# Spreads Calculation, a query from Gabe Ivan

August 6, 2007 | 5 Comments

What is the correct way of calculating the spread between two time series A and B of daily returns? Assuming the spread at t1 is A1-B1 and at t2 is A2-B2, the return of a trade (buy A sell B) entered at t1 and closed at t2 is not (t1-t2) / 2 as expected, but off by a few tenths of a point depending on the distance between t0 and t1 and between t1 and t2. I spent the whole weekend trying to find what I'm doing wrong, to no avail. Any help will be greatly appreciated.

# Depth and Uncertainty, from Nigel Davies

Despite chess being a game of 'perfect knowledge' (game theorists’ term, not mine) we are nonetheless beset by uncertainty. Even in relatively benign, 'typical' positions, it can be difficult if not impossible to assess outcomes with any accuracy.

But does one need to know, to have deep insights? Here the answer is much more clear, in fact it's a definite 'no'. The players who win tournaments are those who play good moves, not the ones who see very deeply. And as evidence I cite the example of Friedrich Saemisch, inventor of several important opening systems but famous for losing on time.

Interestingly Saemisch's impracticality went beyond the bounds of the chessboard, as illustrated by these stories related by Ludek Pachman:

'Isn't Hitler a fool? He thinks he can win the war with Russians!' Samish said completely aloud. Prague of those days was full of Gestapo and Samisch had to be overheard at least at the next few tables. I asked him to speak quietly. 'You don't agree that Hitler is a fool?' was Samisch unconcerned retort.

"Samish stayed 'afloat' untill the Summer of 1944. Then he let his mouth run off at the closing banquette after the Madrid tournament. Upon his return, Samisch was arrested right at the German border and shipped to a concentration camp. In Apr, 1946 I asked Samish in Switzerland what was his internment like. 'Unglaublich, uberhaupt nichts zu Rauchen!' Samish replied; and immediately added: 'Noch schlimmer ist es, dass ich jetzt volkommen frankelos bin!'…" (Unreliable GM translation: 'Unbelievable, above all nothing to smoke. Even worse is that now I'm completely broke.')

## Gabe Ivan remarks:

Bruce Pandolfini says:

Most people believe that great players strategize by thinking far into the future, by thinking 10 or 15 moves ahead. That's just not true. Chess players look only as far into the future as they need to, and that usually means thinking just a few moves ahead. Thinking too far ahead is a waste of time; the information is uncertain. The situation is ambiguous. Chess is about controlling the situation at hand. You want to determine your own future. You certainly don't want your opponent to determine it for you. For that, you need clarity, not clairvoyance.

# The Stock Meltdown, from Gabe Ivan

CNBC should be acquired by the Teleshopping Network. It would be more entertaining and honest if while the pitchman touted the product, they put up a Quantity Sold and an interview countdown: "We have sold 500k shares of AAPL. Only 20 seconds left of this fund manager spewing away, so get yours now while they are hot! And don't forget if you place the trade with our sponsor, we will send you a CNBC trading calendar!" That being said I must disagree with Vic's conclusion. "You" cannot get 6% on stock unless you own the control packet. "You" own whatever the market values that baseball card at, and if you don't own the 6% then the 10% growing in profits is meaningless. The enterprise will do just fine, without the public providers of capital. After the South Sea bubble they banned publicly traded stock in England for decades, and England continued to grow without it.

I read a few times over the empirical facts that Tom Downing, Laurel, and Vic reported in their columns and it's a fantastic work with a single caveat. They're based on the past. And "past performance is not indicative of future results". But 100 years of data must mean something, right? Maybe, if the underlying factors prevail, which might not be the case. Dividend yields three-times higher for the better part of the period, short supply of stock world wide combined with favorable demographics provided the 10% drift which is not sure to be replicated in the next 100 years, with or without innovation, entrepreneurship and human spirit.

You can't expect to win if you don't bring anything to the table anymore (buy and hold). One need only look at other fields (i.e sports, business) to notice the niches are getting narrower by the day and performance more difficult to achieve.

