June 22, 2016 | 1 Comment
During yesterday's Yellen testimony, a Senator asked a profound economics question that we should all be considering:
In essence, he probed Yellen whether the sole effect of monetary easing is to shift forward consumption and investment–that's it's all about timing–and that after nearly a decade of ultra-low interest rates, whether all of the forward consumption and investment had been exhausted.Yellen somewhat demurred–acknowledging that economists agree that there is a shift, but that there are other lasting effects–notably in the housing market.
I was surprised by Yellen's response, especially with respect to investment (not consumption).
Do businessmen lower their hurdle rate on investment based on the market cost of capital? When companies issue new debt and buy back their stock is that an illustration of this effect? And if a company is planning to make a capital investment, does it look at the valuation of its stock as one element of the Capx decision. For example, if a company is considering building a new plant, surely the ability to finance at 3% versus 9% affects the decision…as does the implied cost of capital in its stock price??
Perhaps the counter argument is that this ignores the final demand for goods that come out of the new plant. And it ignores the potential overinvestment and malinvestment that will eventually occur when interest rates are "too low".
But if the Senator is right — then it's not going to be pretty…
Stefan Martinek writes:
Ludwig von Mises ("Human Action") would agree with the Senator:
Resource misallocations => liquidation.
Alan Millhone writes:
whether the sole effect of monetary easing is to shift forward consumption and investment — that's it's all about timing — and that after nearly a decade of ultra-low interest rates, whether all of the forward consumption and investment had been exhausted.
From the cheat seats, this has been the theory of choice for a while. Of course cheap financing moves future consumption into the present. The problem is that every form of consumption has absolute limits unrelated to cost: We only really need one house, and moving is a pain no matter how cheap the financing is; we bought two new vehicles in the last two years, and my prediction is that we will not be in the market for another one for a long time, no matter how cheap the financing is; if Macy's puts shirts on sale for 50%, I might go buy some, but it won't fundamentally change the rate at which I consume shirts.
Add in the profound effects of China+globalization (and India and other countries as well) as an inflation sink, a strong downward vector on global wages, and a powerful upward vector on productive capacity, and it doesn't seem surprising at all that we are kind of muddling along. The real action globally is the chance for poor people to get less poor. The next big phase will be China and India developing and expanding new patterns of consumption.
Eyeballing the data, M2 fell by about 30% from 1929 to 1932. The Bernank's pledge was that no matter how bad things got in the Great Recession, a contraction in money supply was not going to make things worse, and the Fed kept that promise, as far as I can tell, though some argue they acted too slowly.
So here we are with negative interest rates, sub-replacement birth rates, seemingly endless productive capacity, the interweb allowing the cheap utilization of all sorts of physical and human capital…what's not to like?
Question: When a company buys back the last share of its stock, who then owns the company?
Stefan Jovanovich writes:
A corporation does not legally exist without shareholders. The last share of its own stock a company can buy is #2. I have often wondered why Buffett did not follow Henry Singleton's model and use B-H's cash to buy in shares when the stock price was down and keep doing it until he is the last shareholder standing. The snarky explanations I have ever come come up with are (1) buy-backs would screw up his successful tax evasion use of the state insurance laws regulating accounting for reserves, and (2) he has calculated that saving the cash for large acquisitions is a better use of his talents, since he is not a particularly gifted trader.
Gregory Van Kipnis writes:
Had I been Yellen and asked the question and felt free from political retribution I would have answered:
It's not so much a question of bringing forward as it is increasing the set of investment and consumption opportunities which would exceed the hurdle rate (cost of capital in the case of investment) and consumer time preferences (the marginal rate of substitution of present and future consumption). However, nothing occurs in a static environment where only one variable (interest rates) change. If pessimism, risk, and the profit margins associated with investments are worsening at the same pace as interest rates are declining, there will be little positive response from lower interest rates. Take note, however, that economic activity would be a lot more depressed were interest rates not lower. As for the outlook for confidence and profit margins much of that is being adversely impacted by fiscal, administrative and political policies.
The Constructal Principal where all flows move to the most efficient and point of least resistance and the prevalence of round numbers, one believes has a certain comity and unified cause to it. The question is, is it predictive as well as descriptive.
Gregory Van Kipnis writes:
It is macro descriptive, for sure, and it's micro predictive if you have enough information. In personal discussion over the past few days with sports analysts, everyone agreed on its relevance to predicting outcomes in football and hockey (probably other sports as well). If you study the teams, their bio-physical make up and their play strategy (spreading out vs bunching) you can pick the winner with high accuracy. As for markets though, so much is invisible. To understand and predict each event's outcome so much has to be divined.
Orson Terrill writes:
The options volume and open interest clustering at rounds as a partial explanation is good, and also reinforces the idea that there is a structural preference for the round (the standard strikes). What the Chair says about there being a point on the battle field where doves fly so both sides can come to agreements, and get their needs met, is also an excellent nuance that is worthy of consideration.
When I was taking game theory in school, with a Harvard educated game theorist, the Chairman's round number observation was always on my mind in that frame work; there are multiple scenarios(games) that can explain many situations in markets, and make a prediction if you have the information (what van Kipnis said).
SolarCity Jan 2016 Calls
The 10 rounds are ~35% of strikes, but account for ~75% of the open interest.
Column 2 is open interest, column 1 is the strike (rounds are highlighted).
[1,] 8.0 1
[2,] 10.0 1
[3,] 18.0 15
[4,] 20.0 66
[5,] 23.0 1
[6,] 25.0 29
[7,] 28.0 3
[8,] 30.0 202
[9,] 33.0 19
[10,] 35.0 31
[11,] 37.0 14
[12,] 40.0 874
[13,] 42.0 31
[14,] 45.0 264
[15,] 47.0 74
[16,] 50.0 487
[17,] 52.5 66
[18,] 55.0 148
[19,] 57.5 76
[20,] 60.0 3346
[21,] 62.5 60
[22,] 65.0 148
[23,] 67.5 78
[24,] 70.0 1605
[25,] 72.5 146
[26,] 75.0 571
[27,] 77.5 92
[28,] 80.0 2117
[29,] 82.5 23
[30,] 85.0 209
[31,] 87.5 31
[32,] 90.0 425
[33,] 92.5 117
[34,] 95.0 602
[35,] 100.0 2296
[36,] 105.0 382
[37,] 110.0 134
[38,] 115.0 619
[39,] 120.0 244
[40,] 125.0 88
[41,] 130.0 1873
[42,] 135.0 5
[43,] 140.0 204
[44,] 145.0 16
[45,] 150.0 283
[46,] 155.0 892
[47,] 160.0 20
[48,] 165.0 15
[49,] 170.0 391
For many people, listening to music elicits such an emotional response that the idea of dredging it for statistics and structure can seem odd or even misguided. But knowing these patterns can give one a deeper more fundamental sense for how music works; for me this makes listening to music a lot more interesting. Of course, if you play an instrument or want to write songs, being aware of these things is obviously of great practical importance.
In this article, we'll look at the statistics gathered from 1300 choruses, verses, etc. of popular songs to discover the answer to a few basic questions. First we'll look at the relative popularity of different chords based on the frequency that they appear in the chord progressions of popular music. Then we'll begin to look at the relationship that different chords have with one another. For example, if a chord is found in a song, what can we say about the probability for what the next chord will be that comes after it?
I found this article quite fascinating: "Are Artists Liars?"
Its good to classify cons into big and small cons, the degree of complicity of the victim, the use of confederates, and ruses versus bait-and-switches. The market would rate at the top in all of these as is readily seen, especially the use of confederates, and baits-and-switches. I am particularly gullible and an easy mark for cons. Recently, with Aubrey I had the pleasure of being victimized by a nice con at a fair. It was the medium sized con of a basketball game with the player having to shoot into a basket about 20 feet away and 10 feet high, with the basket a little smaller than normal. The only way to get it in is apparently to shoot at so high a vertical angle that the ceiling on the game precludes. The prizes include huge 4 by 5 feet whales and dolphins which I thought would be just the thing for Aubrey. Okay I asked the operator how much it would be to win one of the whales. He demurred. It would be so expensive I am ashamed to say. " How about a hundred i said ? " well, I'll have to ask my boss. " The operator said.
He had a conference with several confederates. And then came back to me with a positive shred. "Bring the kid over and we'll make him a happy camper". I pay my money and then I go to bring Aubrey over. The game is still there, but the big prizes have all disappeared. Only a stuffed Finding Nemo is there. Worth about 1/3 of the prizes I had in mind. "Which one do you want, kid?" Aubrey chooses the Nemo and the man tells him "kid you tried so hard and so well that I am going to give you a prize". As Aubrey walks away holding the Nemo bigger than him many bystanders ask him what he did to get such a prize. " i tried so hard they gave it to me as a reward ". The stages in this con, starting with a rigged game, relying on my desire to get a special deal, bringing in a confederate, then switching the reward are all too familiar. And it is very helpful in thinking about the market to go over these steps I think.
Pitt T. Maner III comments:
I found a nice overview with table of scam types. Elderly are often the main targets.
The success of many attacks on computer systems can be traced back to the security engineers not understanding the psychology of the system users they meant to protect. We examine a variety of scams and “short cons” that were investigated, documented and recreated for the BBC TV programme The Real Hustle and we extract from them some general principles about the recurring behavioral patterns of victims that hustlers have learnt to exploit.
We argue that an understanding of these inherent “human factors” vulnerabilities, and the necessity to take them into account during design rather than naively shifting the blame onto the “gullible users”, is a fundamental paradigm shift for the security engineer which, if adopted, will lead to stronger and more resilient systems security.
From Understanding Scam Victims: Seven Principles for Systems Security , University of Cambridge.
Victor Niederhoffer expands on his remarks:
Part of every big con is the final touch where you make the victim frightful to ever demand restitution,or better yet, ready to put in more money to really get the full advantage. It was a nice touch for the operator to praise Aubrey so highly and let him hold the Nemo with such pleasure that for many many times the amount I paid, I would never have demanded a return to the bigger prize.
Rocky Humbert writes:
The cup is half full: If the objective of The Chair's exercise was to bring joy and happiness to his son, then perhaps this was not a "con" — as Captain Nemo was both larger than Aubrey, yet not so large that his father had to drag around an eight-foot-tall stuffed bear for the rest of the day. After all, the eight-foot-tall stuffed bear had unknown risks including the inability to see oncoming traffic when crossing the street perhaps resulting in the demise of both Bear and Chair.
Jeff Watson comments:
Back in my [adventurous] youth, I ran across a husband wife team that were travelers. Their con was simple and was a beautiful work of art in it's simplicity. The lady(dressed to appear rich and very well coiffed) would drive a brand new Caddie Convertible into a gas station, get a fill up, then would start looking around frantically for the 3 ct. diamond ring she "Lost." while going to the bathroom. She'd enlist the help of the pump jockey and would spend a good 15 minutes looking for the ring. She left very distraught with a note with an address and phone number to the jockey that if the ring were found, there would be a $3000 reward, but please don't tell her husband and only call at a certain time. An hour or so later a ragged man would show up walking through the lot. He'd buy a soda then would show the pump jockey the nice ring he just found. After a little wheeling and dealing, the ragged looking man would walk out with the contents of the register, the pump jockey had the ring and thought he was going to make a big profit. The ring was paste, the address and phone number were all fakes, but the money they made was real serious cash, especially for the 70's when they would regularly pull the con twice a day and average $500 total.
Victor Niederhoffer comments:
What is the market application of Jeff's Cadillac story ? The market applications of the Nemo are that the market has many big up days to lure you in, then you try to buy it on the cheap the next day. At first it doesn't hit your limit so you raise it a little. It doesn't go there so you end up paying near the high ofthe day, or like yesterday, it finally goes down a few points to hit your limit. While this is going on, a tip to a TV or news is given that the market looks great or that his former employee really lost money on that deal et al, and that makes you even more enthused.
You put the position on and then your broker calls you when it goes down. You don't have enough margin in your account. But if you sell within next 10 minutes, he's arranged with his manager not to have the computer extricate you at 1040 the way they did on the flash crash day. Finally, you don't have to come up with more money because you just lost all your margin so you don't have to tell the other half about the tragedy, and the manager gave you an extra special deal by not having the robot take you out ruinously because of your special friendship.
Thomas Miller comments:
Regarding Chair's last paragraph:
Forcing a quick decision under threats and intimidation then showing they are really trying to "help" you is an old scam similar to the "jury scam" I didnt know brokers learned this so well.
Big Al comments:
On a trip to Europe with a friend, after high school graduation, I started talking to a German merchant marine guy who was traveling with his CentAm wife and kids back to Germany. This was back in the Iceland Air/Air Bahama days, when the cheap flights went through either Rekyavik or Nassau. So we talked for an hour or two during the Nassau layover and then on the plane. When we got to Luxembourg, he hit me with the story about not having money for the bus trip with his family, blah blah blah, and we "loaned" him $20 apiece (I insisted my friend participate - more embarrassment). Then he gave us his address (yeah, right) so we could let him know where we ended up and he could then send us the forty bucks. I still remember the street address: 1 Jahnstrasse. Ha ha.
Watching the bus pull away, I knew we'd been had. He used the technique of familiarity and friendliness, and my obvious yokelhood, to get the money. At first I was really angry and embarrassed, but after a while I almost felt grateful, because the guy taught me an incredibly valuable lesson about myself and about the con and he charged me only $20 for the experience. Cheapest, most effective education I've ever had in my entire life.
And on street cons, I've been targeted enough times to know the pattern: First, the con uses a simple question to make contact with the mark and **get the mark to do something**. It can be just, "May I ask you a question?" Or, sitting in a car with the window rolled down, "Could you come closer? I can't hear you." Then, after the mark has offered compliance, the con hits him with an intense, rapid-fire story - "My husband kicked me out of the house and took my credit cards and I need a room for the night but it's eighty dollars…" - and tries to maintain contact and control and also confuse the mark, until the mark may hand over the money just to break off the engagement.
One way to have fun is start giving it back to them: "Oh that's so terrible. That happened to my sister once, but she was better off without him anyway. The police can help - just let me get your license number so they'll know who to talk to when they get here." It's funny but very consistent how angry they get when you start lying back to them.
Ken Drees recounts:
I just asked my daughter if she remembered the mouse I won for her [at a fair].
"Oh yes, 'mousy', where is he?"
Oh I threw it out years ago when you got tired of him.
"Why did you do that, he was my favorite all time stuffed animal ever, he had a red coat and black whiskers…."
I just turned and slowly closed the door.
R.P. Herrold responds to Ken's story:
From time to time, we 'clean house' and we find the black trash bags, presently carefully tied closed, up in the attic; from time to time, I am instructed to 'get rid of that clutter' as the now grown kids 'will never use those again'.
