever been before or, if they were, that this would be bearish. When you consider the record of the proponents of these views, who have been proclaiming them since S&P 300 in 1987, all through the regularly occurring implied volatilities of 25 in 1998 and the 30s in 2002, and their hopes and wishes that America will be doomed unless we scale down consumer spending and retaliations against those who would destroy us, increase our funding of the United Nations and support of the Kyoto agreements, I would commit their books to the flames and indeed insist that they return to the monasteries and austere existences and sabbaticals that many of them have threatened to retire to or engage in since the falsity of their views has been manifest -- for they want common sense and do not take into account the resilience of the enterprise system nor the many good things that counterbalance all their misinformed emphasis and hopes for the negative.

Nay, the very prevalence of their views, the extent of the belief that comparisons of the present times to the 1920s and 1970s when there were crashes without reference to any other decades might be predictive of anything, is evidence that the prospects for future returns are even greater than they have been during the 20th century when markets throughout the world scored a 1.5 million percent return.

As the canon said to Don Quixote, who suffered from similar fancies and disturbances and was carried from place to place in a cage like some lion or tiger exhibited for money, I would urge you to have pity on yourselves, shake off your follies, leave your proverbial and literal monasteries and employ the talents that heaven has blessed you with in the enjoyment of your wealth and the opportunity that others might have to duplicate the great feats that you have obtained in the past through the investment in equities on high leverage during a period of declining interest rates with favorable sheltered rates of sharing with the Service.

It is true that you are a man of great talents. You teach many multidisciplinary classes at the greatest liberal universities, you do not initiate public appearances or submit papers to academic journals but only respond to scholarly requests from editors of major academic or intellectual sites, you collaborate with great scholars and self-proclaimed Nobel prize manqus who share your envy of those who have been making fortunes on the bull side of real estate, buyouts or buy and hold; you stoically demur from investing in stocks or running your previous hedge funds or citing your results for the last 5 or 10 years because of the embarrassment of invidious comparisons concerning the amount of money lost directly in most cases or indirectly through the concept of opportunity costs, and most of all you read books only in the languages they written in, for example, the Iliad and Zorba the Greek in Greek, the Aeneid in Latin, and the path-breaking work of Bachelier in the original French of that great nation of risk takers , international diplomats and devotees of leisure time from work, and abhorrence of hot deterrence.

If a strong natural impulse still leads you out of a feeling of lost opportunity and reduced wealth to books about the good old days, read The Triumph of the Optimists or its updates, in which Dimson, Marsh and Staunton document the 1.5 million percent-a-century returns in all markets, including that of the great United Kingdom, which during this period lost its empire, moved from a free market to a socialist economic system, was exposed to terrorism from its enemies on a unprecedented scale, was almost destroyed by two world wars and lost its position as a leading financial center among other disasters which make the woes of our current time look tame.

I would also commend you to the works of such heroes as Julian Simon in such works as The Ultimate Resource, where he documents the inevitable tendency of commodity prices to fall relative to equities, for standards of living and environmental quality to rise, and the work of Sidney Homer in A History of Interest Rates so that you can see that the current level of long-term interest rates, which are the best estimates of those with trillions on the line as to where they will be in the future, at which all future cash flows should be discounted, are about two-thirds the levels of those that have prevailed in the past.

My friend, these exercises would lead you to become well instructed in history, aware of the economic principles that determine value, able to apply the lessons of decision-making under uncertainty that are used in every other field where uncertainty reigns, enamored with the prospects for the future and improvement in your financial fortunes; and would enable you to acquire, in the words of Cervantes, "improvement in morals, valor without rashness, actions without cowardice, and would at the same time redound to the glory of the muse of markets and your own profits.

Quick Q&A from Professor E and Vic:


You are such a bull that I have a question for you. If investors decide you are correct, can we then anticipate an immediate upward correction in stock prices, followed thereafter by more moderate returns?

Dear Professor E,

If you only would study the results of your work, and not try to denigrate the numbers with gratuitous explanation of why they happened related to dividends and risk preferences, then you'd be able to tread the heroic path to the Elysian fields that you deserve, without recrimination.