# Ron Paul Submits Bill to Abolish Fed, from George Zachar

There is a proposal before congress (H.R. 2755) to abolish the Board of Governors of the Federal Reserve System and the Federal Reserve.

This is the second time, it seems. The first time was in 2003.

## Scott Brooks remarks:

I'm starting to become a Ron Paul fan. But I'm worried about what I've referred to as the Russia effect, meaning that Russia melted down into chaos after they went straight from socialism to capitalism resulting in anything but a capitalist society.

As much as I want to abolish the IRS and 99.99% off all government agencies, what thoughts are there on us melting down into chaos if that were to occur, i.e., abolishing the fed?

## Stefan Jovanovich writes:

"Russia melted down into chaos after they went straight from socialism to capitalism" is not a very good description of what happened after the U.S.S.R. formally dissolved.

Runaway drunkenness, near demographic suicide by abortion, absenteeism rates that made Lordstown look like a Toyota factory, extortion so much a part of ordinary life that someone's not demanding a bribe was cause for paranoia, had all been part of Russia life even before the defeatism and self-doubt that came after Afghanistan. Scott's post assumes that Soviet governmental authority had some moral force in 1988. It had none.

None of us can predict the future, but I would argue that the odds for Russia's future are as good as those were for what used to be known as West Germany in the 1950s. Then there were no local German politicians who could pass muster as anti-Nazis, and the new republic's democracy was a very brittle artifact. If Russia's current leadership seems tainted by associations with the old tyranny, that situation is little different from what was happening under Adenauer.

Ironically, Scott is far more likely to see Ron Paul's monetary regime created in Russia than in the U.S. I leave it to those who really know about currencies to correct my usual amateur errors, but it seems to me that the ruble is the one world currency that can currently be seen as being entirely backed by a gold/petroleum standard.

## Alex Forshaw writes:

Hmmm…with regards to Russia, the so-called "free/ democratic institutions" that "evolved" were anything but. It's one thing to have measured, organic evolution of a free press and robust markets as the US did. But in Russia, the robber baron tycoons immediately built up media machines to massage their public images.

Putin destroyed Russian "free media" because it was Boris Berezovsky's tool, and Berezovsky probably achieved greater control of the Russian economy than the Politburo did (with lots of help from Chechen gangsters, car bombs for his competitors, Russian government force, and other ridiculously coercive methods).

The admiration that the official American press (Time, WP, NYT - the usual suspects) showed for the "free/democratic institutions" that Professor Sachs helped "create" (sic) has its historical match in the obtusely wrong-headed enthusiasm that the Jeffersonian press showed for the progressive insanities of the French Revolution.

## Scott Brooks responds:

Both Stefan and Alex are doing a better job of making the point I was trying to make. These countries were run by demagogues, despots, and gangsters who simply changed their styles, but ultimately remained in charge. They changed from being in charge in the form of a government to being in charge in the form of being the most powerful gangster. The gangsters, of course, whether under the guise of a legitimate government or as just plain gangsters, were able to manipulate powerless people because the gangsters had made them dependent on them.

In the US we don't have gangsters in charge per se, but we do have a system where a large group of people like welfare recipients (no offense intended) who are dependent on the government. So I ask if a country can go from a "dependent system" to one of independence overnight? If not, then how does one move away from that system?

## Alex Forshaw replies:

If by "welfare recipients" you mean agribusiness, the tort bar (and to a lesser extent other unnecessary functionaries which use "the law" as an excuse to siphon money from businessmen who would otherwise have no need for them) then you're getting somewhere

Just in personal experience, I'm 21, I trade about 150k total in political futures (snobbier people would call it "gambling," I laugh at the pseudo-distinction). To get even the most rudimentary legal structure (a "pooling of interest") to facilitate moving the money offshore, (because it's simply stupid and/or prohibitively expensive to risk regulatory harassment over high-risk, novel securities trading in the United States, without the economy of scale of a tens of millions of dollars of a capital pool), I had to utilize the services of two accountants and a securities lawyer.

Fortunately I had friends of the family to do it for me, but what about someone who isn't as privileged as I am? Legal overcomplexity is an incredibly high fixed cost/ barrier to entry in this country.