The Brio trains, the metal Erector set, the cast lead soldiers and molds, the Duplo blocks, the stuffed animals, Lincoln logs, the McGuffey readers, the arrow and ax heads collected in the fields, have all fallen to head of the queue for disposition over time
Stuffed animals were in the dock this past weekend. At that point, I usually carefully re-tie the sack, set it to one side for a moment, and then find a new hiding place for the bag in question after her attention turns to other matters. But a grandchild's mother and the child were delighted with the animal figures from my preservation efforts, even if my spouse was not pleased to see 'those old things' again
A few weeks ago, the Brio train set moved in with a gransdon infatuated with rolling stock and were 'new' again; The Erector set, the melting pot and molds, all gone (not to return with current day safety rules — choking hazard of the nuts and bolts, heavy metal fumes). I am on the lookout for a replacement McGuffey (that friend of books that taught me to read upstrairs in a quiet room as the adults 'talked' downstairs), so I can 'seed' a room for young visitorsThe flints and shaped stones? I was not atuned to their disposition occurring; a 'sharpie' sweet-talked a sale for a pittance from a elderly family memberwhen 'cleaning up' prior to closing down a house before sale. That lot of childhood treasures also carried out the door the minnie balls I dug from the earth at GettysburgEntropy won a round that time; I know we'll battle again.
Jason Ruspini comments:
Forgot who said that cons work because people want something for nothing. Clear implications for naive technical analysis here. See, it's easy, you can get rich by extending straight lines.. just keep one eye on your laptop while at the driving range.
To the young person who had a query about what to do with his trading system, at least he tested something, but perhaps there is some laziness there. Unhealthy to think of one system as your "ticket" even if it looks good. Better to find a good place to work where you might actually learn something new.
Stefan Jovanovich comments:
In the good old days of the 1970s the favorite panhandle con in downtown SF was to be a crazed Viet-Nam veteran. Since I spent half my life in those days lurking outside office buildings waiting to ruin some suits' day by handing him a summons, I got to hear every pitch going. The only way to escape was to do the "crazed killer wanting to go back" routine. "Hey, man, can you help me out; I was in the Nam." "Yeah, me, too, and Brother, am I glad to meet you because we got to go back there NOW!!!!! and finish the job."
Like Big Al's artful sympathy, it worked every time; but the reaction was more fear than anger. The con artists did not want to spend any time near someone who was so obviously crazy - for real.
Gregory van Kipnis writes:
The con that almost got me the first time I encountered it. It repeated itself 4 times over the intervening years.
I have deduced that the mark has to be a distracted businessman, walking alone midtown near the major hotels, hopefully someone in NY on a business trip.
In NYC, about 15 years ago, walking cross town early one evening, lost in thought, I was nudged by someone coming from the opposite direction. That was followed by "Jeez, you knocked the food out of my hand. Don't you look where you are walking". There on the sidewalk was a spilled plastic container of takeout food from the all too familiar corner Korean greengrocers.
I thought for a moment to review the memory playback of the contact and responded, "But you bumped into me."
He turned angry exclaiming he was on a short break from work and I ruined his dinner and I bumped into him and I should pay for the loss.
I started to reach for my wallet, then hesitated sensing a con, and said "No, you bumped into me."
He got belligerent, put his face close to mine and with intensity and a shaking body said he was angry and he ought to take me out. I stepped aside, hand on wallet again and started walking saying "there is a greengrocer around the corner. Let's go in and I will buy you a meal."
After a barrage of invective he leaned down to scoop up the spilled food. I continued on my way with a shaken feeling followed by euphoria when I realized I foiled a con.
I few years later the same thing happened. It was a different person different neighborhood near the St. Regis. This time two people. As soon as he spoke I said "bull shit, you did the same thing to me last month". He tried again to intimidate, but I just repeated the response. The engagement ended. They scooped up the food.
The third time, same guys same neighborhood near the Penninula, they just pulled the same stunt on a couple. He was reaching for his wallet. I yelled from across the street that it was a scam and he should walk away. Lots of hesitation followed on both sides. To my amazement the mark paid anyway.
The fourth time, same guys, I swerved just in the nick of time and yelled "you are still at it huh?" No response.
Whenever I see a food stain on the sidewalk with a few strands of noodles scattered about, I smile — the tell tail sign of the aftermath of the con. You would be surprised at how many there are.
Rocky Humbert comments:
An important distinction between this con and some of the other cons is that this one preys on the mark's sense of duty/charity versus the cons that prey on the mark's sense of greed.
One ponders whether being victimized in the pursuit of selflessness is any worse than being victimized in the pursuit of selfishness ? For example, was Madoff's theft from charities more heinous than his theft from plain old rich people ?
John Steinbeck's East of Eden, which he considered his best novel and is autobiographical at age 43, has much wisdom about the market and life in it. I like the passages where he talks about fattening up the cow before the slaughter the way the father fattened him before having him inducted into the army after a beating by the Cain brother, and the part about his father missing Cain with a shot gun to get revenge thereby changing his life, which Steinbeck extends to say that every little thing you do like stepping on a twig affects everything else in your life, and also the part about 10 year cycles of rain in Salinas County which everyone forgets about selling out at the bottom or living high on the hog during the rain. Totally brilliant and O' Brian-esque albeit a little forced relative to O' Brian.
Kim Zussman adds:
Or when the father came up with the idea of packing lettuce in ice for shipment, only to receive news that the ice melted in the train and the lettuce spoiled anyway. Though he was financially ruined, he optimistically said
"One day someone will develop a way to ship refrigerated produce. It just won't be me."
Later the black sheep son made a fortune speculating on futures as war broke out in Europe. Thinking that repaying his father's debt would redeem him, he was disappointed when father regarded this as blood money which must be returned.
Stefan Jovanovich comments:
East of Eden is that rarest of all things– a great, great novel and movie both. As Kim knows, the father's own fortune came from his selective accountings for the monies collected by his Grand Army of the Republic veterans group (the American Legion, VFW and SEIU of its day which expanded the pension program for Union veterans–no Rebels– from the combat veterans to the children of the clerks who never left their desks). Steinbeck also adds the irony of the father, whose veteran constituents had all been volunteers, serving on the draft board and then finding his son's profits from selling to the British purchasing agent somehow tainted.
Gregory van Kipnis adds:
But the greatest insight to me came from the discourse over the biblical debate about Cain and Abel. Was Cain fated to kill his brother "Thou shalt" or did he have choice: "Thou mayest." The search for a correct translation of the key Aramaic word 'timshel' led to the Chinese immigrant scholars. After much study they ultimately declared that 'timshel' meant that Cain had choice.
Nigel Davies comments:
This is quite a widespread idea, but an alternative way of looking at this may be that the 'stepping on twigs' is relevant only in that it can reflect attitudes (personality traits) that affect broader and more vital issues. On its own it is irrelevant.
1. Walking east across 56th Street from 9th to 6th Avenues the other day, at 5:15 pm, I noted 50 cars parked there, with drivers in the drivers seat waiting, slumbering… It wasn't an invasion of the body snatchers. Just people waiting for the 'no parking till 6 pm' to pass. They save 15 bucks for the night at the cost of an hour or so, valuing their time at less than $15 an hour. I wonder what the implicit price of time is in various cities now as a function of the recent diminution in wealth and loss of jobs.
Along the same lines, I recently received an offer from Icon which has a few hundred parking lots in NYC to park one's car on a monthly basis for $220 a month with "further discounts available" if you call. This might be a good way for the city and others to save money through obvious substitutions.
Fifteen dollars after tax translates to $22 or more pre-tax depending on the bracket. Moreover snoozing or reading have their own value, so the $15 could also be interpreted as the marginal difference in comfort between reading/napping in one's car versus doing the same in another environment. Nonetheless, the point remains: whether these people have anywhere better to be. Such Millhonian observations are enlightening and a reminder of the complexity of the economic system in which even the smallest actors are constantly performing economic calculations, the results of which feed into larger calculations.
I hope these people are reading some mentally enriching material, or at least taking power-naps or meditating, or somehow increasing their human capital, and that this is not complete deadweight loss.
2. At x pm every day, an announcement is made. The market moves to a level. The move is attributed to the announcement. The question is whether the move would have occurred regardless of the announcement. Also, whether the announcement was planned to make the move. For example, at 3:02 on 11/21, an announcement that the new Treasury Secretary was appointed occurred and the market moved up 6% in 59 minutes. Similarly at 3:10 last Friday, the announcement from the current Secretary that he believed everything was under control. The market set a new high and then dropped 6% in 50 minutes. We know that the news follows the price. Also, that the news is often now as "new" as we believe. The proverb comes to mind "the ____ will do what he can do." Also, the ephemeral nature of the news and those who know about it in advance. Is it fate or chance when such moves occur? And does the market do what it's going to do regardless? How would one approach this question and its tests and what insights can be drawn from such a traverse?
3. "The Game" between Harvard and Yale was won 10-0 with Yale limited to 90 yards. Yale previously had allowed just 95 points through 9 games. If the market can't be predicted, let us at least use the market to predict other things. Scores in baseball are always lower during bear markets. That's well known. Can we expect the same in basketball and such others as "What time is it, Mr. Fox?" and does the well documented predictive relation between low scores in baseball still continue to predict the market as previously enumerated in Practical Speculation?
4. Sometimes the kind of language used is a signal of vast underlying unearthed issues and problems. Times of crisis provide many nice examples of these and here a few which should be quantified and tested. In talking about his meeting with the former head of the investment bank who seamlessly moved to the chair of Treasury, the head of the now bankrupt investment bank said, "Our brand with the Treasury is very good." A Canadian central banker said about his meetings with senior bank executives, "If you were having a meeting with a central banker such as I and the conversation drifted to opera or the ski slopes at Davos or some such social setting, I think that's an issue." In discussing his tenure as consultant the former Treasury Secretary who seamlessly moved to consultant of the troubled bank, said "When you have a risk book…, you can't earn more unless you risk more," and he according to others asked to "bulk up" the book. Others involved said that, "as long as you grow revenues you can grow bonuses," and apparently the risk manager and the risk taker in CDOs were once stranded together on a "boat on a lake that ran out of gas" on a fly fishing trip. (That's not exactly language but it recalls the similar incident of the server CEO who was stranded on a boat with his assistant during a survival exercise before the comparable plummet in his stock after they bought an interest in a company he owned for 1000 times revenues or so). In talking about the risk controls, a former president of the troubled bank said "our reputation with the public and the regulators must be an asset." These are paraphrases just to set the ball rolling, and I would be interested in other telltale uses of language that reveal deep truths below the surface.
Gregory van Kipnis replies:
You can not read too much into the fact that 60 cars are waiting for the "No Parking" period to expire so they could park overnight for free. I live in that neighborhood and such a sight has been seen every night for seven years. Perhaps if you knew if there was an increase in the number of cars that didn't get one of those spots you might have a hardship barometer.
Much more revealing, however, is that two weeks ago everyone who parked on the street got a flyer on his windshield, saying he could park for $211 per month, guaranteed for one year, at an undisclosed garage, just call (212) xxx-xxxx. That's a $150-200 per month saving over the prevailing monthly rate in the neighborhood, and was being offered by one of the leading garage chains. I took the deal and wound up in a better garage than the one I left.
It appears that in anticipation of reduced demand for parking and an increase in space capacity, one of the garage chains is trying to cannibalize as much business as possible from the other chain operators, and lock them in for a year with the low teaser rates. After a year they start jacking up the monthly rate by $25 a clip every few months. The assumption must be that the frictional costs of searching for a cheaper deal and adapting to a new location will be high enough to retain most of the new customers while they transition them up to full market rates.
I haven't see parking rate warfare since 9/11/01.
Kim Zussman ponders point 2:
One thing news-related market moves can do is reveal a hidden question or tension. The big jump on Geithner (along with the post-election slump) suggests there was worry about if/how BHO would address the crisis.
I wonder what would have happened had he tapped Volcker? Maybe the same.
Recall the big up open when they caught the other Hussein; then an all-day decline.
It seldom makes sense, which is one reason it's so frustrating to ask logic to predict. If the market were logical, the logical would be rich. If the market were a puzzle, the clever would be rich. If the market were a symphony, Mozart would not have died poor.
There are enough stars to make a thousand constellations, and by design enough movement in the market to keep people believing in a rhyme or reason.
Andrew Moe replies:
Underneath the belly of the beast, we had options expiration on Friday, and it seemed that the 750 strike was running the table for much of the day, creating extreme gains for those on one side of the trade and extreme losses for their counter-parties. Just days before, these levels seemed unthinkable, so emotions were running high on both sides. At 3pm, the market seized upon the Geithner news to speed directly to the 800 strike, delivering comeuppance and salvation in one swift blow. I believe this move was in the can all afternoon as the mistress alternately teased and taunted before finally making a decision as to what news would carry the banner for the advance.
Here's from today's (May's) producer price report:
Greg Van Kipnis replies:
Understanding the "pig" in the python phenomenon, as Eastsider refers to it, is instructive.
The point he is implicitly making is that as the lump in prices (the pig), stemming from energy and ag prices, works its way through each stage of value added in the US manufacturing/services production and distribution machine (the python), raw material prices diminish in importance.
Unit labor costs, offset by productivity gains, and profit margins become the dominant component of prices in the final consumption market. In our competitive markets, labor costs and profit margins are "compressible" and productivity gains are "irrepressible." Then there is the not so small matter of substitution effects to lower prices even more. As the cost of one ingredient rises, every businessman will press his suppliers to either lower their prices or find other substitutes for the other ingredients that were purchased earlier. In the end, consumer prices (and industrial prices) become "well contained."
In discussing history the other day with a client he happened to mention, and educate me on, his family's losses in the Kuwait's Souk al-Manakh Stock Bubble of the 80's and the dabbling in foreign markets. He said that the lessons learned were obviously numerous and that the recent Dubai boom "to him" smelled of the same setting in other asset categories. Anyone remember this or have experience with such?
Greg Van Kipnis replies:
I remember it well.
The Kuwait Souk al-Manakh was an over the counter exchange largely designed for speculation by guest workers and immigrants. The official Kuwait exchange was off limits to all but citizens.
The bubble was financed by virtually infinite leverage. Speculators were allowed to put down margin in the form of post-dated checks and/ or un-cashed checks. The market soared, then crashed, and the Kuwaiti Gov't intervened with a bailout. There is a lot more to the story.
With moves in the first hour of trading on several occasions reaching half the yearly average move in prices, limit moves in the agricultural commodities happening almost one in two days, and volatility in stocks recently showing that a 2% daily change is average, the fifth biggest brokerage saved by just a hair from going under, and Fed infusions to preclude a market meltdown a la 1907 and 1929, it's apparent that the market is no longer for old men.