Your question to me is hypothetical. There is more negative sentiment now about the market than ever before, and this always happens after a 5 year period where the market is below its previous level. Testing such periods, or any similar ones shows the rate of increase is about 1.5 times the norm that your studies have documented. Such quantifications would be a better use of your good efforts than attempts to chisel down your results by 2 or 3 %, thereby setting a very bad example for the many who follow you that hate the enterprise system; especially those that Schumpeter writes about.

Best Vic

Kim Zussman comments:

I don't know whether to laugh or cry.

I cannot tell whether your fervent belief in the current and future versions of American capitalism derive from reading and reasoning beyond my ken or genetic emotional stoicism that escaped my forebears and their progeny.

Recently while losing Monopoly to my youngest, I noticed how I lost interest in playing once the odds of winning became slim. Instead of wanting to beg-borrow-steal to build more houses and claw back, the instinct was to fold and go on to more pleasant activities. A risk Rorschach test?

I am not able to understand why our current era is as risk-free as markets claim. Or that structural and societal progress since the Depression, world wars, Vietnam, and oil embargoes moots the relevance of such recurrences. The worry of what a 5%-10% one-week drop would do to my life savings (if I invested like I think you do) is for me an endless 30% hill-climb that calls out: "Stop! Get off the bike! You might have a heart-attack. But even if not just think how much better you will feel when your burning legs and lungs and eyes and parched throat quit and are quenched with ice-water!"

Lance I'm not. But even with an understanding of such improbable genetic dollops I applaud all the Lances and Vics who stick their formidable necks out as far as they will go to illustrate the envelope of human possibility and humility.

Kim Zussman comments, Part II

A hundred years is a long time; longer than most investment careers and even lifetimes, and the road to such returns was uncertain and arduous. The ideal trader for such longest-term anomalies would be Sleeping Beauty; who, along with anyone going under the knife, asks to "wake me up when its over".

Certainly investors who read Dimson, Siegel, and other market historians can intellectualize the numerical compounding which led to such returns over the last century. And surely they understand that the equity risk premium was vastly over-estimated in 1904, and that the premium has substantially declined since. (Which is not to say it cannot decline substantially further.) But, in deference to the emotional component of risk, how does 1.5 MM% feel?

1.5 MM% gain is 15,000*(initial capital). Assuming no taxes, transaction costs, etc, this is 10.09% annually including price gains and reinvested dividends (1.1009^100=15,000).

However stocks go up because they are risky, and risk (among other things) means lots of variability. Schwert has tabulated annual standard deviation of stocks, which exhibits a large range but hovers around 15%/year (http://tinyurl.com/8yegr).

Using the Excel* random number generator, I simulated 50 different 100-year runs of returns normally distributed with mean 1.1009 and SDEV 0.15. Over 50 different 100-year periods:

Annual mean ranged from 6.2% to 14.1% for the 50 hundred year runs Annual stdev ranged from 12-18% ("" "") Yearly return extrema for all years ranged from -46% to +60% Total 100 year compounded return ranged from 12,364% to 18,973,430%

So if returns are normally distributed and random as above, there is a large range in possible outcomes (especially in 100-year return due to effects of compounding). Also there were instances where lower annual mean returns gave higher final compounded return, due to different return distribution in early years.

A more ambitious project, relevant to the volatility discomfort of experiencing 1.5MM% year-to-year, would be to check for maximum drawdowns in the simulations.


*The value of this post is fully amortized in the correct spelling of Excel.

Mark Mahorney notes:

A few things about inverted yield curves that are never mentioned by the media or the Fed:

  1. The average effective fed funds rate at times of inversion is about 9.90% over the past 50 years, compared to a historical average of 5.78%.
  2. The average rate of maturities longer than 10 years when inverted to the fed funds rate is 7.88%, compared to an overall average of 6.07%.
  3. The range of fed funds rates: 0.6% - 19%. The range of 1yr notes: 0.8% - 17%. The range of 20yr Treasuries: 3% - 15%

Greenspan said the current situation was a conundrum. Then when he changed his tune and said that inverted or flattening yield curves might not be as good a predictor of recession as it once was. But he has never said why. Of course he hasn't because he knows the truth: high effective fed funds rates are the real predictor of recession, not an inverted yield curve. But he'll never say that. Inverted yield curves are not a causation of recession, but rather coincident to high fed funds rates because short-term rates have been more volatile than long-term rates, thanks to the Fed.