And I don't even have day to day interactions with other people, unlike the Korean immigrants in DC who got sued for \$100 million because they refused to give a lawyercrat a \$1000 new suit, or the cerebral palsy doctor ruined by John Edwards.

## Stefan Jovanovich writes:

I will let Alex speak for himself, but that is not the point I was making, Scott. No ordinary Russian thinks that the changes over the past 20 years have been merely a change of styles by "demagogues, despots and gangsters".

For one thing, there is now actual freedom of conscience. (Yes, I know the Russians are giving their own national faith preference and have been less than open to proselytizing by Westerners; but that is a world of difference from the situation that had Jews, Seventh Day Adventists, and devout Orthodox regularly jailed simply for what they believed.) It is also now possible for people to have savings that are not controlled by the government and private land ownership.

These are real changes for the better that have affected millions of people, and they are occurring. But at the same time the conditions of actual life continue to be dreadful. As for the question of dependency, that seems to me a near universal. I have never known a libertarian who actually turned down the offer of a good government job. As the first Mayor Daley once said, "Everyone wants a little honest graft."

No society has ever reached that peak of pure individualism that Ms. Rand dreamed about, but we can hope for a world with enough contending interests to limit the amount of loot that any one group can haul away.

## Gordon Haave remarks:

Russia went chaotic, yes. But most of Eastern Europe did not. Why? The rule of law. Besides, there is no reason why abolishing the Fed would create a chaotic situation.

## George Zachar writes:

Russia went from a closed-economy kleptocracy to an open-economy kleptocracy. The commanding heights of Russian industry never saw capitalism. The looting, aggregation, and export of its wealth are well-chronicled. Using the word "capitalism" in the context of Russia is to deliberately smear the term as gangsterism.

The Federal Reserve, when set up, was ostensibly created to maintain a stable value for the dollar. Looking at the 90%+ drop in the value of the dollar since the creation of the Fed, I'd say there's reason to doubt their somewhat self-serving perspective. A look at Panama, where there is only nominally a central bank, may be instructive as well.

## Stefan Jovanovich continues:

When Queen Elizabeth I came to visit the United States after WW II, my grandfather, who was born in Old Serbia, wrote about the news to my dad, who was born in the coal camp near Ludlow, Colorado that has now physically disappeared. In his letter Tata wrote to his American-born son that "your queen" is coming for a visit. What he meant was that Americans, regardless of their origins, end up having an Anglo-centric view of the world - at least as far as Eastern Europe is concerned.

The Hungarians, who were fervent Nazis and are more completely thorough anti-Semites than anyone to the east, got a better press in London and New York in 1946 than our allies, those awful Russians. They still do. The economic successes in Eastern Europe - Croatia, Slovenia, Poland, Hungary and the Baltic states - have far more to do with their proximity to Germany, Austria, and Scandinavia than with any special qualities of jurisprudence in "eastern" Europe.

For their citizens and for the average Rumanian, Serb, Bulgar, and Ukrainian, the rule of law is no better than it is for the average Russian. What is better for all of them is that now the police are merely corrupt; they are no longer true Marxist believers dedicated to liquidating all class enemies.

Russia went chaotic, yes. But most of Eastern Europe did not. Why? The rule of law.

## Gabriel Ivan writes:

Having spent the first 20+ years of my life in Eastern Europe (Romania) and being exposed to the first 13 years of transition from communism to capitalism, I can second Scott's comment about the melting into chaos in all Eastern Europe, not just Russia. The looting was mind-blowing and cannot be explained if you didn't live it.

With rampant inflation, no social net whatsoever for maybe 80% of the population and opaque legislation, I'm surprised things didn't get more explosive in all these years. I personally witnessed two national distribution companies with strong brand names and infrastructure vanishing in two weeks due to central bank's policies on the exchange rates. And this was '99 - '00 after 10 years of "free market economy".

Unfortunately, fundamentals haven't improved much despite the real estate boom and commodity prices run-up masking an economic growth that is not healthy. High profile businessmen - bank presidents - still get shot in daylight in Bulgaria, (the country is a member of EU for six months now… what a joke) due to their affiliation to organized crime (there is no other way to run a business). Imagine Sandy Weill getting whacked in a drive-by shooting to understand the strength of their banking system.