I've developed a few indicators of this. One being the 90 second, two point move down in Bunds on Friday ("in den Keller gerauscht"), down five points at the time for the week, shifting the decks for $6 billion in value from those with the stops, and the 14 days of 1% or more moves that we've been running each month in stocks, the daily moves in soybeans of limit up or down 10 of the last 20 days, the half-hour declines of 15 points in S&P at the end of the trading day and the frequent air pockets in all markets with 25% of margin moves in 30 minutes.
James Lackey recounts:
For the past month, for all the big up and down opens the total sum of only about 10 points. The problem isn't the open, its the the open to lunch. One day this month the S&P had a glorious comeback to close the day up 48 after a down 15 pointer, but that was a tough 28 point up open pullback to buy. An up open-12:00 had another big up day of 53, sell that big up open of 23 and you missed out. Often the down moves closed down for the day and the ups, up.
If you didn't catch the open or jump on an up open for the open-12:00 you missed many a move. Worse, buy a down open after down days and you get pinned to the mat. That is nothing new for March. How about a double dipsy doodle failure? Friday was miserable.
Janice Dorn writes in:
These movements may be related more to psychological state than to age. Those in their sixth and seventh decades know best when to be in and when to stay away. It looks like there are a lot of novice traders, likely of every age, suffering from manic-depression, who are unable to hold positions for more than 10-30 minutes, and whose moods vascillate from sheer depression to euphoria in fairly rapid sequence. I don't know how to test this other than the types of mail I get every day from traders. They want "in on the action" in the "hot commodities" and don't have a clue what they are doing.
I got mail from someone the other day who had never traded real money and has to go to the back room of a store owned by his cousin to watch the markets since he does not have high speed connection at home. He told me that "some big firm" in the east wanted to hire him immediately and give him $2 million to trade. This was based on his paper trades that showed that he could make 0.4% a day scalping.
I think that we may also may be dealing with increasing emotionality and overconfidence among traders, for a number of different reasons, including instantaneous worldwide communication. Add to this the relentless and shameless promotion by futures and commodity trading services and firms, and one has a recipe for at least part of what often seems to be an incomprehensible, violent and volatile mess.
Usually when someone says "I've never seen anything like this before," it means he is losing. In the past months, it is becoming clear, in a number of commodity markets, that we really have never seen anything like this before.
Nigel Davies proposes a remedy:
Perhaps the more mature speculator should head for Mauritius where the stock exchange is open from 9am to 12.30pm. This leaves plenty of time for hot tea before the open and it finishes in time for lunch. And then one can have a nice game of checkers in the afternoon.
Alston Mabry comments:
The scene that gets shown over and over is where the hit man goes into the gas station and tells the old man to call the flip of the coin. The hit man explains how the coin has been traveling all these years to come here at this moment for this decision. The old man, bewildered, asks, what am I gonna win or lose? Everything.
Which strikes me as an interesting metaphor for what many investors have experienced in the last year or so. That coin is all the things you didn't know about, that were coming your way: the mortgage derivatives, the borrowed money, the margin calls, the collapse in home prices, the volatility, the troubles at Bear. One day a guy walks in the door and says, "Call it."
Gregory van Kipnis adds:
My take on this provocative film is along similar lines, but without the comfort of an apparent opportunity for a decision. For me the "hit man" is pure evil that may come your way and give you the sense you have some control (chose heads or tails), or that the outcome is probabilistic (50/50), when in fact the outcome is predestined, it is all fate made to look like a game. Notice the line, which comes close to the end, when he appears in the wife's bedroom. When asked why he was there he says you were doomed when your husband didn't accept my offer to trade the money for your life. I got him, I got the money and now I getting you. Then he adds, 'this is all I can do for you.' He gives her the appearance of control with the offer of a coin flip. She refuses. The rest is left to your imagination.
James Sogi opines:
Truth is, we have seen this before, the consecutive afternoon drops — right at the bottoms of July and August during 2002, before some big rises. Too few to be robust, but as precedent. But it seems the micro action is slowing down. Like Friday, quite odd. 2-3k on the bid and at the ask. I think the sides are starting to equilibrate. Ranges and gaps are dropping.
In the surf lineup, I'm the oldest guy out except for Makalwaena Bob at 72. I see lots of teens and 20s out. Fewer in their 30s and 40s. None after that. They're strong and careless about danger. They talk about silly kid things. I've seen many of them drop out of the surf lineup: weight, beer, kids, job, drugs, lack of interest, injury, arrests. Its good to still be out there after all these years. It's a different perspective. Its hard to stay in shape and strong and flexible. The speed is down. I try to be in the right spot at the right time. Wait for the nice sets. Avoid getting caught inside. I keep an eye on the horizon, the weather, the buoys, the tides, satellites and can be there when the waves and conditions are right. I like having nice equipment to fit the conditions. I see many parallels in the markets and trading.
Mr. Albert reports:
Here are a few recent qualitative observations from an equity day trader:
1) The speed of price changes is way up and the 'noise cloud' around price is much expanded.
2) The change is volatility from one day to the next is dramatic.
3) Stocks often trade very hard in one direction and then stay there without much of a reaction.
4) My 10 mbps line is compressed to ~1.5 mbps and pinging Yahoo times out for three iterations at the open.
What is a credit crunch? At least in simplistic terms, one would think that it is a situation where credit is hard to come by. Yet, per this graph prepared by the St. Louis Fed, bank lending is holding up just fine, despite a brief dip a few months ago. Yet, we hear constantly about a credit crunch, and the difficulty in borrowing money.
Let me explain something very, very clearly: If you put a lot of money on your credit cards, and default on them, you are going to have a hard time borrowing money shortly thereafter. That is not a credit crunch. Similarly, if you borrow a lot of money in order to lend to unworthy credits, you are going to have a hard time borrowing money shortly thereafter. That is not a credit crunch, it is the most basic works of a free market system, where capital is moved rapidly from productive uses to non-productive uses.
The capital markets have realized that it was a mistake to allocate vast amounts of capital to SIVs and hedge funds who added no value, but merely leveraged up loans to risky borrowers and/or sliced up assets a million different ways and passed them around in a daisy chain, while adding on a huge fees for their "genius".
Their losses have caused dislocations in the credit markets, and there me be worse things yet to come. But, entities that don't actually add any value in the world should have a hard time borrowing money, that does not mean there is a credit crunch.
Alston Mabry explains:
A credit crunch is when I have trouble covering my action.
Anything else is natural market forces, clearing prices, etc., etc.
Russ Humbert writes:
While agreeing with much of what Prof. Haave said, there is a credit crunch of sorts, a loss of confidence in the rating agencies. A quick look at the investment grade ratings credit spreads confirms this. Going from year lows OAS spreads of 33, 54, 74, 104 for credits AAA, AA, A to Baa. (9 year lows ); Jumping to 84, 153, 179, 222 at end of 11/30, with AA reaching record spreads; higher than 2000 and 2002. The AA to Baa spreads seem to be moving in parallel while this occured. Hence rather than simply fleeing from poor credit, the risk premium has increased for most of the investment bonds equally. It would be as if, in your analogy, many deadbeats found how to sneak in an raise themselves to a very high FICO score — ruining your high credit rating.
Ken Smith ruminates:
Seems to me no one in government is producing a graph that extrapolates the above data to the future. What about that? Kurt Vonnegut inquired aloud "Why is there never a Secretary of the Future?" Government has Secretary of Defense, Secretary of Agriculture, etc. but no Secretary of the Future.
In short, no one is dedicated to plan for the future; every bureaucrat and every CEO and every householder is dedicated to short-term goals.
You might chime in to say everyone in the financial industry is dedicated to the future; with due respect I decline that argument. Yes savings are now in the form of 401k and IRA funds, these purportedly are future-thinking instruments. Purportedly. That's the joke. None of them have calculated taxes and inflation that occur in the future.
Taxes and inflation wipe out all gains that purportedly will occur in the future. A simple experiment with extrapolation will prove this to any and all who take on the task of proof. We cannot escape three things in life: taxes, inflation, death.
Three things. But of course there is more. Health, for one thing. A health issue can and does and provedly wipe people out — financially. Who can plan an individual future with such an issue? We don't know ahead of time if we will wake up one morning with dementia.
Greg Van Kipnis critiques:
I am not sure who Prof. Haave is debating or criticizing, however,…
… a credit crunch usually can be defined by the result of a general drying up of short-term credit such that the yield curve inverts. Many things can cause such an outcome, but they are all destructive to economic activity in the near-term.
In the current situation we have something different happening which I am calling a mal-distribution of credit. Obviously the yield curve is not inverted in the treasury market, but it seems to be for poor credits as evidenced by the widening of credit spreads at the short end.
The leading issuers of credit are hemorrhaging equity due to mortgage-related asset write-downs more rapidly than new sources of equity are being tapped to create credit to satisfy the needs of traditional borrowers. Good credits are still able to offset lost access to money markets, e.g. witness the shrinking CP market, by raising money by other means, which currently are lumped by the Fed into the C&I category. As your graph shows that category is exploding. Poor credits are getting rationed out. Many anecdotes are showing up in recent weeks to underscore that development.
If everything happened simultaneously the negative effects of the mal-distribution would show up immediately. The squeeze is likely to intensify as more financial institutions are credit downgraded. To head this off the brighter firms are doing what UBS did and the rest will wither. The 4-fold Fed/Treasury actions of the past month (MLEC , mortgage-terms jawboning, FF/ Discount rate drop, TAF/Swap-Lines) are all attempt to speed the restoration of the mal-distribution of equity. Collectively these are unprecedented historical developments.
So far no one has been "bailed out", whether they are stupid derivative issuers or investors, or stupid mortgagees or mortgagors. There will be bankruptcies, shot-gun marriages, and arrangement of necessity before this is over. The key for the monetary/fiscal authorities is to replace destroyed credit with new credit so the general economy will not be crippled. To pull this off successfully will require extraordinary good luck and judgement.
Gordon Haave responds:
I wasn't debating anyone in particular, but rather the global meme that the financial system is in collapse. It's not. Credit is being denied to people who are bad risks. Because those people tend to be somewhat powerful, they have created this credit crunch meme in order to try to get bailed out. So, I agree with almost everything that you wrote, except that I disagree re: the monetary and fiscal authorities having to replace destroyed credit with good credit. They don't need to do anything. All they need to do is let the markets clear.
A few months ago,everyone said that the monetary authorities needed to do something, meanwhile the markets have been clearing, the prices have been set (as seen by the equity injections into the banks). There is nothing to do except let the markets clear.
There is a market rate for credit. It reflects time preferences. If the Fed creates extra credit, it distorts the markets, it makes it appear that people are demanding more investment than they really are (hence the real estate boom). When it becomes clear that was not the case, that investment gets cleared out. The answer is not to keep distorting the market, but simply to let it clear.
Carlos Nikros remarks:
Like the definition of an asset price bubble, there's much subjectivity in the definition of crunchiness. Although I mostly agree with Prof. Haave, some aspects of the current economic backdrop are not favorable for borrowers with good credit, as opposed to impeccable credit. For instance, A2/P2 commercial paper isn't an easy sale right now. Yes, the corporate bond market is open for business, but if an issuer is not a well-known credit, it has to fight for attention in order to get its deals done smoothly.
Gregory van Kipnis concludes:
For an analogy for how we can be of the same moral-philosophic persuasion yet have significant differences, consider different 'sects' of Amish. One splinter group was called the 'motor-Amish' and another the 'electric Amish' and the third the 'mirror' or 'image Amish'. The first believed that using motor vehicles for certain applications was OK, the second condoned the use of refrigeration and phones for a subset of the congregation to satisfy the FDA rules for milk or getting emergency help, the third did not ban mirrors or any reflective metals from the household. They were all still Amish, but they fought like heck on Biblical interpretation.
Well, I do believe that markets will clear and should be left to clear. But, just as a winding mountain road without guardrails will clear itself of many foolish divers who will go off the cliff, many innocents will be carried away as well. If the damage were only limited to single drivers I'd be content to leave things as they are. Even the most ardent Austrian School adherents understand social costs and the proper limited role of government to address them, however. If markets were atomized with numerous buyer and sellers, no impediments to entry and exist, and wide distribution of information, the 'clearing' process would be swift and fair. Our markets are semi-rigid and relatively concentrated due to complex institutional arrangements. They won't clear neatly. Many innocents will be carried away.
So when I spoke of replacing destroyed credit with new credit, I had in mind the lessons learned and taught by Friedman and Bernanke (among others) in their studies of the causes of the Great Depression. They were clear that many stupid things were done to trip the economy into recession, but when credit was extinguished, partly due to loans' being called in to meet runs on banks, and was not temporarily replaced by some Governmental agency, the recessions cumulated into a disaster.
I know, I know, I can already hear a response from someone that "once you start with regulations to protect people in the name of the people (men united in councils), then lies and deceptions will begin" (I badly paraphrase Tolstoy and Leonard Read). That is the risk we take when we create government. If we are led by men of high standards, who vote their conscience and willingly take personal responsibility for their decisions, the risks are small. I believe the Fed, at least, is governed that way today.
Stefan Jovanovich voices his dissenting view:
The revised standard version of 20th century American history that Dr. van Kipnis is preaching is very much the current gospel. It is what William Poole means when he says that "(m)acroeconomists today do not believe that policies to stabilize the price level and aggregate economic activity create a hazard. Federal Reserve policy that yields greater stability has not and will not protect from loss those who invest in failed strategies, financial or otherwise. Investors and entrepreneurs have as much incentive as they ever had to manage risk appropriately. What they do not have to deal with is macroeconomic risk of the magnitude experienced all too often in the past." Poole quotes a passage from David Cannadine's recent biography of Mellon as an indication of how truly awful things once were before we had professional economic management. "Mellon constantly lectured the president on the importance of letting things be. The secretary belonged (as Hoover would recall) to the "leave it alone, liquidationist school," and his formula was "liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate."
Alas, what Governor Poole fails to note is that this is very much Hoover's version of history. To the end of his life Hoover blamed Mellon for questioning Hoover's presumption that he could "re-engineer" the American economy in the same way that he planned food relief to Belgium and Holland after World War I. Governor Poole and Gregory would seem to share the former President's abiding faith that the application of science could domesticate the feral wildness that results from unregulated buying and selling. What they also share is a complete absence of any skepticism about the unintended effects of allowing "some Governmental agency" to "temporarily replace" "extinguished credit". When the government tries to manage economic risk, it either debases the currency by handing out far more money or promises of money than it can reasonably expect to take in or it establishes a world where prices are administered, not negotiated. In either case, the efforts of "men of high standards" (sic) to "stabilize the price level and aggregate economic activity" create a hazard that is far greater than any credit crisis. They destroy growth and pricing itself, and they risk turning nearly every citizen into a lobbyist or (worse) a lawyer. Friedman and Anna Schwartz are quite clear that the primary causes of the Depression were (1) the passage of the Smoot-Hawley Tariff (which Mellon literally begged Hoover to veto) and (2) the Federal government's attempt to administer the economy through the NRA, etc. Compared to Mellon's prescription (which was to let the markets find out on their own what stocks and farm land were worth), the Hoover-Roosevelt solution was the one that truly ended in liquidation.