Is it really any wonder at all that yields would invert when the Fed raises the target fed funds rate? Of course not. Long-term rates are a bet on the distant future. And when times are bad and the Fed takes rates to outer space the logical bet is that times will get better, to the chagrin of the doomsdayists.

George Zachar adds:

Deutsche Bank recently ran a chart of a rolling 12-month yield curve slope vs. economic activity, since ~1980.

Received wisdom is steeper curve means stronger economy, vice versa, and inversion means recession.

As if to illustrate the point made below, the "fit" between the curve and economy has dropped from an 80ish correlation to zero as nominal interest rates have fallen over the past two decades.

Even allowing for all the fuzziness inherent in measuring two abstract concepts like the yield curve and the economy, the changing cycle is blindingly clear.

Rick Ackerman rejoins:

Just as atheists and sinners must sense what a hellhole this planet would become if not for the righteous and the faithful, we doomsdayers understand that the world desperately needs optimists, even the blind, patronizing kind who hold sway in this forum. I say "blind" because the introduction of facts that might contradict the group's assertively blithe view of the world are discouraged, if not to say censored. Mises himself would only be politely tolerated here, his dour disciples made to wear yellow armbands.

This ideological, factually strained kind of optimism seems to me insecure. At any rate, it pales in comparison to the robust optimism of *my* favorite optimist, Steve Wynn, who stakes billions on bullish positions from which no exit is possible save bankruptcy. Even more impressive is that Wynn is no cold-blooded quant wagering on an obscure statistical quirk, but a seat-of-the-pants risk-taker betting that middle class America's prosperity can only burgeon. In short, a guy with the cajones to put a five-acre fountain in the middle of the desert.

Admittedly, Las Vegas would be a mighty small town if I had been the first capitalist on the scene, and Americans would probably have to drive three times as far to get to the nearest shopping mall. But this doesn't mean pessimism is in my blood. Working for Dresdner in the late 1990s, my reports on Y2K to institutional investors grew increasingly bullish and dismissive of the end-of-worlders as the crucial date approached. Ultimately, my optimism bordered on certitude, buttressed as it was by interviews with hundreds upon hundreds of sources in health care, banking, manufacturing and energy.

Now, with respect to the economy, and having done my homework, I would not venture that "doom" is imminent, nor would I conflate forecasts of economic catastrophe with speculative fears of radical Islam, water and fuel shortages, smallpox, bird flu, asteroids, global warming, and the like. To ratchet down the rhetoric a bit, we deflationists are not warning of "doomsday" -- i.e., some catastrophe that will extinguish civilization. Rather, we see deflation, simply, as the path the financial economy is most likely to take when debtors and creditors are forced by higher real interest rates to come to terms. The process is certain to be wrenching, since settlement will involve hundreds of trillions of dollars of very thinly collateralized obligations.

Stick your head in the sand and tune out the blunt facts, if you prefer. But please don't assert that those of us who are predicting trouble must necessarily be wrong because the world still turns.

The Grandmaster conciliates:

I have been toying with the idea of only playing the long side of stocks. What has also been very noticeable has been the fact that I haven't captured all of the upside's points during the period I've been trading. It seems that there's a case for being somehow long (even if totally unleveraged) all the time and apply different degrees of leverage when things become particularly 'bullish'.

The only thing that makes me wary is that sometimes it has to go down. I don't want to be out on too much of a limb when that happens. But it's good that the bears get the thrive now and then and that Abelson, Prechter & Co. are so popular. As far as I'm concerned the more bears the better and no bears at all would be very dangerous.

So here's to the bears. And I'm not sure we should discourage them too much..

Ryan Carlson comments:

I'd like to suggest a trip to Hiroshima for the Doomsdayists. Last November, after some crippling trading losses on my part, I traveled to the city and was inspired by the spirit of the place. The following two photos contrast how far the city has come as we approach the 60th anniversary of the bombing:



After the visit, it didn't seem too difficult for a young spec to climb back up the stairs.

Allen Gillespie adds:

Valuation is at best a fuzzy science as a security simultaneously has a return based on its own price and internal rates of return as well as a "comp" valuation to other securities. In addition, as the chair has pointed out companies are free to change strategy and reallocate capital to changing conditions in order to raise their value. Thus it may be said that a security's value is the combination of an initial static valuation (which can be observed with more certainty), future fundamental changes (which may or may not be estimated), and futures changes in comparitive position and the speculative conditions. Further complicating matters is the fact we should be concerned with our real returns but we can only directly observe and trade in nominal prices as the future inflation rate is largely unknown and always changing.

