Mar

5

AltmanIn the March 3 edition of Barron's there was an article by A. Bary entitled "Risky Bets". The author cites a number of stocks that are down 40% or more from their highs; he believes investing in these companies could be very profitable if the credit markets begin to normalize and the economy recovers.

There are a number of companies other than those he cites that are down 40-50% or more that may be two or three baggers when the stock market comes back. The question is, "Are they reliable companies or future bankrupts"? I've been using Value Line and Morningstar to determine the financial risk of some of these beaten down companies.

However, I'm also aware of a formula called Altman's Z-Score that predicts future bankrupts with 85% accuracy among stocks with a low Price to Book Value. A Google search yields a number of articles describing the approach and financial data to use.

The data to use are:

1) Earnings Before Interest and Taxes (EBIT)

2) Total Assets

3) Net Sales

4) Market Value of Equity

5) Total Liabilities

6) Current Assets

7) Current Liabilities

8) Retained Earnings

I have, with varying degrees of success found these data in the Yahoo, CNBC-MSNBC, and Morningstar Financial Pages. But the data are 6 or more months old or incomplete. Value Line was a big disappointment.

1) Is anyone aware of where more up-to-date and complete financial data may be found on the web?

2) Or is there a web page that lists companies along with their Z-Scores ?

Gordon Haave replies:

For those of you with Bloomberg (the system, not the mayor), there is a Z-Score function built in.

Larry Williams suggests:

For more up to data company financial data try: MSN Money or Kiplinger.

Allen Gillespie cautions:

Altman Z-Scores is designed to work for certain industries. You might have to use several different scoring methods to cover all industries.

Eric Falkenstein offers:

I just created a website with free default probabilities for public companies, US and worldwide. Better than anything else I've seen, and I've seen 'em all.

Feb

28

DrinkIn most pursuits it's a bad idea to burn bridges. Trading is an obvious example, if one keeps making all or nothing bets then sooner or later it's going to be nothing. Chess is like this too, the professional way of playing being to avoid leaving one's position so brittle that a failed attack means you are lost. This is why Bent Larsen liked to push his rook's pawns; an advance of this pawn rarely compromises one's position beyond hope.

There are also times that bridge burning can be good, when the bridge leads somewhere to which you never want to return. A good example is in throwing out old clothes after losing weight when retreat is no longer an option. Another is to announce to acquaintances that one is giving up the thing that lies on the other side of the bridge. Take your pick between booze, cigarettes and blondes, the statement makes it harder to go back because of the loss of face. One must, of course, mind losing face for this to work.

And this brings me nicely to the point of this email, I'm about to burn one of my own bridges with an announcement: A wonderful 30 year relationship I've had with (moderate amounts of) alcohol has recently come to an end. And I'm now left wondering why I didn't do this earlier.

Scott Brooks replies:

I've had a similiar experience.
 
When I first got into this business it was recommended that I read Tom Hopkins book "How to Master the Art of Selling". It was a very old-school book on selling (but hey, 20 years ago everything was old-school), but it did have some pretty profound advice that I decided to follow.
 
I'm going from memory here, but what Hopkins basically said was, "Remove all people and all things from your life that don't add value."

Then I made several decisions that I believe had an important impact on my life.

1. I stopped hanging around with a group of friends that were hoodoos
2. I gave up drinking altogether. I was never a heavy drinker, but not giving it up was symbolic to me in that it I believed it seperated me from the vast majority of people
3. I reaffirmed my commitment to not use four-letter words.
 
By far and away, giving up the hoodoo's was the best thing I ever did. But quiting drink and not using four-letter words is a constant reminder to myself (since most around me cuss or drink) that I hold myself to different standards, that are solely my own.
 
Now, I'm certainly not proselytizing my way of life to anyone reading this, nor do I look down on others that make choices that are different than mine.

Steve Leslie writes: 

To Nigel, I say, congratulations on your decision and I hope it has meaning for you beyond the physical benefits you will likely experiences.

The Outlaw Josey Wales said it best, “A man’s gotta know his limitations.”

I applaud Nigel for making a public and personal decision. I emphasize the word personal.