There is no way that limited or unlimited government can "address" the problem we have right now without creating greater harm. The mountains of imaginary wealth created by loans against the security of 1800 sq. ft. stick and stucco 1950s bungalows in Pacoima are simply not worth what people thought they were - just as RCA stock was not worth what call loan supported buyers bid it up to in 1928. One does not have to be an economic fundamentalist to believe that common stock valuations usually have some discernible relationship to companies' cash flows from operations. It is also more than a matter of faith to think that, as wonderful as California real estate is, its prices most of the time have at least some distant connection to the ability of their owners to pay their mortgages. Until the homes in Pacoima once again have some vague relationship to what new buyers can afford to pay, the crisis will continue; but it will end - just as past real estate slumps have ended. But, if the wise men (and occasional women) of the Federal Reserve, the Treasury and the Federal government decide that they can "fix" the problem by legislating price levels for the paper issued on the security of those California bungalows and New York condos, we may see the People's Republic of Santa Monica bring the rent control to Iowa. "Credit creation" that tries to restore former unrealistic price levels in the midst of a panic is a bit like having alcohol for breakfast as a cure for hangover. It will - temporarily - take the edge off, but it only makes matters much worse later on.
When I read books from long ago and it states dollar figures I'd like to know what the relative dollar figure is today. For instance, in 1893 during the Panic here in the U.S., if a bank were to make a loan of $15,000, what is the equivalent of that loan today?
I found many ways to try to give me an idea of the relative value, by using the following: CPI, GDP deflator, Consumer Bundle, Unskilled wage, GDP per capita, and Relative share of GDP.
Using the same figure as above here are the numbers computed via the Measuring Worth website:
In 2006, $15,000.00 from 1893 is worth:
$346,788.99 using the Consumer Price Index
$321,038.30 using the GDP deflator
using the value of consumer bundle *
$1,736,739.13 using the unskilled wage
$2,888,877.50 using the nominal GDP per capita
$12,838,014.07 using the relative share of GDP
*Data for consumer bundle only starts in 1900.
After viewing the numbers I still don't understand what $15k in 1893 is worth in 2006. Or, which of the above figures is correct?
Greg Van Kipnis replies:
Income has grown more rapidly than the cost of things people buy, hence a disparity in the rise of 'price' measures (CPI) and 'income or output' measures (unskilled wage, per capital GDP). Your question relates to consumption not income. However, the answer depends on the purpose of the loan.
The question you ask: "…if a bank were to make a loan of $15,000, what is the equivalent of that loan today?" Appears to be related to the general price level, hence the CPI or GDP deflator gives the right answer.
If the question were: "In 1893 it cost $15k to buy a 2000 sq. ft. house in New York City, how much would I have to borrow today?" then you would have to use a different price index. The answer might be close to $2 million.
November 24, 2007 | 1 Comment
It's good to remember that stocks are valued based on an infinite stream of cash flows. And any balance sheet losses on assets held just affect the book value temporarily and are lost in the fullness of the sweep of payments for risk and innovations and entrepreneurial ability . Same for whether earnings growth is going to be 1 % or 5% next year. The earnings yield versus bond yield is now at close to an all time high. The yield on risky loans has risen and the cost of debt capital has eased. Presumably if the default rate on subprimes is 10% , it is more than compensated by the increase in yield that such loans would now carry . All this comes to a head with the disruptive move at the close on Wed, down 1.5% in 30 minutes. This reminds one of the breaking in of horses featured in such novels as Monte Walsh where the unbroken horse gives a final leap into the corral fence before shuffling off with the owner paying the debt to Monte.
Phil McDonnell runs some numbers:
Recently the rate on 30 year Treasuries has fallen from about 5.3% to about 4.45%. This is a decline of about 17%. So if the long term earnings are discounted at the long term rate then a very simplistic back of the envelope calculation shows that the value of stocks should rise by something like 17%. However the reality is that stocks have fallen about 8% from when the rate was 5.3%. Together the 17% increase in value plus the 8% should combine for something like a 25% increase in stock values. Some might argue that a more sophisticated model would use the one year rate to discount expected one year out earnings and a two year rate for two year earnings and so on. That is true. But it is worth noting that all the shorter term rates have fallen even more percentage wise than the long term rate.
Bruno Ombreux extends:
Another exercise is to look at what happens when earnings are changing over time. In the discount formula, the denominator is a power. As a result, early years are heavily weighted and later years much less so.
Let's value the stream of discounting earnings as a perpetuity, because it is easy. It is earnings/interets rate. Let's use 8% which is reasonnable for a risky asset and in line with drift.
Assuming constant $10 earnings, the stock is worth 10/0.08 = 125.
Now let's assume that earnings are going to take a hit for the next 5 years.
If earnings are 0 for the next five years and then 10 in perpetuity, the company is now worth 125/(1.08)^5 = 85
This a a 85/125 = 32% drop in the value of the company.
The next few years are very important in valuing a company. It is not surprising that stocks drop on the slightest hint that they could experience troubled times ahead, even if in the long term they are profitable.
George Zachar cautions:
Notional interest rates are only one factor to consider in calculating the appropriate discount. In the current era of (relatively) low and stable rates, perhaps other variables play a increased role.
What tax rate will those future earnings bear? What is the forward trajectory of the regulatory ratchet? Are currency preferences an issue? Finally, should one use real or nominal rates to discount? That would imply the need to forecast inflation too.
While notional rates remain important, the growing/shifting burdens imposed by Washington, and the increased role of international capital pools, means yields are now one discounting factor among many.
Alston Mabry concurs:
To extend George's argument: What about projections for forex rates? Liquid capital flows across borders, and many investment equations now must contain a forex conversion factor. Must not non-domestic investors evaluate future cash flow discounted by both rates and currency fluctuations?
Gregory Van Kipnis raises an interesting point:
There has been always been a dichotomy in market valuation between the earnings discount model approach and the book value approach. If we reduce the current discussion to a P/BV versus a P=PV(E,g,i) model for assessing the market outlook, the following additional point may be important to consider. Is there a relationship between BV, on the one hand, and E and g, on the other? If BV (book value) losses were simply a drop in the net value of bricks and mortar there might not be much of a connection to future reductions in E (earnings) and g (growth in earnings). If on the other hand, much of the loss of BV is the destruction of income earning assets (mortgages and their related derivatives) then E and g are proportionately reduced as well. Since such a large proportion of the S&P earnings is related to the financial services industry the current 'neutron bombing' of the housing sector, and the associated loss of financial BVs, it is likely to translate into a more protracted bear market, I fear.
November 10, 2007 | 1 Comment
In the Apple Evolution JPG, I count 22 items I've owned, of which only four have been disposed of. I notice they did not show their printers and screens. That would add four to my count.
Let's say that I work really hard and come up with a long-only trading system of largecap stocks that over the last 10 years had a compound annual rate of return of 20% with a maximum drawdown of 15%. The first thing everyone says is my universe was biased — survivor bias or look-ahead bias. I know there is some bias because I test my universe and find the universe I used had a 14% return with a 25% drawdown. So although there is some bias, I still beat the universe. But I am also happy because I know the S&P500 and Russell 3000 each had a 10% rate of return and a 45% drawdown. But the bias charge still nags me. I go back to the computer and come up with a short side to complement my long-only version. So my new system is long-short. Using the same stock universe over the same period, my long-short combined program produces a 10% return with a 3% drawdown. By going to a long-short program, did I eliminate the previously existing bias?
Phil McDonnell replies:
You cannot tell if the bias has been eliminated. Let me give a simple example. The S&P and most indexes are cap weighted. Effectively this means there is a lower bound a company must reach to be included in the S&P. Assume the sample is the current constituents of the index. Then in an historical study the sample includes knowledge of the future because it includes stocks which were added and excludes stacks that were deleted.In the bottom portion of the biggest 500 stocks there is a group of companies which grew their way into the elite index. These stocks probably outperformed. Over the last few years an equal number of stocks dropped out to make way for the new ones. These grew backwards and presumably underperformed.
In this example one would expect bias to arise if the data are filtered on market cap, sales or earnings growth and stock price growth (relative strength). When those factors are implicitly included with future knowledge that the stock will cross the threshold of index inclusion it can lead to a strong bias. For example, relative strength is related to market cap by a simple multiplication by the number of shares.
The only way to really determine what the bias might be is to identify the stocks which were added or deleted from the index but would have met the filtering criteria. Only then can we truly know the bias. But if you are going to do that you might as well simply start with the original stock list which existed at the time and do the study right.
Rob Steele remarks:
If you were data snooping you'd probably see better performance. Survivorship bias is certainly an issue; if you can, expand your universe to include everything that would ever have come into it over the test period. The big issue, however, is the "I work really hard and come up with …" part. How do you know you aren't data mining? The harder you look the more likely you are to find spurious correlations that aren't predictive. You can never be totally positive you've found something real but you can guard against chimeras to some extent. One way is to not look too hard. That is, limit free parameters and the size of your search space. Another is rolling backtests where you repeated introduce previously unseen data. Aronson's Evidence Based Technical Analysis is good on this.
Gregory van Kipnis replies:
What bias? There was still residual information despite survivor/peek-ahead, or are you saying Dr. Rafter did not use a hold-out sample either? Information decays, but if it doesn't decay too quickly you can exploit it. If (big if) there was bias, then going short part of the remaining universe adds to the bias. It doesn't subtract. Systems that learn from the past are not ipso facto completely biased.
A little bias is not such a bad thing (I stay away from all growling dogs for that reason even though most won't bite me). Learning from the past is great. Adding common sense and questioning if anything is different from the past is what creates an edge. I seek that.
From a US perspective, dollar depreciation will cause the price of luxuries to go up, the price of foreign vacations to go up, and the price of foreign assets (real or portfolio) to go up. But the cost of consumer and industrial goods may not change much, due to competitive and substitution effects such as:
1. Many foreign-labeled cars, chemicals, industrial products are already produced in the US.
2. Producers of goods exported to the US will fight hard to protect their markets. They will cut costs, margins, and aggressively change sourcing to offset the dollar depreciation.
3. Buyers of imported goods will shift to lower cost sources.
The bigger threat from dollar depreciation is if raw material producers, particularly oil producers, change their pricing from dollar-based to another currency or basket. Right now, as the dollar depreciates, the cost of oil to Europe goes down, but the cost to the US remains unchanged.
Paradoxical Dualities or Terminal Contradictions?
He who hesitates is lost,
but look before you leap.
Ignorance is bliss,
but knowledge puts you amiss.
It is time we get our heads out of the sand and stop subtracting out food and energy and admit we have an inflation problem. Energy prices are up and are going to stay up. It has been going on for two years and we (the Fed) must stop fooling ourselves into thinking there is only transient inflation which will likely reverse itself and that there is no core inflation. The transient is now permanent, though volatile. We really have an inflation problem.
Michael Cook writes:
I disagree that we necessarily have an inflation problem just because energy prices are up and are going to stay up. The fact that they are up is sending a legitimate economic signal that supply and demand are not in balance, similar for food. Were the Fed to choke off this "inflation" by throwing us into a recession, these price signals would not be able to do their work of drawing out competitive supply in the form of nuclear, solar, biofuels, fuel cells, etc. - whatever the creativity of entrepreneurs comes up with.
Jim Sogi writes:
The other unidentified variables are the global currency/capital flows that render the "island model" obsolete. There are a number of well-tested empirical theories and studies. But early into the floating currency regime the dynamics are not well understood. There are various theories.
Productivity, things like hours per week are one measure. Other tested theories include comparisons of monetary conditions, fiscal policies, economic growth, central bank policies, portfolio balance, purchasing parity (McDonald's indicator) that seek to predict currency flows. The size of these capital flows are so significant as to render traditional measures of domestic economic conditions no longer reliable or as predictive as they were. Ignoring these variables is a mistake.
Charles Pennington adds:
This argument has been made repeatedly, but is there any empirical basis for it, or any rigorous theoretical basis?
Can it be stated in a falsifiable way, such as the following:
"If money supply measure X (M1? M2? M3? something else?) increases by Y percent, then price index Z (CPI? PPI? sum market caps of stocks, bonds, real estate?) will also change by Y percent."?
My understanding is that history shows that there are times when the value of "everything" drops or increases, without any change of comparable magnitude in the various measures of money supply.
The market cap of the U.S. stock and bond markets add up to about $30 trillion. For just residential real estate, I find numbers that are a few $10s of trillion. Meanwhile the most liberal definition of money supply has it on the order of $10 trillion.
From say 1995 to 2000 the stock market more than doubled, and real estate went up, too. Just the changes in value of stocks and real estate over that period clearly add up to more than the entire money supply. Prices of other things, in general (as measured for example by the CPI and PPI), certainly did not go down over the period. So it appears to me that there can be massive repricing of things in general, of magnitude that dwarfs not just the change in money supply (about $2 trillion over that period), but the money supply itself.
This tells me that pricing of things in general has pretty wide latitude to move around. The value of "everything" dwarfs all measures of money supply, and makes moves of magnitudes that dwarf changes in the money supply. One should never think of there being some kind of grand conservation law, though I'm sure there are useful correlations.
One would think commodities would have an ever upward drift in price (everything gets more expensive, right?). Yet, a quick check of historical charts show they are boom and bust; there is no upward drift as in stocks. Why?
My take on it is very basic. The first law of the universe is to survive, the second is to grow. Corporations must grow to survive. All organisms are driven by that basic tenet, unfortunately even government agencies.
Corporations are growing, expanding organisms that morph to change and adapt in their inherent drive to survive.
Commodities are not such an organism… just a price. There is no drive or motivation for an ear of corn to sell at a higher price, to take over the world or gain market share. This also should serve as a warning to commodity long-only index or basket funds. Again, look at those long term charts!
Stocks drift higher because the way of man is to improve, grow, get better. Nothing has been able to stop that; not dictators, nor Communists or Socialists. Stock prices will always advance long-term as corporations are in the business of expanding and taking advantage of opportunities.
It does help the averages that dying stocks are removed (there are only a handful of stocks in the Dow that were also there 20 years ago) yet growth and value are always there to be discovered.
Go forth and prosper is the motto of all corporations.
Gregory van Kipnis writes:
Your observation is correct. I saw the same thing when I analyzed the data 25 years ago. The arguments made then were:
- stocks rise because the have growing earnings; commodities have no earnings
- ceteris paribus inflation is offset by storage and financing costs
- quantity supplied grows along with demand growth, more or less, not so for individual stocks
- commodities are substituted when one becomes relatively too expensive
The long term indexes are usually geometric means of broad baskets of agricultural and industrial commodities. Over time there are substitutions, e.g., kerosene for whale oil.