Obviously, we should concern ourselves with real returns but we must trade in nominal prices, which I think led many a bear astray, as they would like P/Es at 10 and stocks at book, despite the fact that book value is hardly a useful number when looking at many companies particularly in technology, biotech, etc. They simply could not image a scenario, despite several examples that Mr. Rogers has pointed out (when his commodities went bull market), where stocks rallied then went sideways while earnings rose to catch up.

Introducing inflation, however, does create interesting possibilities. For example, taking the Dow pattern of the 1970s where its top to bottom range was around 75% from the 1974 low to the 1976 peak (which was just below the prior), before stabilizing in the upper half of that range for 7 years, we would have a range on the S&P from the 2002 low of 780 to 1365, after which point prices could stabilize between 1030 and 1365. If inflation average just 2.5% a year then purchasing power would decline 18% even if there were no "bear market." At 3% for 7 years the decline would be 23%. Meanwhile, earning could reasonable be expect to double in 7 years, and the market would be at the bear's P/E of 10 at prices where we are currently.

The 1930s market also was charaterized by a market that rallied and declined with each business cycle around its recovery midpoint while continously bring down its P/E ratio because earnings were climbing. In fact, its climb reached the lows of the "crash." A similar rise in the Nasdaq would take it close to 3000.

Given that the NBER puts the average business cycle at 50 months and dates the end of the last recession at November 2001 the bear's best opportunity may occur late this year or early next year. Moreover, the part of mean that like odd facts, suspects that since Greenspan came in just before a huge volatility event, that he might like to leave with it at a low. Moreover, the first few years of a new Fed chair's reign have not always been smooth. I am also a little concerned about the replacement given that 1 potential candidate has said he would drop money from a helicopter and another, even though he is an aquaitaince of mine who I very much like and respect, suffers from a bad precendent as he is at Columbia and part of the president's team. Here is the last Fed chair with credentials like those.

A few words from Rudy Hauser:

First, with regard to inverted yield curves, the initial question should be why do yield curves invert? To point out that long rates represent a forecast of all future short rates is not really a sufficient answer. The usual circumstances in which this happens is Fed tightening and a resulting tightening of liquidity. Now liquidity is important and when it is scarce the liquidity of longer-term instruments diminishes even more. When liquidity is ample there is less need to have assets that are more liquid in order to be able to raise needed cash quickly. When it is scarce, that need becomes even more important and holding less liquid longer-term assets should be more amply rewarded as one is taking more liquidity risk. But that is precisely the time when one might have an inverted yield curve in which the yield on the long-term instrument is less than that of the short-term instrument. How does one explain that? Simply, by realizing that everyone realizes that the situation is temporary and that the high yield (low price) will be reversed when liquidity improves, insuring a capital gain in the long-term instrument at the time. (Interestingly, the yield curve was negative in 1929 but positive thereafter despite drastic declines in money supply resulting in the Great Depression. My explanation was that the liquidity situation was so tight that the expected capital gain added to the current yield to maturity was insufficient to provide a sufficiently large return to the longer dated instrument except when the curve remained positive.) The yield curve is shrinking currently, but is still positive. Long-term rates are low. They are lower than a year ago or at the start of this year. It is hardly a situation in which one expects a rather sure capital gain in the long-dated maturities. Given that, it hardly seems likely that a barely inverted curve would have quite the same negative connotations that it usually does, although it certainly represents a less favorable situation than we have had recently.

As to some of the other doomsday concerns, Vic s arguments are based on the solid ground of past experience. Such concerns are often not realized and even when they come to pass have usually been temporary and overcome. But the free market optimists also suffer from a certain blinked vision. Man s ingenuity and determination when empowered by economic and political freedom, a favorable cultural environment and a rule of law and order certainly are capable of great achievements and are the most efficient and effective way to insure the growth and well being of humanity. That however does not insure that all problems can be overcome. Nor are we assured that those favorable conditions of freedom will always endure. For that matter, we do not have optimum freedom at present, just a very substantial amount. There could be improvement in world freedom or the other factors that influence growth and prosperity. A case for moves in both directions can be made and it is uncertain which way the future will turn.