I agree that moderate drinking, consumption of fine food, recreational gambling, enjoying a fine cigar, or trading futures, in most cases is probably not very destructive. When it is a chronic condition when it might become a problem.

Even helping out those in need and advising others can be a noble pursuit.

Many of us are aware when this crosses the line and becomes destructive to our own lives.

For those who might not have the gift of discernment or may be too soft-hearted or gullible, it can be very helpful to have at your disposal an inner circle of advisors. It also is important to distinguish as to whom one includes in this circle. Napoleon Hill in his excellent book “Think and Grow Rich” discusses this in great detail. Others such as Tony Robbins, Zig Ziglar and Jim Rohn have also expounded the validity of such a strategy. It would serve us all well to visit Hill’s book and review his profound wisdom.

Nigel Davies replies:

Steve makes a good point that such decisions are personal. It wasn’t meant as a criticism of other peoples’ choice to drink either moderately or immoderately. In fact one of my all time favourite quotes is by former World Chess Champion Mikhail Tal, who on learning that the Soviet authorities were going to clamp down on vodka drinking exclaimed: “The State against vodka? I’m on the side of vodka!” It was vodka that killed him, by the way, though without the vodka he might not have been able to tolerate life in the USSR.

My purpose in going public was really just to keep myself in line; making a public declaration like this really binds you to the decision. And I made the choice to quit after starting not to feel too good the morning after even moderate consumption. This sudden intolerance could be a result of having taken up Zhan Zhuang (’standing like a tree’) some months back — I’ve been advised by that such practices can produce this kind of effect. Whatever the reason I can say that I now feel better than I have done in years. And it will be a sad day if I ever build a bridge to go back. 

Jeff Watson recounts:

I used to be guilty of not burning bridges, and it cost me dearly.  I got a reputation for being a shoulder to cry on, and found myself inserted into the problems and drama of others.  This took a physical and emotional toll on myself and my family, and I finally had to cry, "No Mas!"  About 15 years ago, I made a concerted effort to to free my life of all of this flotsam and jetsam, and the result of doing so has simplified everything in my life. I got away from negative people, the ones who suck the very lifeblood from your soul.  However, I do like to listen to hoodoos, encouraging them to give their views in great detail.  Hoodoos are great fade indicators, and I look forward to their views  like the Israelites devoured the manna from heaven.  I listen to them with a jaundiced ear, and never allow them to convince me that their views are right.  I learn a lot from them, and consider them a great source of what not to do and what to fade.  I've burned a few bridges in the past by not doing business with friends, not co-signing on loans, and not financing ill prepared business ventures.  Although I've disappointed a few people with my "Scrooge" like approach, life has been better for myself and my family, and that's what really counts.  The only bridge I never burned was that of my favorite charity.  Although it sucks up a lot of time and money, and I would personally be better off distancing myself, whenever they need something, I always answer their siren's call.

Chris James adds:

I used to have a lot of married friends who would often try to drag me into their fights to be on the man’s side or the women’s side. When I was younger I use to bite and take one side or the other only to deeply regret it later after they made up. The one I had sided against was not to pleasant to me for a long time.

This is probably a common experience for a lot of people…

Solved it with a one liner. No couple who hears it has ever bothered me again. “Listen, You guys don’t invite me when you make love so consider me dis-invited when you make trouble!”

Eric Falkenstein cautions:

I think in ridding oneself of people who don’t add value, it is important to take the long view. If you are the kind of person who only deigns to return calls or hang out with people in a position to do you favors, right now, you are all too common. You would be an unreliable friend or colleague, because when adversity hits, you can’t be counted on. Further, there are many behind you that engage in mercenary friendships, so you aren’t needed–a fun replacement who values my friendship for the favors I can bestow him is simple. Such a person would be constantly trying to get into asymmetric relationships, always the lower-status guy trying to get the better of his ‘friend’.

No one likes these people, for obvious reasons. Thus, relationships should be addressed with a long view, in terms of intellectual, business, or social growth. To the extent their interests are base, unenlightened, or self-destructive, you need to avoid them.

Dec

7

Victor and Laurel have suggested that a fruitful area for market research may lie in replicating the methods of Brahe and Kepler. Brahe scrupulously gathered very precise data though years of observations. It was left to Kepler, his student, to develop the first model. Kepler first identified planetary orbits as elliptical.