Eli Zabethan adds:
One must consider carry when looking at futures. There is a world of difference between the non carry considered charts and those where carry is considered…
Greg Rehmke offers:
Commodities as “natural” resources goes down in price over the long term (only one resource, labor, goes up in price). As Julian Simon explained, man is The Ultimate Resource, and all others we call natural now were once just rocks.
Black gunk bubbling up in salt marches became oil after whales became scarce and people started looking around for substitutes. The early oil in Pennsylvania ran out quickly, and only after Rockefeller’s army of chemists discovered how to get the sulfur out of similar black gunk in Ohio did it become oil too.
Discovering resources requires reason, freedom, and hard work. Without these rocks stay rocks, tar sands stay buried and useless, penicillin stays mold, DDT stays banned.
Over recent decades more and more world oil and mineral supplies left the free world and fell into government hands. I am reading about Zambia in Robert Guest’s book “The Shackled Continent.” Copper production in Zambia peaked in 1969 at 825,000 tonnes a year. Then it was nationalized and production has since fallen by two-thirds.
Oil resources, nearly all discovered by free people in private firms, have been grabbed by governments around the world. (Oil reserves in Russia, during few years of relative freedom between Soviet control and Putin control, went up dramatically.)
The economic freedom finally reaching hundreds of millions in China and India is lifting wealth creation and the demand for natural resources. How fast entrepreneurs, engineers, and enterprises respond to higher prices with new discoveries, technologies, production, substitutes, and efficiency gains, is anyone’s guess.
But looking back at the inflation-adjusted prices for natural resources over the decades and centuries shows a steady trend.
Of course, as commodities are priced in dollars, it is not clear whether the genius of private industry in extracting natural resources from the earth will match the “genius” of governments in extracting value from fiat currencies.
All news is not equal. Some news tells you what has happened in the past, other news tells you what is coming in the future. Some news becomes important again, like knowing the Sage had bid 15% below asset value for LTCM. That's where the market cleared in 2002. For example, on 9/11 there was news about the attack that drove stocks like INVN from $8 to $50 over the next three months, because it led to the installment of baggage screens at every airport. It led to a fundamental shift in air travel demand leading to airline bankruptcies.
Other news, like the Congressional hearings and the questioning of high profile investment bankers in July 2002 signaled a market low of significance. Currently, news of the Fed pause has led to expectations of a Fed rate cut, which subprime reinforced, so if there is news that shifts that expectation it would be dramatic — much as Clinton shifted expectations at the high in 2000 with a comment on genomics. That's why I continue to watch gold closely here, because the expectation is for an easing of inflation and gold at a new high would shatter that expectation.
Gregory van Kipnis remarks:
Words betray us and never seem to mean what they intend. What is meant by news, what is meant by prices? Here are the principles that guide me:
First, There is something called analysis; analysis of news or analysis of prices.
Second, if markets are very efficient there will not be many occasions when the analysis of news or prices will yield predictive insights.
Third, "news" is generally used to refer to fundamentals, i.e., events that shift supply or demand or any of the assumptions that govern the stability of prices. Prices, on the other hand, refer to the unfolding outcome of changes in views about fundamentals.
Fourth, most fundamentals are discounted, so prices move in advance or swiftly. Therefore, I rarely get an information edge about changes in fundamentals. Nonetheless, the persistent analysis of human action yields insights, from time to time, to the prepared mind. But there are false positives. Monitoring prices in relation to quantitative tripwires can also signal a fundamental is changing, but here too there are many false positives. I may never know why views are changing, so I would have to satisfy myself that it is sufficient to figure out that others are valuing things differently and that is all I need to know.
So I pick my poison.
I would always prefer to have an independently obtained opinion about the likely causes of changes in equilibrium rather than constantly trying to figure out if others are changing their minds about what to value, and never understanding why. However, there is a caveat. Just as when driving on a busy highway, to use an analogy, fundamentals first –but also a wary eye always cocked to discern technical signs to avoid risk. I don't have to know if a bad driver was drunk or having a heart attack, I just have to pick up quickly that something is wrong and make sure he doesn't take me out on his way to his maker.
Hany Saad replies:
News does not drive prices. I would like to see empirical evidence to the contrary.
Prices predicted 9/11 and other events if you look close enough at the options markets. Now, if you suggest that 9/11 drove prices with an open gap down when the market finally opened, how would you have profited as an operator? In retrospect you were handed the same cards every other operator was and you had to make a decision based on your historical views, your system, your statistical edge — but not on news.
Even if news drives prices, it is very questionable that an operator will be able to benefit from public news from off the floor. Can one really profit from the news in real time? Yes, news might have an effect on price but this ignores the main use of news for the speculator — profitability. The correct question is whether a speculator can trade profitably using news.
I maintain that prices predict news, and trading on statistical patterns and measuring psychological biases is the only good niche in a market where there are more newswires than brokerage houses.
David Higgs adds:
It's the interpretation of when good news is bad news and bad news is good news. Changing cycles, sea changes. Those with the knack of getting these right become wizards.
February 28, 2007 | 1 Comment
NYT, February 28, 2007 ECONOMIX A Recession That Arrived on Cats' Paws
By DAVID LEONHARDT The nation's manufacturing sector managed to slip into a recession with almost nobody seeming to notice. Well, until yesterday.
The misleading New York Times headline suggests recession is here. The bias is manifest. I guess liberals want a larger market correction?
George Zachar replies:
You're way too kind. They want a visible recession and a nasty asset price decline to use as rhetorical clubs through the 2008 election cycle. Their academic sock-puppets hit my email box this morning with gloating doomsterism. Expect at least a full week's news cycle of chronicmania.
Unless there's a photo of Anna Nicole necking with Elvis in a Des Moines Burger King…
The moves in markets often seem to imitate the kinds of things we see in nature: in gas; in water; and in electricity. For example, the gentle back and forth of the stock market last week, gradually building up pressure and then exploding on the downside, is like a cork bursting from a bottle of champagne, or a volcano erupting.
In electronic circuits we often see a signal gently oscillating between set points, then gathering a slight bit of amplitude on one side or the other, and finally tripping the set point thereby triggering a major change in the output. In capacitor resistor circuits, we find the same buildup of charge, with little change in the output until the time constant of the capacitor is fulfilled and the output suddenly and dramatically changes.
The reason for these similarities is they are all results of various energy conservation laws. Energy coming into a system cannot just disappear. One major conservation law in electronics is Kirchoff's Current law. It holds that current going into the confluence of two wires equals the current coming out. Another major law is Kirchoff's voltage law. It states the voltage that's input to a closed circuit is equal to all the voltage used up in work in the circuit.
I find the major applications of conservation laws in markets relating to some input from outside a system. Usually, some information or money flow gets distributed to the various components, companies, and markets of the system. A major merger announcement affects not just one company but all companies related to it. An increase in liquidity in the system gets distributed according to market's laws similar to Kirchoff's laws in electronics.
Click here for information on Kirchoff's laws.
To be continued.
Philip McDonnell adds:
Two summers ago, in Central Park, the Chair said something to me which was at once profound yet seemingly too simple. "There is only so much money." That was all that he said. To someone who did not understand, it would seem rather sophomoric or even downright cryptic. But it was all he needed to say because I had read his books.
The statement referred to a simple conservation law much like the conservation laws of physics. In physics energy and mass are the most significant variables in most mechanical systems. So we have laws such as the Conservation of Energy, Conservation of Mass and Conservation of Momentum. In financial markets a similar law applies. Money is conserved. At any given time 'there is only so much money'.
Let us imagine an island economy where there are only two stocks X and Y. There is only so much money on the island. When the traders on the island decide they want to invest in X they need to figure out how to pay for the purchase. The only liquid source of money is stock Y. So they sell Y. The price of X goes up and Y goes down.
Let us draw this on an X-Y coordinate plot and assign some real numbers to it. The relationship between X and Y would show up as a line from high up on the Y axis sloping downward to some point of a large X value. Suppose the amount of money were $100. If everyone wanted to own Y and no one wanted X then we would have Y=100, X=0. Conversely if everyone wanted X and not Y then Y=0 and X=100.
We can think of the distance of the current market valuations as the distance from the origin that is equal to the buying power of the money. It is a simple conservation law on our island. The $100 defines a radius from the origin. It thus defines a circle. It is easy to draw on a two-dimensional chart or even in 3D. Drawing a 5000 dimensional sphere for the 5000 actively traded stocks is a project still in progress.
Charles Sorkin adds:
Is it not the beauty of Eurodollars that since there is no reserve requirement (being out of the country and not under the auspices of the Fed), foreign banks can create and loan as many dollars as they want?
Gregory van Kipnis adds:
Not quite. After the Eurodollar blew up in 1974, central bankers convened at the behest of the Bank of England to put a lid on the runaway growth of the Eurodollar market. It was agreed that each CB would be responsible for defaults of the banks they regulate even if the default were in the Eurodollar market. Following that, each foreign CB put reserve requirements on Eurodollar deposits.
From: George R. Zachar:
Not quite. After the eurodollar blow up in 1974 of Bank Herstadt, central bankers convened at the behest of the Bank of England to put a lid on the runaway growth of the eurodollar market. It was agreed that each CB would be responsible for defaults of the banks they regulate even if the default were in the eurodollar market. Following that, each foreign CB put reserve requirements on eurodollar deposits. /Gregory van Kipnis/
1) That central banks are increasingly players themselves,
2) The clubby incestuous relationships within the govt/bank community in places like Italy,
3) The fact that one major central bank has had a high official murdered by someone he regulated (Russia),
4) The asset explosion in nations whose financial infrastructure hasn't been tested (the Gulf States),
5) The nil possibility that govt bankers grok the array and scope of derivatives…
I would not assume the central banking clerisy is on top of things. They might be, but there's reason for doubt.
Easan Katir writes:
The moves in markets often seem to imitate the kinds of things we see in nature… VN
To continue the Chair's analogy, it would seem the next practical question is how do we predictively discover the impedance of that market capacitor which discharged on February 8, provided the "3 of a kind," then tripped another point of capacitance and surged in the opposite direction for the past 4 days? What voltmeter can we use to measure the current passing through?
Or is this market more like a big kid bouncing on a "40-day moving average" trampoline for the past seven months?
February 8, 2007 | Leave a Comment
There has been entirely too little thought given to the mechanism, pathways and reasons that negative feedback works in markets. Perhaps the main reason is that the feeding web is based on a reasonable stability in what and how much is being eaten and recycled.
The people who consume and redistribute must maintain a ready and stable supply of those who produce. They develop mechanisms to keep everything going. One of them is the specialization and great efficiency in their activities. If markets deviate too much from the areas and levels within which the specialization has developed, then much waste and new effort and mechanisms will be necessary.
Aside from the grind that trend following causes (i.e. the losses in execution), and the negative feedback system of movements in the supply and demand schedules that equilibrate, which Marshall pioneered and are now standard in economics, and the numerous other reasons I've set forth (e.g. the fixed nature of the system and the flexibility to profit from it), this appears to me to be the main reason that trend following doesn't work.
Here are a few interesting articles on the subject:
Bill Rafter writes:
Dr. Bruno had posed the idea of beating an index by deleting the worst performers. This is an area in which we have done considerable work. Please note that we do not consider this trend-following. The assets are not charted, just ranked.
Let us imagine an investor who is savvy enough to identify what is strong about an economy and invest in sectors representative of those areas, while avoiding sectors representing the weaker areas of the economy. Note that we are not requiring our investor to be prescient. He does not need to see what will be strong tomorrow, just what is strong and weak now, measured by performance over a recent period.
What is a market sector? The S&P does that work for us, and breaks down the overall market (that is, the S&P 500) into 10 Sectors. They further break it down into 24 Industry Groups, and further still into 60-plus Industries and 140-plus Sub-Industries. The number of the various groups and their constituents changes from time to time as the economy evolves, but essentially the 500 stocks can be grouped in a variety of ways, depending on the degree of focus desired. Some of the groupings are so narrow that only one company represents that group.
Our investor starts out looking at the 10 Sectors and ranks them according to their performance (such as their quarterly rate of change). He then invests in those ranked first through fourth (25 percent in each), and maintains those holdings until the rankings change. How does he do? Not bad, it turns out.
From 1990 through 2006, which encompasses several types of market conditions, the overall market managed an 8 percent compound annual rate of return. Our savvy investor achieved 10.77%. A less savvy investor who had the bad fortune to pick the worst six groups would have earned 7.23%. Those results are below. (Note, for comparison purposes, all results excluded dividends.)
How can our savvy investor do better? By simply sharpening one's focus, major improvements can be achieved. If instead of ranking the top 4 of10 Sectors, our savvy investor invests in a similar number (say the top 4, 5 or 6) of the 24 Industry Groups, he achieves a 13.12% compoundedannual rate of return over the same period. Note that the same stocks are represented in the 10 Sectors and the 24 Industry Groups. At no time did he have to be prescient.
One thing you will notice from the graphs above is that the equity curves of our savvy and unlucky investors mimic the rises and declines of the market index itself. Being savvy makes money but it does not insulate one from overall bad markets because the Sectors and even the Industry Groups are not significantly diversified from the overall market.
Why not keep going further out and rank all stocks individually? That clearly results in superior returns, but the volume of trading is such that it can only be accomplished effectively in a fund structure - not by the individual. And even ranking thousands of stocks will not insulate an investor from an overall market decline, if he is only invested in equities. The answer of course is diversification.
It is possible to rank debt and alternative investment sectors alongside equities, in the hope of letting their performances dictate what the investor should own. However the debt and commodities markets have different volatilities than the equities markets. Anyone ranking them must make adjustments for their inherent differences. That is, when ranking really diverse assets, one must rank them on a risk-adjusted basis for it to be a true comparison. However if we make those adjustments and rank treasury bonds (debt) against our 24 Industry Groups (equity) we can avoid some of the overall equity declines. We refer to this as a Strategic Overlay:
Adding this Strategic Overlay increases the returns slightly, but more important, diversifies the investor away from some periods of total equity market decline. We are not talking of a policy of running for cover every time the equities markets stall. In the long run, the investor must be in equities.
Invariably in ranking diverse assets such as equities, debt and commodities, our investor will be faced with a decision that he should be completely out of equities. It is likely that will occur during a period of high volatility for equities, but one that has also experienced great returns. Thus, our investor would be abandoning equities when his recent experience would suggest otherwise. And since timing can never be perfect, it is further likely that the equities he abandons will continue to outperform for some period. On an absolute basis, equities may rank best, but on a risk-adjusted basis, they may not. It is not uncommon for investors to ignore risk in such a situation, to their subsequent regret.