I expect the majority of "emerging markets" money managers to be separated from their wealth in the foreseeable future due to their lack of due diligence and reliance on official statistics.

# Super System, from Steve Leslie

June 18, 2007 | 2 Comments

In 1979 Doyle Brunson released the bible of all poker books: Super System. It is a 624-page compendium of useful information, notably instructional on hold-em poker. It also has chapters devoted to different poker games such as 7-card stud, lowball, hi-low, and draw poker. Contributing authors include Bobby Baldwin, Chip Reese, Dave Sklansky, and Mike Caro. Caro also devotes a chapter and he has very interesting insights.

Since the recent atomic explosion of no-limit hold-em, many how-to books on poker have surfaced. Books that I would recommend are Harrington on Hold-em , Volumes 1 and 2, and Play Poker Like the Pros, by Phil Hellmuth. Both are instructional and will do much to advance the knowledge of the game. Zen and the Art of Poker, by Larry Phillips, deals with the psychological side of poker and is critical to have in the poker players arsenal of book weaponry.

These are five books that if studied, read, and re-read will go far in the development of a sound poker acumen.

I do caution the student that this will only serve as a foundation for a sound poker mind. The next step is to log in very important hours at the poker table. Live poker is preferred as poor habits can be developed by playing online. And live poker is the only way to learn how to read opponents and develop a "feel for the game." The great T.J. Cloutier said that every time he sits down at a table he tries to learn something about the game or the people he is playing.

It is interesting to note that after releasing Super System, Doyle Brunson had to alter his game strategy as many who read his book began to use Doyle's own methods against him. Just as with all other games, the pursuit of poker is a never ending one. Mike Sexton who has played professional poker for more than 25 years commented that he became a much better tournament player after watching the top players and commenting for the World Poker Tour.

Poker can be a great game, a rewarding game financially and emotionally and it also can become a nightmare. It offers many paths and a student will be well served to be a lifetime practitioner of the game if they expect to extract the maximum positive aspects of poker.

## Alex Forshaw writes:

What gets me about all those poker players is how much better they could do trading on a bigger market than nine people's buy-in at a table at the Bellagio.

I agree that "Super System" is a true poker bible. Can't say the same for Hellmuth's book, though. It’s kind of like how he was on TV, pretty high ratio of drama/braggadocio to substance, but that's just my two cents.

One sort-of poker book I'd recommend is The Professor, the Banker, and the Suicide King: Inside the Richest Poker Game of All Time. It's about a Texas banker who took up no-limit hold'em at around 40, became utterly devoted to it, and challenged individual poker stars to multimillion-dollar heads up games and started blowing them up, because the stakes were so unbalancing to the hold'em stars (who were not nearly as rich as he was). That's how it starts, anyway.

## Nick Marino replies:

Readers should realize that at best these books will only help you lose money at a slower rate when playing against professionals. The game is constantly changing because the players and their strategies are constantly changing. Sound familiar?

## Gabe Ivan writes:

I read both Brunson's and Helmuth's books recently and I agree that Helmuth's writing is very shallow. His only theme is to play tourneys super-tight at the beginning and change gears as you go. Nothing about the game philosophy. Brunson is a delight and the Caro, Baldwin, and Sklansky chapters provide you with nuggets of knowledge about poker and betting in general. I also recommend Sklansky's "The Theory of Poker," which explains very clearly the nuts and bolts for beginners such as I.

The meal of a lifetime is the opening paragraph where Brunson says, "I made millions playing poker and I lost them at sport betting." This speaks volumes about staying within one's circle of competence when dealing in probabilistic fields, where every niche is so competitive that a legend like him gets wiped out when he steps outside.

# Bubbles on the Brain, noticed by Gabe Ivan

The human psyche seems to have a powerful underlying need to predict doom and gloom. I suspect this need was evolved into us way back when. If there is a nonzero chance that a giant man-eating saber-tooth tiger is going to come over the nearest hill and chomp you, then it's in your evolutionary best interest to predict doom and gloom more frequently than it actually happens.