Suppose we have two planetary bodies with periods P1 and P2 respectively. A quick review of Kepler's Laws reminds us that his third law is as follows:

P1^2 / P2^2 = R1^3 / R2^3

where R1 and R2 are the semi major axes of the two bodies. It is interesting to note that there are no linear terms in the above relationship. It can be read as the ratio of the squares of the periods are equal to the ratio of the cubes of the axes.

In the markets we know that the Efficient Market Hypothesis tells us that the market price change today should have no linear correlation with the price change tomorrow. Empirically this seems to be true most of the time for most markets. However a strict interpretation of EMH says nothing about the existence of non-linear relationships.

In particular when we evaluate the squares of changes we find they are significantly correlated. The same holds for the cubes at similar lags. It is left as an exercise for the reader to calculate the magnitude and direction of such correlations. So at first blush there may be an application for Kepler's third law in the markets.

In order to see if there is any similar Keplerian relationship in daily price series the data from the table on page 121 of Education of a Speculator hardback was studied. Using the midpoints of the classes in the table the model used only the squares and cubes of change to predict the next days performance. It turns out that the fit is statistically significant. Notably there is no linear term in the model. Checking whether a linear term would help, the data showed that it would not be helpful. Although the regression model was statistically significant it was based on out of date data and would have to be redone with current data.

Michael Cook remarks:

Kepler was not a student of Brahe; he came to Brahe's observatory because Brahe had good data, continuous night by night observations of the planets. Kepler was desperate to prove that the orbits of the planets were circles, because the circle is the perfect shape, consistent with the beauty of the divine Mind. He decided to work on Mars because it seemed to be closest. After much work he realized the ellipse was a better fit. His comment: "I set out to show that the universe was based on the eternal harmony of the spheres. Instead I showed that it rests on a carthill of dung [the ellipse]."

The other beautiful law of Kepler's is that the planets sweep out equal areas in equal times.
 
It is also significant that all of his laws can be deduced mathematically from the inverse square law of gravitation.

Adam Robinson replies:

As I'm sure Dr. Cook realizes, the point was that the law of gravitation can be deduced from Kepler's laws, as indeed Robert Hooke (whose insights into force and inverse square relationships were at least contemporaneous with Newton's) was able to do.  Newton's genius (in that regard, there were many instances of course) was in showing the equivalence of the acceleration of a falling object with the acceleration of an object in orbit.

Newton, in other words, gave the relationships a theoretic underpinning (until then Hooke's insights, along with Kepler's, were mere "curve fitting," in the literal sense of the phrase!), just as Einstein did, since numerous scientists at the time (Poincare for one) had come to similar conclusions (e.g., the Lorentz contraction), but lacked any overarching theory to explain why such phenomena had to occur.

Dr. Cook's quotation of Kepler also reveals the extent to which aesthetics can hinder the progress of theory as much as promote it.

Michael Cook responds:

Actually, I am not aware of any derivation of the inverse square law from Kepler's laws. I believe Hooke claimed to derive Kepler's laws from an inverse square law, which resulted in Newton's publishing his proof of the result. Hooke never published an actual proof — it's hard to do without calculus. Feynmann has a paper in which he does so, which I don't think he would have published it if it were already in the literature. 

It is incorrect to say the law of gravitation can be deduced from Kepler's laws — Kepler's laws are descriptive, and don't by themselves imply any causal mechanism.

Adam Robinson replies:

I refer Dr. Cook to the letters between Hooke and Newton; there was much controversy between the two about who had which insights, when. Hooke's insight was more of a conjecture, not a formal "derivation" as such. Not surprisingly, of course, since Hooke's inverse square law with springs contains a surprising analogue with gravitation.

Kim Zussman writes:

Jim SimonsA recent Bloomberg article on Jim Simons of RenTech mentions sunspots and markets, so along with Kepler's dung [see Dr. Cook's remarks above] this must explain the beauty of markets.