Ranking is not without its problems. For example, if you are selecting the top 4 groups of whatever category, there is a fair chance that at some time the assets ranked 4 and 5 will change places back and forth on a daily basis. This "flutter" can be easily solved by providing those who make the cut with a subsequent incumbency advantage. For a newcomer to replace a list member, it then must outrank the current assets on the selected list by the incumbency advantage. This is very similar to the manner in which thermostats work. We have found adding an incumbency advantage to be a profitable improvement without considering transactions costs. When one also considers the reduced transaction costs, the benefits increase even more.
Another important consideration is the "lookback" period. Above we used the example of our savvy investor ranking assets on the basis of their quarterly growth. Not surprisingly, the choice of a lookback period can have an effect on profitability. Since markets tend to fall more abruptly than they rise, lookback periods that perform best during rising markets are markedly different from those that perform best during falling markets. Determining whether a market is rising or falling can be problematic, as it can only be done with certainty in retrospect. However, another key factor influencing the choice of a lookback period is volatility, which can be determined concurrently. Thus an optimal lookback period can be automatically determined based on volatility.
There is certainly no question that a diligent investor can outperform the market. By outperforming the market we mean that he will achieve a greater average rate of return than the market, while limiting the maximum drawdown (or percentage equity decline) to less than that experienced by the market. But the average investor is generally not up to the diligence or persistence required.
In the research work illustrated above, all transactions were executed on the close of the day following a decision being made. Thus the strategy illustrated is certainly executable. Nothing required a forecast; all that was required was for the investor to recognize concurrently which assets have performed well over a recent period. It is not difficult, but requires daily monitoring.
Charles Pennington writes:
Referring to the MathInvestor's plot:
At first glance it appears that the "Best" have been beating the "Worst" consistently.
In fact, however, all of the outperformance was from 1990 through 1995. From 1996 to present, it was approximately a tie.
Reading from the plot, I see that the "Best" portfolio was at about 2.1 at the start of 1996. It grew to about 5.5 at the end of the chart for a gain of about 160%. Over the same period, the "Worst" grew from 1.3 to 3.2, a gain of about 150%, essentially the same.
So for the past 11 years, this system had negligible outperformance.
One should also consider that the "Best" portfolio benefits in the study from stale pricing, which one could not capture in real trading. Furthermore, dividends were not included in the study. My guess is that the "Worst" portfolio would have had a higher dividend yield.
In order to improve this kind of study, I would recommend:
1.) Use instruments that can actually be traded, rather than S&P sectors, in order to eliminate the stale pricing concern.
2.) Plot the results on a semilog graph. That would have made it clear that all the outperformance happened before 1996.
3.) Finally, include dividends. The reported difference in compound annual returns (10.8% vs 8.0%) would be completely negated if the "Worst" portfolio had a yield 2.8% higher than the "Best".
Bill Rafter replies:
Gentlemen, please! The previously sent illustration of asset ranking is not a proposed "system," but simply an illustration that tilting one's portfolio away from dogs and toward previous performers can have a beneficial effect on the portfolio. The comparison between the 10 Sectors and the 24 Industry Groups illustrates the benefits of focus. That is, (1) don't buy previous dogs, and (2) sharpen your investment focus. Ignore these points and you will be leaving money on the table.
We have done this work with many different assets such as ETFs and even Fidelity funds (which require a 30-day holding period), both of which can be realistically traded. They are successful, but not overwhelmingly so. Strangely, one of the best asset groups to trade in this manner would be proprietarily-traded small-cap funds.
Unfortunately if you try trading those, your broker will disown you. I mention that example only to suggest that some assets truly do have "legs," or "tails" if you prefer. I think their success is attributed to the fact that some prop traders are better than others, and ranking them works. An asset group with which we have had no success is high-yield debt funds. I have no idea why.
A comment from Jerry Parker:
I wrote an initial comment to you via your website [can be found under the comments link by the title of this post], disputing your point of view, which a friend of mine read, and sent me the following:
I read your comment on Niederhoffer's Daily Spec in response to his arguments against trend following. Personally, I don't think it boils down to intelligence, but rather to ego. Giving up control to an ego-less computer is not an easy task for someone who believes so strongly in the ability of the human mind. I have great respect for his work and his passion for self study, but of course disagree with his thoughts on trend following. On each trade, he is only able to profit if it "trends" in a favorable direction, whether the holding period is 1 minute or 1 year. Call it what you will, but he trades trends all day.
He's right. I was wrong. Trend following is THE enemy of the 'genius'. You and your friends can't even see how stupid your website is. You are blinded by your superior intelligence and arrogance.
Victor Niederhoffer responds:
Thanks much for your contributions to the debate. I will try to improve my understanding of this subject and my performance in the future so as not to be such an easy target for your critiques.
Ronald Weber writes:
When you think about it, most players in the financial industry are nothing but trend followers (or momentum-players). This includes analysts, advisors, relationship managers, and most fund or money managers. If there is any doubt, check the EE I function on Bloomberg, or the money flow/price functions of mutual funds.
The main reason may have more to do with career risk and the clients themselves. If you're on the right side while everyone is wrong, you will be rewarded; if you're on the wrong side like most of your peers you will be ok; and if you're wrong while everyone is right then you're in trouble!
In addition, most normal human beings (daily specs not included!) don't like ideas that deviate too much from the consensus. You are considered a total heretic if you try to explain why, for example, there is no link between the weak USD and the twin deficits. This is true, too, if you would have told anyone in 2002 that the Japanese banks will experience a dramatic rebound like the Scandinavian banks in the early '90s, and so on, or if you currently express any doubt on any commodity.
So go with the flow, and give them what they want! It makes life easier for everyone! If you can deal with your conscience of course!
The worse is that you tend to get marginalized when you express doubt on contagious thoughts. You force most people to think. You're the boring party spoiler! It's probably one reason why the most successful money managers or most creative research houses happen to be small organizations.
Jeremy Smith offers:
Not arguing one way or the other here, but for any market or any stock that is making all time highs (measured for sake of argument in years) do we properly say about such markets and stocks that there is no trend?
Vincent Andres contributes:
I would distinguish/disambiguate drift and trend.
"Drift": Plentifully discussed here. "Trend": See arcsine, law of series, etc.
Basically, our tendency is to believe that random equals equiprobability everywhere (2D) or random equals equiprobability everytime (1D), and thus that nonequiprobability everywhere/everytime equals non random
In 1D, non equiprobability everytime means that the sequence -1 +1 -1 +1 -1 +1 -1 +1 is in fact the rare and a very non random sequence, while the sequences -1 +1 +1 +1 +1 +1 -1 +1 with a "trend" are in fact the truly random ones. By the way, this arcsine effect does certainly not explain 100% of all the observed trends. There may also be true ones. Mistress would be too simple. True drift may certainly produce some true trends, but certainly far less than believed by many.
Dylan Distasio adds:
For those who don't believe trend following can be a successful strategy, how would you explain the long-term performance of the No Load Fund X newsletter? Their system consists of a fairly simple relative strength mutual fund (and increasingly ETF) model where funds are held until they weaken enough in relative strength to swap out with new ones.
The results have been audited by Hulbert and consistently outperform the S&P 500 over a relatively long time frame (1980 onwards). I think their results make a trend following approach worth investigating…
Jerry Parker comments again:
All you are saying is that you're not smart enough to develop a trend following system that works. What do you say about the billions of dollars traded by trend following CTAs and their long term track records?
Steve Leslie writes:
If the Chair is not smart enough to figure out trend following, what does that bode for the rest of us?
There is a very old yet wise statement: Do not confuse brains with a bull market.
Case in point: prior to 2000 the great tech market run was being fueled by the hysteria surrounding Y2K. Remember that term? It is not around today but it was the cause for the greatest bull market seen in stocks ever. Dot.com stocks and new issues were being bought with reckless abandon.
New issues were priced overnight and would open 40-50 points higher the next trading day. Money managers had standing orders to buy any new issues. There was no need for dog-and-pony or road shows. It was an absolute classic and chaotic case of extraordinary delusion and crowd madness.
Due diligence was put on hold, or perhaps abandoned. A colleague of mine once owned enough stock in a dot.com that had he sold it at a propitious time, he would have had enough money to purchase a small Hatteras yacht. Today, like many contemporary dot.coms, that stock is essentially worthless. It would not buy a Mad magazine.
Corporations once had a virtual open-ended budget to upgrade their hardware and software to prepare for the upcoming potential disaster. This liquidity allowed service companies to cash in by charging exorbitant fees. Quarter to quarter earnings comparisons were beyond belief and companies did not just meet the numbers, they blew by them like rocket ships. What made it so easy to make money was that when one sold a stock, all they had to do was purchase another similar stock that also was accelerating. The thought processes where so limited. Forget value investing; nobody on the planet wanted to talk to those guys. The value managers had to scrape by for years while they saw their redemptions flow into tech, momentum, and micro cap funds. It became a Ponzi scheme, a game of musical chairs. The problem was timing.
The music stopped in March of 2000 when CIO's need for new technology dried up coincident with the free money, and the stock market went into the greatest decline since the great depression. The NASDAQ peaked around 5000. Today it hovers around 2500, roughly half what it was 7 years ago.
It was not as if there were no warning signs. Beginning in late 1999, the tech market began to thin out and leadership became concentrated in a few issues. Chief among the group were Cisco, Oracle, Qwest, and a handful of others. Every tech, momentum, and growth fund had those stocks in their portfolio. This was coincident with the smart money selling into the sectors. The money managers were showing their hands if only one could read between the lines. Their remarks were "these stocks are being priced to perfection." They could not find compelling reasons not to own any of these stocks. And so on and on it went.
After 9/11 markets and industries began to collapse. The travel industry became almost nonexistent. Even Las Vegas went on life support. People absolutely refused to fly. Furthermore, business in and around New York City was in deep peril. This forced the Fed to begin dramatically reducing interest rates to reignite the economy. It worked, as corporations began to refinance their debt and restructure loans, etc.
The coincident effect began to show up in the housing industry. Homeowners refinanced their mortgages (yours truly included) and took equity out of their homes. Home-buyers were thirsty for real estate and bought homes as if they would disappear off the earth. For $2000 one could buy an option on a new construction home that would not be finished for a year. "Flipping" became the term du jour. Buy a home in a hot market such as Florida for nothing down and sell it six months later at a much higher price. Real estate was white hot. Closing on real estate was set back weeks and weeks. Sellers had multiple offers on their homes many times in the same day. This came to a screeching halt recently with the gradual rise in interest rates and the mass overbuilding of homes, and the housing industry has slowed dramatically.
Houses for sale now sit on the blocks for nine months or more. Builders such as Toll, KB, and Centex have commented that this is the worst real estate market they have seen in decades. Expansion plans have all but stopped and individuals are walking away from their deposits rather than be upside down in their new home.
Now we have an ebullient stock market that has gone nearly 1000 days without so much as a 2% correction in a day. The longest such stretch in history. What does this portend? Time will tell. Margin debt is now at near all-time highs and confidence indicators are skewed. Yet we hear about trend followers and momentum traders and their success. I find this more than curious. One thing that they ever fail to mention is that momentum trading and trend following does not work very well in a trendless market. I never heard much about trend followers from June 2000 to October 2002. I am certain that this game of musical chairs will end, or at least be temporarily interrupted.
As always, it is the diligent speculator who will be prepared for the inevitable and capitalize upon this event. Santayana once said, "Those who cannot remember the past are condemned to repeat it."
From "A Student:"
Capitalism is the most successful economic system in the history of the world. Too often we put technology up as the main driving force behind capitalism. Although it is true that it has much to offer, there is another overlooked hero of capitalism. The cornerstone of capitalism is good marketing.
The trend following (TF) group of fund managers is a perfect example of good marketing. As most know, the group as a whole has managed to amass billions of investor money. The fund operators have managed to become wealthy through high fees. The key to this success is good marketing not performance. It is a tribute to capitalism.
The sports loving fund manger is a perfect example. All of his funds were negative for 2006 and all but one was negative over the last 3 years! So whether one looks at it from a short-term one year stand point or a three year perspective his investors have not made money. Despite this the manager still made money by the truckload during this period. Chalk it up to good marketing, it certainly was not performance.
The secret to this marketing success is intriguing. Normally hedge funds and CTAs cannot solicit investors nor even publicly tout their wares on an Internet site. The TF funds have found a way around this. There may be a web site which openly markets the 'concept' of TF but ostensibly not the funds. On this site the names of the high priests of TF are repeatedly uttered with near religious reverence. Thus this concept site surreptitiously drives the investors to the TF funds.
One of the brilliant marketing tactics used on the site is the continuous repetition of the open question, "Why are they (TF managers) so rich?" The question is offered as a sophist's response to the real world question as to whether TF makes money. The marketing brilliance lies in the fact that there is never a need to provide factual support or performance records. Thus the inconvenient poor performance of the TF funds over the last few years is swept under the carpet.
Also swept under the rug are the performance figures for once-great trend followers who no longer are among the great, i.e., those who didn't survive. Ditto for the non-surviving funds in this or that market from the surviving trend followers.
Another smart technique is how the group drives investor traffic to its concept site. Every few years a hagiographic book is written which idolizes the TF high priests. It ostensibly offers to reveal the hidden secrets of TF.
Yet after reading the book the investor is left with no usable information, merely a constant repetition of the marketing slogan: How come these guys are so rich? Obviously the answer is good marketing but the the book is moot on the subject. Presumably, the books are meant to be helpful and the authors are true believers without a tie-in in mind. But the invisible hand of self-interest often works in mysterious ways.
In the latest incarnation of the TF book the author is presented as an independent researcher and observer. Yet a few days after publication he assumes the role of Director of Marketing for the concept site. Even the least savvy observer must admit that it is extraordinary marketing when one can persuade the prospect to pay $30 to buy a copy of the marketing literature.
Jason Ruspini adds:
"I attribute much of the success of the selected bigs to being net long leveraged in fixed income and stocks during the relevant periods."
I humbly corroborate this point. If one eliminates long equity, long fixed income (and fx carry) positions, most trend-following returns evaporate.
Metals and energies have helped recently, after years of paying floor traders.
I don't agree with all the points above. For example, the beauty of capitalism is not its puffery, but the efficiency of its marketing and distribution system as well as the information and incentives that the prices provide so as to fulfill the pitiless desires of the consumers. Also beautiful is in the mechanism that it provides for those with savings making low returns to invest in the projects of entrepreneurs with much higher returns in fields that are urgently desired by customers.
I have been the butt of abuse and scorn from the trend followers for many years. One such abusive letter apparently sparked the writer's note. Aside from my other limitations, the trend following followers apparently find my refusal to believe in the value of any fixed systems a negative. They also apparently don't like the serial correlation coefficients I periodically report that test the basic tenets of the trend following canon.
I believe that if there are trends, then the standard statistical methods for detecting same, i.e., correlograms, regressions, runs and turning point tests, arima estimates, variance ratio tests, and non-linear extensions of same will show them.