# Games Within Games, from Rodger Bastien

Signals are interspersed within most of the games that I love. Nowhere are they more prevalent than in the games of baseball and investment markets. They largely go unnoticed by the pedestrian observer, the complex communication between the important players belying the perceived orderliness of the contest. However, to ignore or miss a signal often results in dire consequences, loss of a game or loss of your capital.

Many people decry baseball as dull or boring compared to more fast-paced games like basketball or football. Perhaps they are unaware of the action taking place each moment of each inning of each game. As a pitcher begins the wind-up, rather than the beginning of a play, it is instead the culmination of that play. The key participants have performed their secret pantomime designed to communicate, deceive, or reinforce the intentions of those players on their respective side.

Typically, the manger of the team in the field has signaled to the catcher the type of pitch he wants thrown to the batter through an elaborate series of signals; the catcher then signals to the pitcher (usually one finger for a fastball, two fingers for a curve, etc.); and the middle infielders will signal the outfielders with an open mouth hidden behind their fielder's glove for a fastball and a closed mouth for an off-speed pitch. For their part, the team at bat has their own communication system. Most hitters are allowed to determine which pitches to swing at, however, you will notice that before virtually every pitch the batter will step out and gaze at his third base coach. That is because his manager has signaled the coach before every pitch and he has the ultimate discretion as to what the batter can do. Many managers may want the batter to take (not swing) at a pitch in a count (2-0, 3-1) to work a walk. At a 3-0 count a manager may give a hitter a "green light" to swing, knowing the pitcher may send one down the middle expecting the batter not to swing.

With runners on base, the manger may signal for a steal, a bunt, or a hit and run. All of these occur simultaneously with the covert communication from the other dugout. Adding intrigue to the mix, the majority of the signaling being done is designed to deceive and mislead. A manager resembles a madman with a nervous tic as he goes through his repertoire of touching, tugging, and poking at himself, 90% of which is absolutely meaningless. However, once he displays the predetermined indicator (maybe it's the touch of the cap or the tip of the nose), the player is alerted that the signal or play is on. Missing this important part of the signal means the play falls apart.

In the investing arena, signals play an equally vital role in our success. What at first glance appears to be a simplistic exchange of capital for goods is instead rife with misinformation and deceit and head-fakes and head-games and attempts at whatever sleight of hand may separate a person from his stake in the game.

As we used to say, there in only one rule and that is that there are no rules. In baseball this serves as a proper excuse for notorious trickery such the spitball and the hidden ball trick. But for investors the stakes are so high that to ignore the markets signals is to welcome financial suicide. And that's not to be confused with the suicide squeeze.

This is a brilliant post of yours. The stuff on baseball is very poignant, and the stuff on the markets is very suggestive — which is where I come in. Some day, when we have time, we should do it the right way, and have readers digest publish us. We should reference Dickinson's book on this, with his hundreds of layers of deception and coaches who are expert at stealing signals, and all the mechanical devices that have been used. If you don't have his book, which I guess you may not, let me send it to you.

Signals in the markets often come with the lead off batter causing a big move. There are signals before big meetings, like there were today, designed to make you think a bunt is coming when a big hit is really on the cards.

This interview of the "wild man" by one of his employees is from last winter, but it illustrates the topic nicely. I posit here that these signals are not very powerful, though, and the dynamic hedgers have a stronger impact on price.

# A Review of GaveKal Research, by Victor Niederhoffer

January 16, 2007 | 3 Comments

The GaveKal research group has an optimistic view of the forces that will affect economies across the world. This is almost the exact opposite view that Steve Roach, the Sage, the Palindrome, and the Elizabethan ghost take. Gavekal build their view on the foundation that globalization, industry de-regulation, technological processes, smaller families, the spread of the internet, low volatility as a result of more stable employment, and the emergence of the platform companies guided by trade and the invisible hand will lead to low inflation, a high profit margin, and an ebullient stock market environment. They make a written case for this in their book Our Brave New World and in two research reports, The Invisible Hand's Impressive Work I have read all these reports and I feel like one of the doubters described by Thomas Kuhn in The Structure of Scientific Revolution, although every serious student of Austrian Economics, Adam Smith, and Dimson, Marsh and Staunton should know that equity prices are incessantly going up and that Gavekal's view, opposite to that of the Abelprechfaberoachbuffesoros', will lead to great riches anyway.