There are concerns about events that could end all humanity. We may be due for a massive volcanic eruption in the Yellowstone basin or Indonesian basin that exceeds more than a hundred-fold the largest such eruptions in human memory. They do seem to happen every 70,000 years or so. But humans live only a bit over 100 years at best so there is a good chance that it will not happen in our lifetimes (even if still young, which I, alas, am not.) An asteroid hit could do us in also. Or we could do it to ourselves with a full-scale nuclear war. Less drastic events could also be quite devastating. A massive tsumni that would cause 120 foot waves to hit the East coast and surge inward for miles could result if another volcanic eruption on one of the Carnary islands causes the island to split in half and fall into the Atlantic. Europe could be in for Siberia like weather if the Gulf Stream stops flowing because of decreased salinity of the waters around Greenland. That could happen over decades or could happen abruptly if certain ice sheets in Greenland should break off into water. But in the case of the first series, we would all be killed anyway so what difference does it make how we have invested. As to the lessor dangers, the events might never happen in our lifetimes so the lost opportunities would be great indeed. The only logical precaution is geographic diversification.

Another risk is a new disease that could wipe out most of humanity. This is a risk that should diminish over coming decades as we gain more knowledge that will allow us to fight disease at the molecular level and fuller understanding of the proteins in the human body. There is an immediate risk with regard to the H5N1 virus (bird flu) that could create a new influenza pandemic if it mutates to a form spreadable from human-to-human. The July-August issue of Foreign Affairs has some excellent articles on this risk. There have been less serious pandemics in recent decades but the last really scary one was the Spanish influenza of 1918. But a quick look will show that stock prices advanced in the aftermath of that epidemic. Granted this one could be much worse and with a dependence on international commerce being what it is it could be a major catastrophe for the economy and markets. But there will still be time to sell after it mutates to a human-to-human transmission form. If we are lucky it will not happen or the mutation will be such as to make this virus less deadly than it now seems. With delay our ability to fight it should it happen will be enhanced.

The concern over peak oil production may or may not be real. There is no assurance that we will always have the resources we use. The fact that in the past we have been able to surprise by finding new ways to increase production is not guarantee that it will also happen. But the doomsayers should realize how premature or outright wrong such predictions have been in the past. In any case, the main economic problem is abrupt supply interruptions given how price inelastic energy use is in the short-term. But a peaking of production creates a gradual shortage problem that can be come as new technology and changing capital investments resulting in greater efficiency in both consumption and production, along with the development of other sources of energy can help us cope with the problem. It might well be that the changes will make us less efficient, but that does not preclude improvements from the diminished base level. Also often a higher real return is required to justify the development and use of new technologies but once those changes are made future improvements are made in such that result in even cheaper and better energy than we had formerly. That certainly was true of the switch from whale oil to petroleum. The auto industry would never have started if we still had to rely on whale oil even if whales had not been hunted almost to extinction.

J.T offers quote:

Nice quote for Mr. Dimson:

"Remember. Things in life will not always run smoothly. Sometimes we will be rising toward the heights - then all will seem to reverse itself and start downward. The great fact to remember is that the trend of civilization itself is forever upward, that a line drawn through the middle of the peaks and the valleys of the centuries always has an upward trend." Endicott Peabody (Roosevelts Groton Headmaster)

Not to go out on a limb but, yes an upward correction will happen, and yes followed by more and more moderate returns.

That drift is like cuttin' salami! Consistency and Texture will remain no matter how you try to slice it. If you happen to run out then we got more to slice. Pound after Pound.

Thoughts from a Reader:


They cant stand to watch people prosper, and, yes fail on their own accord. They see themselves as a divine shepherd. And, as you can see currently, when they see their number of sheep dwindling - the more fanatical they get. The individual is the most powerful source of energy on this globe - that is why, as you know, they must control it. Thank You Vic. You are but one of many individuals who have taught me that. The list is many and the language, and topics differ, but never the conclusion - free people always prosper.

Chad "wannabe pittsburghphil" Rich Durham, NC

Dear Chad:

Thanks for those kind words. And like the football team down on its last legs having to resort to the Hail Mary pass, or Bill Tilden forced way off the court at the side trying to go for a winner at the base line at such a sharp angle it never cleared the net on the court, the doomsdayists are testy and tense. They point to such things as declining intentions to purchase back to school items, and the reduction in manufacturing activity in Philadelphia in July.