Such tests as I have run do not reveal any systematic departures from randomness. Nor if they did would I believe they were predictive, especially in the light of the principle of ever changing cycles about which I have written extensively.
Doubtless there is a drift in the overall level of stock prices. And certain fund managers who are biased in that direction should certainly be able to capture some of that drift to the extent that the times they are short or out of the market don't override it. However, this is not supportive of trend following in my book.
Similarly, there certainly has been over the last 30 years a strong upward movement in fixed income prices. To the extent that a person was long during this period, especially if on leverage, there is very good reason to believe that they would have made money, especially if they limited their shorts to a moiete.
Many of the criticisms of my views on trend following point to the great big boys who say they follow trends. To the extent that those big boys are not counterbalanced by others bigs who have lost, I attribute much of the success of the selected bigs to being net long leveraged in fixed income and stocks during the relevant periods.
I have no firm belief as to whether such things as trends in individual stocks exist. The statistical problem is too complex for me because of a paucity of independent data points, and the difficulties of maintaining an operational prospective file.
Neither do I have much conviction as to whether trends exist in commodities or foreign exchange. The overall negative returns to the public in such fields seem to be of so vast a magnitude that it would not be a fruitful line of inquiry.
If I found such trends through the normal statistical methods, I would suspect them as a lure of the invisible evil hand to bring in big money to follow trends after a little money has been made by following them, the same way human imposters work in other fields. I believe that such a tendency for trend followers to lose with relatively big money after making with smaller amounts is a feature of all fixed systems. And it's guaranteed to happen by the law of ever-changing cycles.
The main substantive objection to my views that I have found in the past, other than that trend followers know many people who make money following trends (a view which is self-reported and selective and non-systematic, and thus open to some of the objections of those of the letter-writer), is that they themselves follow trends and charts and make much money doing it. What is not seen by these in my views is what they would have made with their natural instincts if they did not use trend following as one of their planks. This is a difficult argument for them to understand or to confirm or deny.
My views on trend following are always open to new evidence, and new ways of looking at the subject. I solicit and will publish all views on this subject in the spirit of free inquiry and mutual education.
Jeff Sasmor writes:
Would you really call what FUNDX does trend following? Well, whatever they do works.
I used their system successfully in my retirement accounts and my kids' college UTMA's and am happy enough with it that I dumped about 25% of that money in their company's Mutual Funds which do the same process as the newsletter. The MFs are like an FOF approach. The added expense charges are worth it. IMO, anyway. Their fund universe is quite small compared to the totality of funds that exist, and they create classes of funds based on their measure of risk.
This is what they say is their process. When friends ask me what to buy I tell them to buy the FUNDX mutual fund if their time scale is long. No one has complained yet!
It ain't perfect (And what is? unless your aim is to prove that you're right) but it's better than me fumfering around trying to pick MFs from recommendations in Money Magazine, Forbes, or Morningstar.
I'm really not convinced that what they do is trend following though.
Dylan Distasio Adds:
For those who don't believe trend following can be a successful strategy, how would you explain the long-term performance of the No Load Fund X newsletter?
Michael Marchese writes:
In a recent post, Mr. Leslie finished his essay with, "I never heard much about trend followers from June 2000 to October 2002." This link shows the month-to-month performance of 13 trend followers during that period of time. It seems they did OK.
Hanny Saad writes:
Not only is trend following invalid statistically but, looking at the bigger picture, it has to be invalid logically without even running your unusual tests.
If wealth distribution is to remain in the range of 20 to 80, trend following cannot exist. In other words, if the majority followed the trend (hence the concept of trends), and if trend following is in fact profitable, the majority will become rich and the 20-80 distribution will collapse. This defeats logic and history. That said, there is the well-covered (by the Chair) general market upward drift that should also come as no surprise to the macro thinkers. The increase in the general population, wealth, and the entrepreneurial spirit over the long term will inevitably contribute to the upward drift of the general market indices as is very well demonstrated by the triumphal trio.
While all world markets did well over the last 100 yrs, you notice upon closer examination that the markets that outperformed were the US, Canada, Australia, and New Zealand. The one common denominator that these countries have is that they are all immigration countries. They attract people.
Contrary to what one hears about the negative effects of immigration, and how immigrants cause recessions, the people who leave their homelands looking for a better life generally have quite developed entrepreneurial spirits. As a result, they contribute to the steeper upward curve of the markets of these countries. When immigrants are allowed into these countries, with their life savings, home purchases, land development, saving and borrowing, immigration becomes a rudder against recession, or at least helps with soft landings. Immigration countries have that extra weapon called LAND.
So in brief, no - trends do not exists and can not exist either statistically or logically, with the exception of the forever upward drift of population and general markets with some curves steeper than others, those of the countries with the extra weapon called land and immigration.
A rereading of The Wealth And Poverty Of Nations, by Landes, and the triumph of the optimist may be in order.
Steve Ellison adds:
So Mr. Parker's real objective was simply to insult the Chair, not to provide any evidence of the merits of trend following that would enlighten us (anecdotes and tautologies that all traders can only profit from favorable trends prove nothing). I too lack the intelligence to develop a trend following system that works. When I test conditions that I naively believe to be indicative of trends, such as crossovers of moving averages, X-day highs and lows, and the direction of the most recent Y percent move, I usually find negative returns going forward.
Bacon summarized his entire book in a single sentence: "Always copper the public play!" My more detailed summary was, "When the public embraces a particular betting strategy, payoffs fall, and incentives (for favored horsemen) to win are diminished."
Trend Following — Cause, from James Sogi:
Generate a Brownian motion time series with drift in R
MU<-.15*DELTAT;SIG<-.2*sqrt(DELTAT);TIME<-(1:1024)/252 stock<-exp(SIG*RW+MU*TIME) ts.plot(stock)
Run it a few times. Shows lots of trends. Pick one. You might get lucky.
Trend Following v. Buy and Hold, from Yishen Kuik
The real price of pork bellies and wheat should fall over time as innovation drives down costs of production. Theoretically, however, the nominal price might still show drift if the inflation is high enough to overcome the falling real costs of production.
I've looked at the number of oranges, bacon, and tea a blue collar worker's weekly wages could have purchased in New York in 2000 versus London in the 1700s. All quantities showed a significant increase (i.e., become relatively cheaper), lending support to the idea that real costs of production for most basic foodstuffs fall over time.
Then again, according to Keynes, one should be able to earn a risk premium from speculating in commodity futures by normal backwardation, since one is providing an insurance service to commercial hedgers. So one doesn't necessarily need rising spot prices to earn this premium, according to Keynes.
Not All Deer are Five-Pointers, from Larry Williams
What's frustrating to me about trading is having a view, as I sometimes do, that a market should be close to a short term sell, yet I have no entry. This betwixt and between is frustrating, wanting to sell but not seeing the precise entry point, and knowing I may miss the entry and then see the market decline.
So I wait. It's hard to learn not to pull the trigger at every deer you see. Not all are five-pointers… and some will be bagged by better hunters than I.
From Gregory van Kipnis:
Back in the 70s a long-term study was done by the economic consulting firm of Townsend Greenspan (yes, Alan's firm) on a variety of raw material price indexes. It included the Journal of Commerce index, a government index of the geometric mean of raw materials and a few others. The study concluded that despite population growth and rapid industrialization since the Revolutionary War era, that supply, with a lag, kept up with demand, or substitutions (kerosene for whale blubber) would emerge, which net-net led to raw material prices being a zero sum game. Periods of specific commodity price rises were followed by periods of offsetting declining prices. That is, raw materials were not a systematic source of inflation independent of monetary phenomena.
It was important to the study to construct the indexes correctly and broadly, because there were always some commodities that had longer-term rising trends and would bias an index that gave them too much weight. Other commodities went into long-term decline and would get dropped by the commodity exchanges or the popular press. Just as in indexes of fund performance there can be survivor bias, so too with government measures of economic activity and inflation.
However, this is not to say there are no trends at the individual commodity level of detail. Trends are set up by changes in the supply/demand balance. If the supply/demand balance changes for a stock or a commodity, its price will break out. If it is a highly efficient market, the breakout will be swift and leave little opportunity for mechanical methods of exploitation. If it is not an efficient market (for example, you have a lock on information, the new reality is not fully understood, the spread of awareness is slow, or there is heavy disagreement, someone big has to protect a position against an adverse move) the adjustment may be slower to unfold and look like a classic trend. This more often is the case in commodities.
Conversely, if you find a breakout, look for supporting reasons in the supply/demand data before jumping in. But, you need to be fast. In today's more highly efficient markets the problem is best summarized by the paradox: "look before you leap; but he who hesitates is lost!"
Larry Williams adds:
I would posit there is no long-term drift to commodities and thus we have a huge difference in these vehicles.
The commodity index basket guys have a mantra that commodities will go higher - drift - but I can find no evidence that this is anything but a dream, piquant words of promotion that ring true but are not.
I anxiously stand to be corrected.
Marlowe Cassetti writes:
"Along a similar vein, why would anybody pay Powershares to do this kind of work when the tools to do it yourself are so readily available?"
The simple answer is if someone wishes to prescribe to P&F methodology investing, then an ETF is a convenient investment vehicle.
With that said, this would be an interesting experiment. Will the DWA ETF be another Value Line Mutual Fund that routinely fails to beat the market while their newsletter routinely scores high marks? There are other such examples, such as IBD's William O'Neal's aborted mutual fund that was suppose to beat the market with the fabulous CANSLIM system. We have talked about the great track record of No-Load Fund-X newsletter, and their mutual fund, FUNDX, has done quite well in both up and down markets (an exception to the above mentioned cases).
For full disclosure I have recently added three of their mutual funds to my portfolio FUNDX, HOTFX, and RELAX. Hey, I'm retired and have better things to do than do-it-yourself mutual fund building. With 35 acres, I have a lot of dead wood to convert into firewood. Did you know that on old, dead juniper tree turns into cast iron that dulls a chain saw in minutes? But it will splinter like glass when whacked with a sledgehammer.
Kim Zussman writes:
…about the great track record of No-Load Fund-X newsletter and their mutual fund FUNDX has done quite well in both up and down markets… (MC)
Curious about FUNDX, checked its daily returns against ETF SPY (essentially large stock benchmark).
Regression Analysis of FUNDX versus SPY since inception, 6/02 (the regression equation is FUNDX = 0.00039 + 0.158 SPY):
Predictor Coef SE Coef T P
Constant 0.00039 0.000264 1.48 0.14
SPY 0.15780 0.026720 5.91 0.00
S = 0.00901468 R-Sq = 2.9% R-Sq (adj) = 2.8%
The constant (alpha) is not quite significant, but it is positive, so FUNDX did out-perform SPY. Slope is significant and the coefficient is about 0.16, which means FUNDX was less volatile than SPY.
This is also shown by F-test for variance:
Test for Equal Variances: SPY, FUNDX
F-Test (normal distribution) Test statistic = 1.17, p-value = 0.009 (FUNDX<SPY)
But t-test for difference between daily returns shows no difference:
Two-sample T for SPY vs FUNDX
N Mean St Dev SE Mean
SPY 1169 0.00041 0.0099 0.00029
FUNDX 1169 0.00045 0.0091 0.00027 T=0.12
So it looks like FUNDX has been giving slight/insignificant out-performance with significantly less volatility; which makes sense since it is a fund of mutual funds and ETFs.
Even better is Dr Bruno's idea of beating the index by deleting the worst (or few worst) stocks (new additions?).
How about an equal-weighted SP500 (which out-performs when small stocks do), without the worst 50 and double-weighting the best 50.
Call it FUN-EX, in honor of the fun you had with your X that was all mooted in the end.
Alex Castaldo writes:
The results provided by Dr. Zussman are fascinating:
The fund has a Beta of only 0.157, incredibly low for a stock fund (unless they hold a lot of cash). Yet the standard deviation of 0.91468% per day is broadly consistent with stock investing (S&P has a standard deviation of 1%). How can we reconcile this? What would Scholes-Williams, Dimson, and Andy Lo think when they see such a low beta? Must be some kind of bias.
I regressed the FUNDX returns on current and lagged S&P returns a la Dimson (1979) with the following results:
Multiple R 0.6816
R Square 0.4646
Adjusted R Square 0.4627
Standard Error 0.0066
df SS MS F Significance F
Regression 4 0.0444 0.0111 251.89 8.2E-156
Residual 1161 0.0511 4.4E-05
Total 1165 0.0955
Coefficients Standard Error t-Stat P-value
Intercept 8.17E-05 0.000194 0.4194 0.6749
SPX 0.18122 0.019696 9.2007 1.6E-19
SPX[-1] 0.60257 0.019719 30.5566 6E-151 SPX[-2] 0.08519 0.019692 4.3260 1.648E-05 SPX[-3] 0.04524 0.019656 2.3017 0.0215
Note the following:
(1) All four S&P coefficients are highly significant.
(2) The Dimson Beta is 0.914 (the sum of the 4 SPX coefficients). The mystery of the low beta has been solved.
(3) The evidence of price staleness, price smoothing, non-trading, whatever you want to call it is clear. Prof. Pennington touched on this the other day; an "efficiently priced" asset should not respond to past S&P price moves. Apparently though, FUNDX holds plenty of such assets (or else the prices of FUNDX itself, which I got from Yahoo, are stale).
S. Les writes:
Have to investigate the Fund X phenomenon. And look to see how it has done in last several years since it was post selected as good. Someone has to win a contest, but the beaten favorites are always my a priori choice except when so many others use that as a system the way they do in sports eye at the harness races, in which case waiting for two races or two days seems more apt a priori. VN
I went to the Fund X website to read up, and the information is quite sparse. It is a very attenuated website. I called the toll free number and chatted with the person on the other line. Information was OK, but, in my view, I had to ask the proper questions. One has several options here. One is to purchase the service and do the fund switching themselves based on the advice of their experts. The advisory service tracks funds that have the best relative strength performance and makes their recommendations from there, www.fundx.com.
Another is to purchase one of four funds available. They have varying levels of aggressiveness. Fund 3 appears to be the recommended one.
If one purchases the style 3 one will get a very broad based fund of funds. I went to yahoo to look up the holdings at www.finance.yahoo.com/q/hl?s=FUNDX.
Top ten holdings are 47.5% of the portfolio, apparently concentrated in emerging markets and international funds at this time.
In summary, if money were to be placed into the Fund X 3 portfolio, I believe it would be so broad based and diversified that returns would be very watered down. Along with risk you would certainly be getting a lot of funds. You won't set the world on fire with this concept, but you won't get blown up, either.
Larry Williams adds:
My 2002 book, Right Stock at the Right Time, explains such an approach in the Dow 30. The losers were the overvalued stocks in the Dow.It is a simple and elegant idea…forget looking for winners…just don't buy overvalued stocks and you beat the idex.