Recall that sunspots (which have been observed and recorded since well before Galileo) are magnetic storms on the sun, which appear dark in contrast to the photosphere because (though they are hot) they are relatively cooler.  And to the extent that there may be related effects on solar wind (solar ions flowing past the earth), radiation levels, and earth's ionosphere, and radio/satellite communications, here is a study.

Monthly average sunspot count (American, of course) 1944-2007 is available from the National Geophysical Data Center:

Regression of SP500 monthly index return vs. monthly avg sunspot count (1950-Oct 07) shows almost significant negative correlation (P=0.07):

Regression Analysis: SP CHG versus SPOT AV

The regression equation is
SP CHG = 0.0110 - 0.000052 SPOT AV

Predictor         Coef     SE Coef      T      P
Constant      0.010961    0.002534   4.33  0.000
SPOT AV      -0.0000518   0.000029  -1.79  0.074

S = 0.0405916   R-Sq = 0.5%   R-Sq(adj) = 0.3%

Analysis of Variance

Source           DF        SS        MS     F      P
Regression        1  0.005288  0.005288  3.21  0.074
Residual Error  691  1.138548  0.001648
Total           692  1.143836

Here is a plot of monthly avg sunspots vs date, which clearly shows the 11 year solar cycle. Note that we now near a minimum (good for stocks), and regardless of Fed actions relative to the housing market, explains the recent 5 year bull market (OK the last sunspot maximum was Sept 2001, so the prediction was off by about 1.5 yr).

Eric Falkenstein remarks:

One of the keys of finance is the implication that arbitrage implies that pricing is linear in 'risk', or whatever is priced. Otherwise, you could generate arbitrage by buying bulk and selling little bits, or vice versa. It is intriguing to think that there are nonlinear relations in markets, but these necessarily imply profits, so, to the degree they exist, they must not be too obvious (please email me the exceptions!).

Jun

28

I had a chance to read an advance copy of An American Hedge Fund, by Timothy Sykes, about his experience as a very young trader and his hedge fund start up. It is the story of a college student who made money on over the counter buy back stocks very quickly, leveraging on short-term market inefficiencies in a very speculative and volatile market. The book made me think about the following aspects of trading:

  1. A trader's ability to adapt to changing market conditions is the key to successful trading.
  2. While many praise foresight, they mistake incredible luck for incredible intelligence.
  3. A speculator succeeds when he/she is able to identify and take advantage of market inefficiencies.
  4. Trading books usually ignore the evolution of marketplaces.
  5. Traders pick up on any consistently successful strategy until it lasts before the cycle changes again.
  6. Short term trades that turn into long term situations often become the source of financial and mental agony.
  7. Sometimes you need to accept defeat and move onto new opportunities.

Sam Humbert adds:

I also read a proof of Mr. Sykes's self-published (why self- rather than Wiley-published is another thread) book on the plane back from Chicago last week, and here's my back-of-the envelope: I liked the book better than I'd expected. It's a fast and breezy read, and had a pleasantly candid and enthusiastic tone. Mr. Sykes comes across as an eager, hard-working, observant market participant with good hondling sensibilities.

Several of his trading ideas, though generally not original/unique to him, are well-presented and explained. The one negative is the long digression about a private-equity situation that didn't pan out, which distracts from the main narrative flow. But I guess those are the facts he had to work with. For a market veteran, it's best read with an empty mind, without preconceptions such as 'what the heck does a 20-year-old know?' and can be enjoyed as such. 

Eric Falkenstein remarks:

Sounds fascinating. I would accept some overestimation of skill vs. luck, but generally many big money situations involve people's being in the right place at the right time — and the recipients aren't morons. But I couldn't see where to buy this book.

Tom Alexander writes:

I also had the opportunity to read an advanced copy of Mr. Sykes's book. I think there are several lessons here. Mr. Sykes sent me a flattering note requesting I review a copy of his book. I accepted; flattery works really, really well on my old ego. While I have not had the opportunity to read it yet, my wife found it very readable and illuminating from her lay perspective.

Mr. Sykes is self-publishing his book, allowing him to keep a much higher percentage of the profits. The downside is he has to do his own marketing. He seems to have very effectively figured this out by using viral marketing and the wonders of the Internet to spread the word through blogs.

It is nice to see entrepreneurship alive and well. 

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