Despite this, a close reading of the work shows that they build their view from many concepts and buzz words of economics, finance, and business management that are completely untested, and counterbalanced by many more incisive and useful economic theories. Their recommendations as to what to do with their work are fuzzy and are not particularly likely to lead to above average profits.

Central to their view is that a new kind of company has emerged, which is the platform company. This kind of company consistently increases its profits by concentrating mainly on design and marketing its products. It has no need for outside capital, and it buys all its goods from companies in China and India that do the unprofitable manufacturing and inventorying, and care only about employment. But is any part of this assertion true? Are such companies more prevalent than they were before? Do they make greater returns? Are they better buys than companies in China where there are 3000 ball bearing manufacturers, and 300 automobile manufactures? Do companies that outsource manufacturing, or do service companies, make a higher return than others? Is there an increasing number of such companies and will this lead to higher or lower returns? An extensive list of linked queries and studies with ever-changing answers will determine whether this is a useful concept.

Another pillar of their argument is that we are moving toward perfect competition and perfect information where companies such as Walmart, Carrefour, Ikea, Li and Fung, and the IDS group, are the optimum investment issues and models for others to follow. This will lead to constantly decreasing prices in the bottom end of the market where the masses buy their goods, and higher prices at the top end where the rich are constantly finding it more expensive to be rich/individual. The cost of capital will remain low, prices will continue to drop, and excess capacity will develop.

I find no reason to believe that excess capacity will develop, as decision makers are very knowledgeable and they all wish to increase their wealth and opportunity. Continued above average rates of return on investment are highly transitory, subject to great competition and affected by many shifts in regimes and tastes. I doubt that Chinese manufacturers will constantly realize declining profits, and that platform companies will be able to garner these to any greater extent than the more integrated manufacturing companies that were the standard model in the older days. Such suppositions would again have to be tested.

One of their favorite points, which many of their conclusions are based on, is a very elementary form of the quantity theory of money; mv1 + mv2 = p1t1 + p2t2 — They believe that one part of the right side of the equation increases, and that the other side will decrease.

In opposition to this belief, velocity is always changing and there is constant substitution between goods, and shifts in demand and supply. To assume knowledge of velocity or to assume its constancy is to conclude that interest rates, and competition and substitution, don't come into play. They conclude that there will be higher rates of inflation for luxury goods, an irresistible rise of real estate, declining volatility, the propriety of taking on more debt, and the chronic tendency to over-capacity. These conclusions are based on a simple model of the quantity theory, related fixed shibboleths about the rigidity of capital, and the continuation of present trends. Here's one of their typical conclusions, which I find no supporting evidence for, except for that it explains some of the movements of markets in 2003-2005.

"As the prices of financial services and luxury goods are driven persistently higher, service producing countries such as Britain, Honk Kong, or the U.S. get richer relative to countries which specialize in manufacturing … The virtual limitless supply of cheap labor and capital in China, and the chronic misallocations of capital ensures that manufactured goods continue to get cheaper."

One of their 'buzz' subjects is the idea of Schumpeterian Growth versus Ricardian Growth . Schumpeterian Growth is driven by technology and disruption and leads to income disparities, which the lower part of the distribution will accept because of their hopes for the future. Ricardian Growth is driven by efficiency and liquidity, and investment banks have been key to providing this, thereby smoothing out our business cycles. Gavekal believe that politicians have striven too much to provide for the dark, lower side of the disruption, and that's why the U.S. has grown faster than Europe. Does such a typology have any predictive or descriptive value?