This notion was developed in 1997, when i began actually doing it, and written about in the book. This approach has continued to outperform the Dow, it is fully revealed.
Craig Cuyler writes:
Larry's comment on right stock right time is correct and can be used to shed a little bit of light on trend following. This argument is at the heart of fundamental indexation, which amongst other points argues that cap weighting systematically over-weights overvalued stocks and under-weights undervalued stocks in a portfolio.
Only 29% of the top 10 stocks outperformed the market average over a 10yr period (1964-2004) according to Research Affiliates (this is another subject). The concept of "right stock right time" might be expressed another way, as "right market right time." The point is that constant analysis needs to take place for insuring investment in the products that are most likely to give one a return.
The big error that the trend followers make, in my mind, is they apply a homogeneous methodology to a number of markets and these are usually the ones that are "hot" at the time that the funds are applied. The system is then left to its own devices and inevitably breaks down. Most funds will be invested at exactly the time when the commodity, currencies, etc., are at their most overvalued.
Some worthwhile questions are: How does one identify a trend? Why is it important that one identifies a trend? How is it that security trends allow me to make money? In what time frame must the trend take place and why? What exactly is a trend and how long must it last to be so labeled?
I think it is important to differentiate between speculation using leverage and investing in equities because, as Vic (and most specs on the list) point out, there is a drift factor in equities which, when using sound valuation principles, can make it easier to identify equities that have a high probability of trending. Trend followers don't wait for a security to be overvalued before taking profits. They wait for the trend to change before then trying to profit from the reversal.
Jeff Sasmor adds:
As a user of both the newsletter and the FUNDX mutual fund I'd like to comment that using the mutual fund removes the emotional component of me reading the newsletter and having to make the buys and sells. Perhaps not an issue for others, but I found myself not really able to follow the recommendations exactly - I tend to have an itchy trigger finger to sell things. This is not surprising since I do mostly short-term and day trades. That's my bias; I'm risk averse. So the mutual fund puts that all on autopilot. It more closely matches the performance of their model portfolio.
I don't know how to comment on the comparisons to Value Line Arithmetic Index (VAY). Does anyone follow that exactly as a portfolio?
My aim is to achieve reasonable returns and not perfection. I assume I don't know what's going to happen and that most likely any market opinion that I have is going to be wrong. Like Mentor of Arisia, I know that complete knowledge requires infinite time. That and beta blockers helps to remove the shame aspect of being wrong. But there's always an emotional component.
As someone who is not a financial professional, but who is asked what to buy by friends and acquaintances who know I trade daily (in my small and parasitical fashion), I have found that this whole subject of investing is opaque to most people. Sort of like how in the early days of computing almost no one knew anything about computers. Those who did were the gatekeepers, the high priests of the temple in a way. Most people nowadays still don't know what goes on inside the computer that they use every day. It's a black box - opaque. They rely on the Geek Squad and other professionals to help them out. It makes sense. Can't really expect most people to take the time to learn the subject or even want to. Should they care whether their SW runs on C++ or Python, or what the internal object-oriented class structure of Microsoft Excel is, or whether the website they are looking at is XHTML compliant? Heck no!
Similarly, most people don't know anything about markets; don't want to learn, don't want to take the time, don't have the interest. And maybe they shouldn't. But they are told they need to invest for retirement. As so-called retail investors they depend on financial consultants, fee-based planners, and such to tell them what to do. Often they get self-serving or become too loaded with fees (spec-listers who provide these services excepted).
So I think that the simple advice that I give, of buying broad-based index ETFs like SPY and IWM and something like FUNDX, while certainly less than perfect, and certainly less profitable than managing your own investments full-time, is really suitable for many people who don't really have the inclination, time, or ability to investigate the significant issues for themselves or sort out the multitudes of conflicting opinions put forth by the financial media.
You may not achieve the theoretical maximum returns (no one does), but you will benefit from the upward drift in prices and your blended costs will be reasonable. And it's better than the cash and CDs that a lot of people still have in their retirement accounts.
BTW: FOMA = Foma are harmless untruths, intended to comfort simple souls.
An example : "Prosperity is just around the corner."
I'm not out to defend FUNDX, I have nothing to do with them. I'm just happy with it.
Steve Ellison writes:
One might ask what the purpose of trends is in the market ecosystem. In the old days, trends occurred because information disseminated slowly from insiders to Wall Streeters to the general public, thus ensuring that the public lost more than it had a right to. Memes that capture the public imagination, such as Nasdaq in the 1990s, take years to work through the population, and introduce many opportunities for selling new investment products to the public.
Perhaps some amount of trending is needed from time to time in every market to keep the public interested and tossing chips into the market. I saw this statement at the FX Money Trends website on September 21, 2005: "[T]he head of institutional sales at one of the largest FX dealing rooms in the US … lamented that for the past 2 months trading volume had dried up for his firm dramatically because of the 'lack of trend' and that many 'system traders' had simply shut down to preserve capital."
I saw a similar dynamic recently at a craps table when shooters lost four or five consecutive points, triggering my stop loss so that I quit playing. About half the other players left the table at the same time. "The table's cold," said one.
To test whether a market might trend out of necessity to attract money, I used point and figure methodology with 1% boxes and one-box reversals on the S&P 500 futures. I found five instances in the past 18 months in which four consecutive reversals had occurred and tabulated the next four points after each of these instances (the last of which has only had three subsequent points so far). The results were highly non-predictive.
Starting Next 4 points
Date Continuations Reversals
01/03/06 3 1
05/23/06 1 3
06/29/06 2 2
08/15/06 2 2
01/12/07 1 2
Anthony Tadlock writes:
I had intended to write a post or two on my recent two week trip to Cairo, Aswan, and Alexandria. There is nothing salient to trading but Egypt seems to have more Tourist Police and other guards armed with machine guns than tourists. It is a service economy with very few tourists or middle/upper classes to service. Virtually no westerners walk on the streets of Cairo or Alexandria. I did my best to ignore my investments and had closed all my highly speculative short-term trades before leaving for the trip.
While preparing for taxes I was looking over some of my trades for last year. Absolute worst trade was going long CVS and WAG too soon after WalMart announced $2 generic pricing. I had friends in town and wasn't able to spend my usual time watching and studying the market. I just watched them fall for two days and without looking at a chart, studying historical prices and determining how far they might fall, decided the market was being stupid and went long. Couldn't wait to tell my visitors how "smart" a trader I was and my expected profit. It was fun, until announcement after announcement by WalMart kept causing the stocks to keep falling. The result was panic selling near the bottom, even though I had told myself before the trade that I could happily buy and hold both. Basically, I followed all of Vic's rules on "How to Lose."
Trends: If only following a trend meant being able to draw a straight line or buy a system and buy green and sell red. The trend I wrote about several months ago about more babies being born of affluent parents still seems to be intact. I have recently seen pregnant moms pushing strollers again. Planes to Europe have been at capacity my last two trips and on both trips several crying toddlers made sleep difficult, in both directions. Are people with young children using their home as an ATM to fund a European trip? Are they racking up credit card debt that they can't afford? Depleting their savings? (Oh wait - Americans don't save anything.) If they are, then something fundamental has changed about how humans behave.
From James Sogi:
My daughter the PhD candidate at Berkeley in bio-chem is involved in some mind-boggling work. It's all very confidential, but she tried to explain to me some of her undergrad research in words less than 29 letters long. Molecules have shapes and fit together like keys. The right shape needs to fit in for a lock. Double helices of the DNA strand are a popular example, but it works with different shapes. There is competition to fit the missing piece. They talk to each other somehow. One of her favorite stories as a child was Shel Silverstein's Missing Piece. Maybe that's where her chemical background arose. Silverstein's imagery is how I picture it at my low level.
Looking at this past few months chart patterns it is impossible not to see the similarity in how the strands might try fit together missing pieces in Wykoffian functionality. The math and methods must be complicated, but might supply some ideas for how the ranges and strands in the market might fit together, and provide some predictive methods along the lines of biochemical probability theory. I'll need some assistance from the bio-chem section of the Spec-list to articulate this better.
From Kim Zussman:
Doing same as Alex Castaldo, using SPY daily change (cl-cl) as independent and FUNDX as dependent gave different resluts:
Regression Analysis: FUNDX versus SPY ret, SPY-1, SPY-2
The regression equation is FUNDX = 0.000383 + 0.188 SPY ret - 0.0502 SPY-1 - 0.0313 SPY-2
Predictor Coef SE Coef T P
Constant 0.000383 0.00029 1.35 0.179
SPY ret 0.187620 0.03120 6.01 0.000* SPY-1 -0.050180 0.03136 -1.60 0.110 SPY-2 -0.031250 0.03121 -1.00 0.317 *(contemporaneous)
S = 0.00970927 R-Sq = 3.2% R-Sq (adj) = 3.0%
Perhaps FUNDX vs a tradeable index is the explanation.
Volatility is life and stability is rigor mortis. The only time markets are without volatility is when they are dead or administered. Free markets were created to break the stranglehold of price fixing in markets controlled by oligopolies, monopolies, and government. When Chicago created futures markets, each market shifted one by one from being administered to becoming efficient, cum volatility.
January 4, 2007 | 1 Comment
Recent evidence and posts to this site suggest there may be ’stars’ who obtain consistent out performance. We believe that some of these “stars” obtain their success from rigorous quantitative approaches. There may be other explanations for other investors. Since risk is such an important and enduring focus of this group the following may serve as a basis for some new directions of thought on the subject.
The term “power elite” was coined by C. Wright Mills (and later used by Noam Chomsky) to describe a conspiracy-type theory of how the direction of the US economy and polity is driven. The elite who make up this power structure are neither monolithic nor constant in the US, nonetheless they exist and confer and it is from amongst their number that many leadership roles are filled. The newly wealthy, powerful and brilliant are invited to join the circles.
In matters of this earth the working assumption of the “power elite” is that everything of consequence is knowable. The perception of risk, therefore is a form of admitted ignorance. Consequently the realization of risk is optional and avoidable if ignorance can be overcome. If we proceed from this assumption then the experience of risk, as opposed to the initial assessment of risk, possibly can be reduced to zero if you pick your spots. Zero risk might be achieved through hard research. But the preferable and quickest method of the “power elite” is to buy information and/or obtain quid pro quo — giving the appearance of doing a lot of research may be just cover. Once the essential knowledge is obtained positions in the market can be taken with confidence. The only risk remaining, which is statistical, is the noise associated with how the market will react to the order flow and the ultimate announcement of the development that is being exploited. All this works until, from time to time, the rules of the market change requiring the innovation of new methods and new sources.
The ability of any one person or group within the “power elite” to consistently succeed over time and across changing rule regimes is not guaranteed. It takes work. The cunning of competitors, hubris, fatigue, and possibly legal enforcement may do in the previously successful.
If this model operates selectively within markets then it suggests that risk is optional for some classes of investors because they are able to exploit unique sources of information which transform risk into reward directly. These are people who count but don’t count.
I thought I was exempt from hitting Deer until a few years ago. For 15 years I drove nearly weekly (300 miles round trip) on the Taconic parkway (no fencing, always surrounded with woods, no gas stations) to and from my Mass. country house. I am a speedy driver but extremely vigilant for all the telltale signs of danger. It was snowing and there was snow pack on the road and 4′ foot snow embankments along the side. Nonetheless, three years ago, an adult deer leapt over a snow bank and landed in front of me. There was no possibility to avoid hitting him. Now here is the key to survival (I read about this maneuver years earlier and had rehearsed it mentally several times).I avoided swerving, braked (got down to about 45mph), then eased off the brake as I was about to hit him to get the nose of my Volvo cross country back up — this is to prevent him sliding up the hood and come through the windshield. I hit him square; split him open, and propelled him ahead. A trooper came by. We pulled the carcass off to the side and, yes, the Volvo survived with only one headlight out and I continued the next 120 miles home. There is no doubt luck helped as well. And, the AWD was also equipped with four studded winter tires; that helped too.
Rod Fitzsimmons Frey adds:
When my brother was 17, he had a season pass to a ski hill about 3.5 hours drive from our home. He would drive there every Friday and return every Sunday night with his friend who also had a season pass. They were in a Chevy Sprint.
Being 17, they were foolish. One of the games they played to pass the time was: sometimes when they were passing a car on the fairly deserted highway one or the other would yell “DUCK!”, whereupon both would duck below the dashboard for three seconds or so, just as they passed the other car. In their imagination, the other driver would see a driverless car passing on the highway. Great fun.
In any event, one Sunday they were driving back about 11pm. My brother’s friend catches a glimpse of a running moose out of the corner of his eye. “DUCK!” Because of this foolish game, reflexes take over, and they both duck under the dash as the moose shears off the top of the Sprint. Both boys unhurt: car now completely lacking any metal above the windshield wipers.
November 14, 2006 | Leave a Comment
Hedge Manager Is Almost Famous
By LANDON THOMAS Jr.
Published: November 14, 2006
Managers of billion-dollar hedge funds do not usually drive Hondas — except at Goldman Sachs, that is. Traders at Wall Street investment banks are now priming themselves for another big bonus haul this year. And Raanan A. Agus, the manager of one of Goldman's largest internal hedge funds, and the owner of a Honda minivan, will be in line for one of the richer paydays.
This puffpiece on a Goldman trader in today's New York Times lacks a discernable "news peg". Anyone have a theory as to why the agenda-driven broadsheet would run a story like this?
Gregory van Kipnis replies:
NYT does human interest stories, usually about the downtrodden. However, perhaps the angle is that there have been so many stories about hedgefund types who live rich, conspicuous (and sometimes dishonest) lives they (Goldman Sachs) felt it is time to show a counterexample to minimize public backlash.
Eliza Bethan adds:
There is a new TV soap-opera/series that will stereotype hedgefund managers. Among the images to be broadcast are self-praising or youthful managers with advanced degrees, arrogance in winning at all costs, overcoming defeats and obstacles, and of course media stardom, all with a lack of humility and humor…
The US is six-for-six for the prize so farr, which means the Literature prize will go the the North Korean press release describing the "happiness caused by the bomb test."
Economics goes to "expectations-weighted Phillips Curve" dude. An odd choice, since a Phillips by any other name still a Phillips… Once you introduce expectations into economics you get its bastard child: finance!
Gregory van Kipnis replies:
The 'new' Phelps isn't like the one we remember, the 'old' Phelps, who wrongly theorized that inflation was inversely related to unemployment.
I especially like the way Phelps balances Rawlsian theories of social justice for the least advantaged with the injustice of depriving entrepreneurial types of their need for self-expression. Should a society be limited by serving the needs of the least at the expense of the best, or does it not follow that by bringing out the best from the best, all of society, including the least, benefit?
Prof. Adi Schnytzer adds:
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