The investment conclusions that Gavekal develops in Brave New World are by far their weakest and most naive chapter. However, as they have pointed out to me in their above note, the book was dated 2005, and they constantly change the specifics of their recommendations based on changing applications of their basic principles and framework tailored to current shifts in the international competitive situation, foreign exchange and commodity market trends, and changes in monetary policy. The jury is still out on their ability to fathom the changes in monetary policy better than the next Fed watcher and I would recommend that they pay much more attention to the term structure of interest rates, especially the long term bond rate as a very accurate indicator of inflation. However, unlike the current naysayers who believe that the Fed Funds Rate is all that matters and this is totally in the control of the Fed, I agree with their focus on the old fashioned bond vigilantes as the posse that tells us what, who, and when it's good and bad.

Their first investment conclusion is that to avoid index funds, one should employ reversion to the mean strategies. The second is that one should identify momentum strategies and get in and out at the right time, and the third is that one should employ carry trade strategies by borrowing at low rates and investing at high rates, and:

"hope that the markets remain continuous. Most of the arbitrage type of hedge funds run some kind of carry trade." They conclude that macro type managers "are most likely to perceive the important changes in the investment climate."

After a thorough immersion in GaveKal, I conclude that they suffer from the use of naive tools of economics, a view that the recent trends of the world will continue, a lack of appreciation of the forces of change and competition for rates of return, and a naiveté about how to invest. And yet, their world view, which is based on the creative and resilient power of capitalism, will lead one to far greater success over the long term than the doomsday view of the Abelprechfabers, which they counter at every turn. Hopefully, they will improve on their models, develop some more rigorous economic tools to support their work, and sharpen the practical investment conclusions that flow from their firm in the future.

… a new kind of company has emerged, which is the platform company. This kind of company consistently increases its profits by concentrating mainly on design and marketing its products. It has no need for outside capital, and it buys all its goods from companies in China and India that do the unprofitable manufacturing and inventorying, and care only about employment. But is any part of this assertion true?

Here is an example. I bought a coffee grinder some time ago. It was a good one, and the distributor replaced the broken canister part last year. But when the main gear broke, this question arose: Is there a coffee grinder repair shop or small appliance repair anywhere in town that does not charge a minimum greater than the cost of buying a new one shipped from China at a price that does not also provide profits for the importer, the distributor, the shipper, the warehouseman and advertiser? After great debate in our house, another question arose: Does not the labor of the grinder in China or India greatly benefit from the opportunity to lift themselves out of subsistence and into the global market, and in two generations soon lead the world?

## Gabriel Ivan replies:

Does not the labor of the grinder in China or India greatly benefit from the opportunity to lift themselves out of subsistence and into the global market, and in two generations soon lead the world?

They will certainly benefit (and they ought to), but in order to lead the world, one needs to builds its foundation on more than cheap labor. "The Birth of Plenty" explains the factors of wealth creation better than I can attempt to. (find the 1st chapter free here).

This goes to validate (in my opinion) this 1997 paper, and will have a huge impact on where I'll focus my investment efforts. I would test these regressions across sectors myself, but unfortunately I don't have the tools (prices database).

# Efficient Markets, by Gabriel Ivan

I came across this Morningstar article regarding indexes valuation. The author used a bottom-up approach and calculated the true value of S&P by adding the fair values of the constituents as calculated by Morningstar analysts covering the stocks. Based on their focus on ROC and from what I can tell, Morningstar analysts' valuations are based on a discounted EVA (or variation thereof) combined with Sage's moats. The results came in surprisingly close to the market prices: S&P500 1.7 points overvalued, DJIA 3.6 points undervalued, NASDAQ 4 points overvalued

If 70% of the market is institutional indexing, and sector-rotation has such a big influence on the index level, how come the S&P price is within 2 points to a quantitative, bottom-up technique combining 500 stocks? Can the wisdom of the crowds truly be that powerful?

# GaveKal, by Edward Humbert

This week’s Barron’s plugged GaveKal’s idea of the “platform company”. This is a polite illustration of Bacon’s concept of the public’s being always behind the form, as pointed out by Victor and Laurel. GaveKal has been on this theme for at least three years. I’ve been a subscriber to their services since the late 1990s. GaveKal is smart. I’m talking super smart. They are a small team of French, English and Americans based in Hong Kong and I have met the team a few times. It amazes me how their output is consistently informative, rational and timely. They beat the pants off the big guns on the Street like Steve Roach et al.. It shows how a small team of highly motivated individuals can outperform their much better capitalized peers. There is a lesson in that for all of us. By the way, I highly recommend their book Our Brave New World. The tome is a cage match between market memes and logical quantitative thought. I am in no way associated with the authors, other than being a regular subscriber to their services and do not in any way benefit from increased sales of their book, etc.

Gabriel Ivan replies:

There is no doubt in my mind that Charles Gave is “super smart” but his Barron’s interview is riddled with half-truths, smoke and mirrors, which shows crystal clear he’s got an agenda. Just a few remarks were:

Reading his comments on the “platform companies” I experienced a NASDAQ 2000 deja-vu all over again. Back then, the smart folks that run Legg Mason today, also had a pretty compelling argument on how dotcoms can generate cash flow indefinitely through working capital and low Capex layouts. The “new economy” model, and we know how that story ends. Furthermore, he presents the valid r&d expenses argument, but conveniently forgets to adjust the Motorola capital to cash flow example accordingly.

In the current-account deficit argument he starts by anchoring the reader in the 7% of GDP as being a banana republic level, but then he switches immediately to the net worth comparison where the 1.5% looks better. This jumping around between income statement and balance sheet would make any Shenanigan CFO blush.

Including the volatile stock and bond holdings in the U.S. net worth calculations, (although a favorite shill of the Fed. Reserve), is not comforting if the trade policy is based on it.

He claims most of the U.S. consumption goes towards healthcare and education like it’s a positive thing per se, with no regards to the return on that capital spent. The quality of healthcare and education (esp. undergrad) per \$ spent might have been a better read.

The nail in the coffin is the play-down of the real estate problem. It is the true mark of poor salesmen — lying about the obvious. The growth in real estate prices, in other countries says nothing about their affordability, own to rent analysis, etc., nor do the interest rate increases have an effect, when such increases have much lower impact due to central banks’ lower reach onto business cycles, the absence of mortgage markets, etc..

It concludes with the reassuring and economically sound remark:

More workers now are ensconced in the recession-resistant service economy and have the additional security of a working spouse and the prospect of parental financial assistance in a pinch. This, perhaps, explains why consumer delinquencies have dropped so drastically.

Ronald Weber offers:

I couldn’t agree more with Mr. Humbert and Jonathon Lang (below) regarding Gavekal. There are indeed few research boutiques and brainstorm platforms that manage to bring much needed original views and help stretch your brain in the process, Daily Specs being one of them.

Regarding the US C/A and accounting deficits, I recommend reading the article from ex-fund manager turned author Andy Kessler on the iPod economy entitled We Think They Sweat.

Mr. Kessler describes the iPod statistics flow between China and the US:

• Apple send an email file to China (zero value in the statistics)
• China assembles the iPod for close-to-zero margins
• China sends the iPod to the US (= 200USD trade deficit)

So would you rather be Apple with its enviable margin, unique brand and soaring market cap, or would you rather be the (no-name and easily replaceable) manufacturer in China?

Regarding analysts, I am constantly amazed how much of a quasi oligopoly on views and ideas Wall Street still exercise. That a Stephen Roach still manages to be in business is a riddle, maybe he is just a good investors’ crowds entertainer? I have nothing against getting the market or the economy wrong, but I do not understand how you can remain stubborn in your narrow views for so long without even questioning them or admitting that you have missed something. Notice also the Wall Street fallacy on the link between the USD and the US trade deficits, the state of the economy or the savings ratio — the totally missed estimates on the Yen is another one of my favorite.

As we all know, at the end of the day it is all about “opinions follow price” and “career risk” (more about analysts and their careers). It may also explain why one of the few respectable analyst, Andy Xie, was fired for being to outspoken on his ideas, (where is he now by the way?).

But, thanks to God, this is the beauty of our business: it is mainly a function of the brain, not scale (save for marketing, administration and distribution functions), and one unknown individual may get it right while another respectable 100 analysts may get it wrong.